The IRS released two pieces of favorable guidance on Friday, December 22, 2023, clarifying the definition of contract research and identifying automatic changes in accounting methods for the 2023 taxable year in relation to Section 174 research and experimental (“R&E”) expenditures. While taxpayers are still waiting for Congress to pass legislation allowing immediate expensing of Section 174 research and experimental expenditures, the IRS clarification may provide some relief for software development or research activities under a contract arrangement.
Contract Research Definition Clarified
Under Notice 2023-63 provided in September of 2023, the IRS confirmed that R&E expenditures include not only the costs paid or incurred by the taxpayer for research or experimentation undertaken directly by the taxpayer but also expenditures paid or incurred for R&E carried out on their behalf by another person or organization. The IRS’s original clarification surrounding contract research was extremely broad, stating contract research is deemed to be provided if:
- The contract researcher bears financial risk under the contract terms; or
- The contract researcher has a right to use any resulting R&E products in their trade or business or otherwise exploit any resulting R&E products through sale, lease, or license.
Under the original guidance, the only exception for contract researchers to not be deemed using or exploiting R&E was if the contract researcher obtained approval from another party to the research agreement unrelated to the contractee.
Based on this broad definition, many software development or research contracts were deemed Section 174 R&E expenditures as the research provider retained some right to use the product, either because the R&E was needed in order to conduct the contract research or because, as part of the contract negotiations, there was an agreement that any know-how discovered could be retained by the contract researcher for future use. The IRS interpretation could require R&E expenditures to be classified as Section 174 capitalized costs at both the contractor and contractee level.
Based on the interim definition, governmental contract research facilities were required to capitalize their contract R&E expenditures, generate taxable income, and make required federal cash tax payments. In addition, the governmental grants received for contract research often do not allow any of the governmental funds to be utilized to pay taxes.
Under Notice 2024-12, the IRS clarified that:
- If the contract researcher does not bear financial risk; and
- Obtains an excluded product right.
The R&E expenditures will not be deemed Section 174 R&E expenditures.
An excluded product right includes a product right that is:
- Separately bargained for by the contract researcher (a product right that arose from consideration other than the cost paid or incurred by the research provider to perform the R&E expenditures); or
- Was acquired for the limited purpose of performing R&E activities under that contract or another contract with the contractee.
Based on this modified guidance, contract researchers should review their legal documents carefully to determine whether they can fall under the excluded product right exception and most likely immediately expense the R&E activity as a trade or business expense.
Until the proposed regulations are published, taxpayers can rely on the excluded product right exception for R&E expenditures paid or incurred in the taxable years beginning after December 31, 2021.
Method of Accounting
Many have been waiting for clarification surrounding the IRS administrative procedures that should be followed in order to adjust 2022 federal taxable income to follow the IRS interim guidance provided in Notice 2023-63 and, more recently, Notice 2024-12. A change in a federal income tax accounting method generally requires the Commissioner’s consent by filing a Form 3115 and must be filed in the year the taxpayer wants the change to be reflected. However, automatic changes in accounting methods can be filed on Form 3115 and are not due until the extended due date of the tax return.
Rev. Proc. 2024-9, provides procedures that allow taxpayers to obtain automatic consent to change their method of accounting for expenditures paid or incurred in tax years beginning after December 31, 2021, due to the interim IRS guidance issued. The Revenue Procedure specifically allows for an automatic change in the method of accounting when adjusting R&E expenditures that were previously capitalized under Section 174 and are no longer considered Section 174 R&E expenditures due to the most recent IRS guidance. For the identified Section 174 automatic method changes, the general rule that a change cannot occur again within five years has been waived. Therefore, taxpayers who filed a statement with their 2022 tax return regarding a Section 174 R&E automatic change in method of accounting can still request an automatic change in method of accounting on their 2023 tax return.
If a taxpayer did not attempt to adjust for Section 174 R&E expenditures in relation to their 2022 taxable year, the taxpayer could still file an automatic method change for the 2023 taxable year. However, no audit protection will be provided for Section 174 R&E expenditures that were ignored in the 2022 taxable year. However, if a taxpayer did attempt to capitalize Section 174 R&E expenditures in 2022, a 2023 automatic method change would receive audit protection for the 2022 taxable year.
The newly issued IRS guidance is welcomed, but the impact is limited to designated areas of the research industry. The overall hope should still be for Congressional leaders to recognize the importance of Section 174 R&E immediate expensing and pass a tax extender bill in the next few weeks.
This article was originally published by Lynn Mucenski Keck in Forbes on January 2, 2024.
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