Desired Changes to Section 174 Research Expense Rule Left Off Final Bill of 2022

The Consolidated Appropriations Act, 2023 (CAA), created to fund the government through the fiscal year ending Sept. 30, 2023 is working its way through Congress. Notably absent from the bill are changes to Section 174 rule requiring the capitalization and amortization of research and experimentation (R&E) expenses.

There was hope that changes would be made to the rule that took effect at the beginning of this year, and the topic of Section 174 has been top of mind for business owners throughout. Without changes, the current Section 174 rule will be relevant for the 2022 tax filing season.

Section 174 explained

Prior to the enactment of the Tax Cuts and Jobs Act, Section 174 expanded the deduction rules for those incurring expenditures while conducting research and experimentation. Until 2022, taxpayers had the option to immediately deduct R&E expenditures or elect to capitalize and amortize them over periods of time. Many of those expenditures could have also qualified for Research and Development (R&D) Tax Credit under Section 41.

Section 174 was altered under the Tax Cuts and Jobs Act, and the effective date was set for several years later. As of 2022, R&E expenditures are required to be capitalized and amortized over five years for expenditures incurred in the U.S. or 15 years for those incurred outside the U.S. The shift alters the original structure of the rule and can increase current-year taxable income by deferring deductions to later years.

Contrary to most items within the Tax Cuts and Jobs Act (TCJA), which reduced tax rates and expanded deduction opportunities, Section 174 was unfavorable to taxpayers and was estimated to raise $120 billion of revenue over its first six years.

Hopes for retroactive changes

While retroactive modifications are possible, the legislative process is much more complicated. Any legislation would need to be completed as part of a bipartisan effort due to Republican control of the House and Democratic control of the Senate. Tax season is also rapidly approaching in early 2023, adding to the challenge of making any retroactive changes.

IRS guidance on amortization of R&E expenditures

As CAA was being finalized, the IRS released Rev Proc. 2023-08, simplifying the procedure for implementing an accounting method change in Section 174 from the TCJA. Simplifications included:

• Form 3115, Application for Change in Accounting Method no longer required: Taxpayers can adopt the new required capitalization of R&E expenditures by attaching a statement to their return for the 2022 tax year. The IRS provided additional details about the contents of such a statement in the Revenue Procedure.
• Special transition rule: Tax returns for 2022 that are filed before January 10, 2023, will be deemed to have been compliant with the Revenue Procedure so long as the R&E expenditures were properly reported on Form 4562, Part IV.

The simplifications outlined in Rev. Proc. 2023-08 are welcomed by taxpayers, but the procedures within the guidance have been met with some criticism.

Critical planning required ahead of 2022 filing season

Whether your business has already identified costs subject to required capitalization for the upcoming filing season or waited in hopes of legislative changes, the coming weeks and months will be a crucial period for identifying the requisite expenditures and determining how they will impact taxable income for 2022. One mitigation strategy is an R&D Tax Credit claim, and businesses may want to explore the credit in 2023.