April 18, 2023
IRS revokes a long-standing revenue ruling on correcting missed deductions for R&E expenses
In Revenue Ruling 2023-8, the IRS obsoleted Revenue Ruling 58-74, 1958-1 C.B. 148, which allowed taxpayers to amend prior returns to correct missed deductions for R&E expenses under IRC Section 174. The new revenue ruling explained that "[t]he rational … for obsoleting Revenue Ruling 58-74 is independent of the removal of the expense method by the [Tax Cuts and Jobs Act] amendments to former [IRC Section] 174."
Revenue Ruling 58-74, which is very brief, was published in 1958, just four years after the enactment of IRC Section 174. The ruling allows taxpayers to amend their returns to correct an erroneous application of their method of accounting for IRC 174 expenses (i.e., their IRC Section 174 method of accounting). Under the ruling, a taxpayer deducting R&E expenditures on its return for the first tax year in which it pays or incurs R&E expenditures adopts the expense method under IRC Section 174 and is bound to use that method for "until it properly changes to another method.
Because the taxpayer adopted the expense method, Revenue Ruling 58-74 requires the taxpayer to "file a timely claim … or amended return and claim the additional research or experimental expenses for the year or years in which they were omitted"; amortizing R&E expenses that it failed to deduct on prior returns or charging them to a capital account are not options. "
General rationale for revoking Revenue Ruling 58-74
In explaining the rationale for obsoleting Revenue Ruling 58-74, the IRS stated that Revenue Ruling. 58-74 does not provide sufficient facts to properly analyze whether the taxpayer's failure to deduct certain R&E expenses constituted a method of accounting or an error. It also noted that Revenue Ruling 58-74 fails to describe the cause and extent of the taxpayer's deviation from its method of deducting other R&E expenses under IRC Section 174.
According to Revenue Ruling 2023-8, the IRS periodically obsoletes rulings when " (1) the applicable statutory provisions or regulations have been changed or repealed; (2) the ruling position is specifically covered by a statute, regulation, or subsequent published position; or (3) the facts set forth no longer exist or are not sufficiently described to permit clear application of the current statute and regulations." The last criteria appears to apply to the IRS's evaluation of Revenue Ruling 58-74.
Observation: While Revenue Ruling 2023-8 justifies Revenue Ruling 58-74's obsolescence on a failure to provide sufficient facts, Revenue Ruling 58-74 incorporates the only pertinent fact for properly analyzing whether the taxpayer's change in its treatment of R&D expenditures is a change in method of accounting or correction of an error: whether the taxpayer adopted the expense method for R&E expenditures. If it did, it must file a timely claim or amended return to claim the R&E expenses it failed to include in its deduction.
When adopted, the expense method applies to all R&E expenditures paid or incurred during the tax year. As such, the cause and extent of the taxpayer's failure to include all of its R&E expenses in its deduction for a tax year would not indicate that the taxpayer's deviation constitutes a method of accounting. IRC Section 174 and Treas. Reg. Section 1.174-3 (which is virtually unchanged since its original publication in 1957 (see T.D. 6255 (Oct. 3, 1957) and T.D. 6500 (Nov. 26, 1960)) indicate that adopting the expense method for IRC Section 174 expenses applies to all R&E costs paid or incurred in the tax year. The regulation states: "In no event will the taxpayer be permitted to adopt the method described in this section as to part of the expenditures relative to a particular project and adopt for the same [tax] year a different method of treating the balance of the expenditures relating to the same project." Treas. Reg. Section 1.174-3(a). Because a taxpayer's adoption of the expense method under IRC Section 174(a) applies to all R&E expenses, the taxpayer's correction of divergent treatment (e.g., missing expenses) should only be considered the correction of an error in applying the method and not a change in method of accounting.
Additional justification for revoking Revenue Ruling 58-74
The new ruling notes that a taxpayer must secure IRS consent to change its method of accounting, and determining whether a change in accounting treatment is a method of accounting or correction of an error "depends on the specific facts of a particular situation." The Treasury Department and IRS express concern, in Revenue Ruling 2023-8, that a taxpayer relying on Revenue Ruling 58-74 could be violating statutes, regulations, and procedures that prohibit changing a method of accounting on an amended return. These concerns appear to be further justification for obsoleting Revenue Ruling 58-74.
Observation: Because Revenue Ruling 58-74 applies only if the taxpayer adopted an IRC Section 174 method but failed to apply the adopted method to all eligible R&E costs, the application of Revenue Ruling 58-74 to a taxpayer properly applying an IRC Section 174 method to all eligible R&E costs should not conflict with method change rules.
Treatment as a change in method of accounting limits the taxpayer's ability to deduct such costs in the appropriate period(s) or take the change into account under IRC Section 481(a) in the year of the change due to the application of a "cut-off" approach required under applicable revenue procedures.
Effective date for Revenue Ruling 58-74's obsolescence
According to Revenue Ruling 2023-8, Revenue Ruling 58-74 is obsoleted as of July 31, 2023. Taxpayers may, however, rely on the ruling until that date if they are filing a claim for refund, amended return or an Administrative Adjustment Request, provided they are "(1) claiming a deduction for additional research or experimental expenditures to which the expense method under former IRC Section 174(a) is applicable for the taxable year or years in which they were improperly deferred or capitalized, [and] (2) otherwise using the expense method for such taxable year or years." The ruling notes that the IRS will challenge the applicability of Revenue Ruling 58-74 in appropriate circumstances (for example, if the taxpayer did not adopt the expense method under IRC Section 174(a)).
Implications: Although Revenue Ruling 58-74 has supported taxpayers' ability to correct errors in application without treating the change in treatment as a change in method of accounting, it is not the only authority that supports the use of amended returns to correct errors in application. Case law supports the same approach as described in Revenue Ruling 58-74 in analogous circumstances (see Gimel Bros., Inc. v. U.S., 535 F.2d 14 (Ct. Cl. 1967) (IRS non-acq. AOD 1967-345), Standard Oil Co. v. Comm'r., 77 T.C. 349 (1981) (IRS acq. in result only, 1989-1 C.B. 1), Northern States Power Co. v. Comm'r., 151 F.3d 876 (8th Cir. 1998)). As noted in Revenue Ruling 2023-8, the application of the principles in Revenue Ruling 58-74 depends on the particular taxpayer's facts and circumstances.
As the IRS has announced that it will challenge amended returns relying on Revenue Ruling 58-74, taxpayers should be prepared to demonstrate that they had a method of accounting of deducting IRC Section 174 costs in the tax year being amended. They should also be able to explain the cause and extent of their failure to include all R&E expenses in their deduction for the tax year being amended. Taxpayers with a fact pattern similar Revenue Ruling 58-74's should consider filing an amended return before July 31, 2023, to correct an erroneous treatment of their IRC Section 174 costs.
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor