Section 174 – What is the impact and how can it be mitigated?

By Jonathan Forman and Michael Bowman

Background

IRC §174 addresses the treatment of expenses incurred in research and experimentation activities (“R&E”) or what many of us describe as research and development (“R&D”).

This code section was introduced in 1954 and historically provided an incentive to taxpayers to conduct R&D by allowing a full deduction for R&D costs the year such amounts were incurred. Alternatively, taxpayers could choose to capitalize and amortize R&D costs under §174, treat R&D expenses under a different code section (like §59) or ignore them altogether.

The Tax Cuts and Jobs Act of 2017 (“TCJA”) modified §174. The rules now require costs that meet the definition of R&E under §174 to be accounted for under the rules of §174. Additionally, all costs incurred in connection with software development, regardless of complexity, use, or intent, must be treated as §174 expenses. Critically, the option to deduct such amounts was eliminated, meaning that all costs that meet the definition of R&E under §174 AND all software development expenses MUST now be capitalized.

This change is effective for tax years beginning after Dec. 31, 2021.

The numerical implications

The new rules require domestic R&D costs to be amortized over five years, and foreign R&D to be amortized over 15 years. In both cases, amortization must be calculated using a mid-year convention, meaning that taxpayers get half the benefit in the first year. The effect of this change can be significant and have a major impact on a taxpayer’s tax rate and tax horizon.

For illustrative purposes, assume company A has $10M in annual R&D costs. Prior to 2022, Company A would have deducted $2.1M on its tax return ($10M x 21%) every year. In 2022, however, Company A’s R&D spend creates a benefit (or deduction) of $210K ($10M x 20% x 0.5 x 21%). This is the equivalent of the taxpayer adding $9M of revenue to its tax return.

For organizations unprepared for the additional tax burden, the impact of this rule change can be significant. Many loss companies turning the corner that had forecasted becoming taxable far into the future are realizing that the future is now. For some, the impact is more dramatic as illustrated below.

Assume a technology start-up receives a Small Business Innovation Research (“SBIR”) grant of $2M to fund the development of an innovative treatment for a common medical condition. The company has no other income source. Under the old rules, the entire $2M would be deductible, and the company would offset $2M in grant revenue and not pay any federal tax. The entrepreneurs would conduct scientific research, and work to develop a product that could benefit society. Under the new rules, the same company will still have revenue of $2M but will have to amortize the expenses it pays for with the grant over six years. This would leave the company with a $378K tax bill that it could not pay.¹ Unfortunately, this fact pattern is not a theoretical one. Many companies are currently deciding whether to accept government grants (SBIR, STTR, etc.) or not because of the tax burden of §174 or are facing bankruptcy because the funding was already accepted and now they cannot pay the tax. Either way, innovation is stifled.

An increase in taxable income created by §174 can also impact other key calculations like FDII, GILTI, and BEAT; impact existing transfer pricing positions, cost sharing arrangements and IP rights; impact state taxes (and credits); and, change cash flow planning (estimated tax payments).

The linguistic implications

The TCJA did not revise the verbiage of §174 in a significant manner. The clarity or precision of the old rules was not overly important because of the flexibility inherent in the code section. However, the rigidity of the new rules has revealed major ambiguities – ambiguities that create real uncertainty in the proper treatment of costs.

§174 specifically states that R&D costs are “…research or experimental expenditures which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product.”.

¹ Income of $2M (grant) x 21% federal tax rate minus $42K of tax R&D expenses ($2M (R&D cost) x 20% (five-year amortization) x 50% (first year mid-year convention) x 21% (tax rate)).

It does not clearly define:

1. What expenditures are included

2. The meaning of “in connection”

3. What “trade or business” means in this context

Unlike IRC section 41 (R&D tax credit rules), it also does not differentiate between funded and non-funded research, nor whether or not an entity is part of a controlled group.

The pharmaceutical industry provides a good example of this ambiguity. In that industry, a common arrangement is for an entity to perform R&D on behalf of a related party on a “cost-plus” basis. The related party or funding entity often retains IP ownership and ultimately manufactures and markets any applicable commercial products.

In this case, the research entity pays employees, purchases supplies, bears overhead costs, and houses all the infrastructure needed to support the R&D. These are all costs “incident” to the R&D. The funding entity is paying for the R&D on a cost-plus basis, therefore also incurring costs incident to the R&D. So which entity can amortize R&D? Was the intent to have both parties amortize the R&D resulting in double capitalization inside the controlled group?

Potential positions

If we assume that Congress did not intend double capitalization, and in the absence of additional guidance, we must look to legislative history, and legal precedent for clues to a more reasonable position. The following is not an exhaustive analysis, but rather a simple example to demonstrate an alternative viewpoint.

Consider the terms “trade or business” and “product.”

As noted above, §174 requires the R&D expenditure to be incurred “in connection with the taxpayer’s trade of business” and “includes all such costs incident to the development or improvement of a product.”

Treasury Regulation §1.174-2(a)(3) defines a product as “any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license.” By this definition, for an expense to be included as a §174 expense, it must be related to the development or improvement of something that will either be used by the taxpayer’s trade or business, or sold, leased, or licensed by the taxpayer’s trade or business.

The term “trade or business” is more unclear, but judicial history² has consistently held that for a taxpayer to be able to treat expenses as R&E under §174, the taxpayer must intend to generate income from the results of the research (e.g., manufacture and/or sell a product resulting from the research). If there is no such intent, the research is not in connection with a trade or business.

Therefore, if an entity conducts research but does not use the result of the research within the business or has no intention of generating income from the fruits of the research, the research does not fall within the definition of R&E under §174.

Using this analysis, in the example above, the research entity would not have to amortize the expenses, but the related funding entity – the one that plans to manufacture and/or sell the results of the research – would have to amortize the costs. This approach appears far more reasonable than the alternative double taxation.

Where the R&D Tax Credit fits –the good news

The R&D tax credit under IRC Section 41 is another consideration. Historically, the credit has been linked to §174 because one requirement for includible expenses is that relevant amounts have to be of the kind that “may be treated” under §174. Now that the new rules require costs that meet the definition of R&E to be treated as §174, the result is that §41 costs will now have to be a subset of §174. The new requirement could and should lead to far more efficiency – including the possibility of a significant amount of automation – in calculating the credit.

Because the calculation of §174 expenditures is now mandatory, the costs making up the credit should be a secondary calculation. There should be far less “searching” throughout the organization for credit-eligible activity as it will now already be captured under mandatory capitalization.

Another quirk in the new rules is their relationship with §280(C). Although the details are beyond the scope of this article, the impact of amortization over deduction on the credit means that for all but a very few exceptions, taxpayers will be able to take the benefit of the full credit as opposed to the §280(C) reduced credit. This creates a 21% credit boost for most taxpayers.

Considering the tax impact of R&E amortization, any way to reduce the tax bill is welcome, and the credit is one of the best ways to do it.

Takeaways

There’s no way to sugarcoat it, the new §174 amortization requirement is not a good thing for taxpayers. The negative impact of the new rules may be mitigated in certain circumstances with the potential to implement an improved, automated process to calculate §174 and 41 costs, and use of the enhanced credit (and state credits) to help offset the additional tax.

Jonathan Forman is the managing director of the GTM global tax management's R&D tax credit services practice.

Michael Bowman is a director in GTM’s global tax management Ohio practice.

² See Lewin v Commissioner No. 02-1169 (Lewin v. Commissioner, IRS, 4th Cir. (2003), Levin v. Commissioner, 87-2 USTC Para. 9600, 832 F.2d 403 (7th Cir. 1987), Court Opinion, Kantor v. Commissioner of Internal Revenue (72 A.F.T.R.2d 93-5476, 93-2 USTC P 50,433), Scoggins v. Commissioner of I.R.S, 46 F.3d 950.