September 14, 2023
New IRC Section 174 guidance addresses disposition, retirement and abandonment of SRE property
In its recent guidance on the cost recovery of SRE expenditures under IRC Section 174 (Notice 2023-63, the Notice), the IRS outlines two rules on how to apply the amortization deduction to unamortized SRE expenditures for SRE property, if that property is disposed, retired or abandoned when a corporation ceases to exist. The IRS also addresses the treatment of SRE expenditures in certain specific transactions, including:
Taxpayers are not required to apply the rules in Notice but may apply them for tax years beginning after December 31, 2021, provided they rely on all the rules and apply them consistently. For a discussion of the entire Notice, see Tax Alert 2023-1526.
The Tax Cuts and Jobs Act (TCJA) added a new sub-section (d) to IRC Section 174, which prevents taxpayers from deducting SRE expenditures upon the disposition, retirement or abandonment of property for which those SRE expenditures are paid or incurred. Therefore, taxpayers generally cannot recover costs before the end of the applicable IRC Section 174 amortization period.
Impact of corporate cessation on unamortized SRE expenditures
Section 7.04 of the Notice provides two special rules on the disposition, retirement, or abandonment of SRE property when a corporation ceases to exist. Which of these mutually exclusive rules should apply turns on whether the cessation arises in a transaction described in IRC Section 381(a).1
If a corporation ceases to exist for federal income tax purposes in a transaction or series of transactions described in IRC Section 381(a), the acquiring corporation will continue to amortize the distributor or transferor corporation's unamortized SRE expenditures over the remainder of their' applicable IRC Section 174 amortization period, beginning with the month of transfer. Thus, the transferee or distributee inherits the ongoing amortization of the SRE expenditures even though IRC Section 174 amortization is not an inheritable attribute listed in IRC Section 381(c).2
To illustrate this point, the Notice includes the following example:
Company X, an accrual method, calendar-year taxpayer, incurs SRE expenditures in 2023 for research performed in the United States. On October 16, 2025, Company X is acquired by Company Z, an accrual-method, calendar-year taxpayer, in a transaction described in IRC Section 381(a).
In 2025, Company X amortizes a portion of the remaining, unamortized SRE expenditures, and Company Z also amortizes a portion of the remaining, unamortized SRE expenditures. In 2026 through 2028, Company Z ratably amortizes the remaining SRE expenditures.3
Under Section 7.04(2)(a) of the Notice, a corporation that ceases to exist for federal income tax purposes in a transaction or series of transactions to which IRC Section 381(a) does not apply may deduct the unamortized SRE expenditures in its final tax year. This does not apply, however, if a principal purpose of these transactions is to claim a deduction for the unamortized SRE expenditures.4
The Notice illustrates how its operative rules apply in certain transactions by way of example. Significantly, these examples make clear that the SRE expenditures are separate from the SRE property:
Company X, an accrual-method, calendar-year taxpayer, incurs SRE expenditures in 2023 for research performed in the United States. On September 30, 2025, Company X sells the SRE property to Company Y and recognizes gain under IRC Section 1001. In 2025 through 2028, Company X ratably amortizes the remaining, unamortized SRE expenditures, notwithstanding Company X's disposition of the SRE property.
Company Y does not amortize any portion of the SRE expenditures originally paid or incurred by Company X. Company X does not factor its unamortized SRE expenditures into the computation of gain or loss under IRC Section 1001.5
In the following example, the Notice also illustrates where the disposition of SRE property occurs in an IRC Section 351 transaction:
Company X, an accrual-method, calendar-year taxpayer, incurs SRE expenditures in 2023 for research performed in the United States. On September 30, 2025, Company X transfers the SRE property to Company Y in an exchange described in IRC Section 351. In 2025 through 2028, Company X ratably amortizes the remaining, unamortized SRE expenditures notwithstanding Company X's disposition of the SRE property.
Company Y does not amortize any portion of the SRE expenditures originally paid or incurred by Company X.6
As noted in the implications section, this example is important because it presumably extends to similar provisions, such as IRC Section 361.
Requests for comments
Section 11 of the Notice requests comments on numerous areas that were and were not covered in the Notice. The sole request regarding Section 7 centers on partnership transactions and anti-abuse considerations. Based on the comments requested, it appears the IRS believes it has properly addressed any subchapter C considerations around dispositions, retirements and abandonments of SRE property.
Notice 2023-63 makes clear that disposing of SRE property does not accelerate the deduction of the transferor's unamortized SRE expenditures, nor does it permit the use of the unamortized SRE expenditure in computing the transferor's gain or loss on the transfer. The Notice also makes clear that a transferee may succeed to unamortized SRE expenditures under IRC Section 381(a).
Aside from these clear, mechanical results, some key transactional implications arising from IRC Section 174(d), and the Notice's elaboration of them in Section 7, all trace to a single dynamic: the separation of the SRE expenditure amortization from the SRE property. This separation approach contrasts starkly with the pre-TCJA treatment of amortizable SRE expenditures,7 under which unamortized SRE expenditures were reflected in the basis of the SRE property.8 The following discusses some significant implications of this separation.
Divisive D transactions
For SRE property contributed by a distributing corporation to a controlled corporation under IRC Section 361 in a divisive transaction described in IRC Sections 368(a)(1)(D) and 355 (i.e., a "divisive D transaction"), it would appear the prior IRC Section 351 example provides a close analogy. Applying this example, the distributing corporation would continue to amortize all the remaining SRE expenditures even though the controlled corporation holds some or all of the underlying SRE property. This contrasts with the IRS's historic treatment of these expenditures.9
Relatedly, the Notice implicitly rejects an alternative reading of IRC Section 174(d), specifically that an allocation of the unamortized SRE expenditures is permissible because the transferor is not claiming a current "deduction … on account of such disposition" but instead the transferor and transferee are merely continuing to amortize them. Although it is unclear what the drafters of IRC Section 174(d) may have intended,10 such an interpretation would be plausible, although the Notice suggests otherwise.
The request for comments in Section 11 of the Notice does not refer to divisive D transactions. Thus, it appears the IRS believes no substantial issue remains on this topic.
The separation of the SRE expenditure amortization from the SRE property would appear contrary to the general, and principal, accounting method goal of clear reflection of income (which includes avoiding artificial mismatches of income and deduction). For instance, in Revenue Ruling 95-74, the location of a deduction of a contingent liability assumed in an IRC Section 351 transaction turned on whether the transferee succeeded to the underlying business assets from which the contingent liability arose. Separating the SRE expenditures from the SRE property in an IRC Section 351 (or IRC Section 361) transaction arguably is inconsistent with clear-reflection-of-income principles because the SRE property may generate income attributable to the SRE expenditures.
As another example, consider the implications of the sale of a US target in a transaction in which an IRC Section 338(h)(10) election is made. Under IRC Section 338(h)(10), the US target is generally treated as selling its assets in a transaction that is characterized as an IRC Section 1060 applicable asset acquisition followed by an IRC Section 332 liquidation, which results in the following:
In the context of the clear-reflection-of-income standard, the Notice appears to permit greater distance between the location of the SRE expenditure incurrence and the SRE property. The same is true for other transactions treated as taxable asset sales followed by an IRC Section 332 liquidation (see, for example, Revenue Ruling 69-6).
In the consolidated return context, the separation of SRE expenditures from SRE property may produce unusual consequences. For example, if consolidated group member S sells SRE property to consolidated group member B at no gain or loss, the SRE expenditure amortization will remain in S and will reduce the S stock basis under Treas. Reg. Section 1.1502-32(b)(3)(i) as the amortization occurs. The B stock basis, however, is not adjusted, even though B's prospective income or loss from the SRE property may be attributable in varying degrees to the SRE expenditures.11
As noted previously, a corporation may generally deduct the unamortized SRE expenditures in its final tax year if it ceases to exist in a non-IRC Section 381(a) transaction. Section 7.04(2)(B) of the Notice, however, contains an anti-abuse rule that overrides the general rule if a principal purpose of the transaction is to claim a deduction for the unamortized SRE expenditures. Under the anti-abuse rule, as currently drafted, the IRS would completely disallow the otherwise permitted recovery of unamortized SRE expenditures under Section 7.04(2)(a) if it determined the corporate cessation transaction had, as a principal purpose, the claiming of a deduction for those expenditures.
Given that this rule applies outside of IRC Section 381(a) transactions and that the corporation's existence has ceased, there seems to be no further opportunity for the SRE expenditures to be recovered, despite the continued existence of the SRE property in the tax system. This would permanently distort the ceased corporation's lifetime income (i.e., it incurred actual, recoverable economic expenses, which were permanently denied). Hopefully, the IRS will revisit this decision under its request for comments in Section 11.01(4) of the Notice ("What, if any, changes to the rules in section 7 … are appropriate to address potential abuses?").
Treatment as basis or as a deferred expense
As noted previously, it is unclear whether SRE expenditures are considered basis in a separate intangible or a deferred expense. Treatment of the SRE expenditures as basis or as a deferred expense may have implications for other Code provisions. For example, treatment as basis or as a deferred expense can have implications under IRC Section 382 for determining whether a loss corporation has a net unrealized built-in gain or net unrealized built-in loss and whether the SRE expenses are treated as recognized built-in deductions, which may be limited by IRC Section 382.12
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
1 IRC Section 381(a) generally applies to a liquidation under IRC Section 332 or a reorganization under IRC Section 368(a). The application of Section 7.04 of the Notice does not turn on whether there is gain recognition in the transaction (e.g., an IRC Section 368(a) reorganization in which the target shareholder recognizes gain due to the receipt of cash or other property nevertheless is an IRC Section 381(a) transaction).
2 See Notice 2023-63, Section 7.04(1). Cf. IRC Section 381(c)(6) (carryover of depreciation allowance); IRC Section 381(c)(9) (carryover of bond amortization allowance); IRC Section 197(f)(2) (carryover of intangible amortization allowance).
3 See Notice 2023-63, Sec. 7.05(2).
4 See Notice 2023-63, Sec. 7.04(2)(b). This result contrasts with such seminal cases as Granite Trust v. United States, 238 F.2d 670 (1st Cir. 1956) (taxpayer permitted to undertake planning to qualify a liquidation under IRC Section 331 in order to realize a stock loss).
5 See Notice 2023-63, Section 7.05(1)(b). See also Notice 2023-63, Sec. 7.05(1)(c) (providing the same result where the sale of SRE property is part of an applicable asset acquisition under IRC Section 1060(c).
6 See Notice 2023-63, Section 7.05(1)(d).
7 See e.g., Tony Brown and Mary Duffey, Treatment of R&E Expenses in Asset Dispositions, Tax Notes (July 31, 2023) (noting this significant departure from prior law and suggesting that a more reasonable approach would be a rule similar to the loss disallowance rules in IRC Section 197(f)(1), which prohibits taxpayers from recognizing a loss upon the disposition of certain intangibles and, instead, requires them to amortize the loss over the remainder of the 15-year amortization period).
8 Cf. H.R. Rep. No. 115-409, 115th Cong., 1st Sess. (Nov. 13, 2017) ("In the case of retired, abandoned, or disposed property with respect to which specified research or experimental expenditures are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period."). The reference to "remaining basis" is unclear; despite the implication in the legislative history, the text of IRC Section 174(d) does not appear to contemplate the SRE expenditures being added to basis (e.g., under IRC Section 1016, which was not revised in the TCJA with respect to IRC Section 174(d)), so this language may be a non-technical description of the cost recovery dynamic under IRC Section 174(d) (e.g., that the SRE expenditures are reflected in an "account" rather than in one or more specific items of property). Cf. IRC Section 174(a)(2)(A) (treating SRE expenditures as chargeable to a capital account; however, the language of IRC Section 174(d) and in Section 7 of the Notice is at odds with the attachment of SRE expenditures to basis as basis ordinarily would be recovered, in some fashion, at the time of disposition in a recognition transaction).
Before the TJCA, IRC Section 174(b) permitted elective amortization of SRE expenditures, with IRC Section 1016(a)(14) and Treas. Reg. Section 1.1016-5(j) regarding such expenses as basis (i.e., connected to the SRE property through its capital account). Similarly, IRC Section 59(e) permitted (and arguably still permits) an election to capitalize and amortize SRE expenditures, with IRC Section 1016(a)(20) regarding these expenses as basis in the SRE property. See also PLR 200117006 (January 17, 2001) (ruling that IRC Section 59(e) expenses are treated similarly to former IRC Section 174(b) deferred expenses and should be charged to capital account as an adjustment to the basis of the property to which they relate). Note that Treas. Reg. Section 1.1016-5 was issued before IRC Section 59(e)'s enactment and is therefore silent on the capital account consequences thereof.
9 See PLR 200812005 (December 11, 2007); PLR 201033014 (May 13, 2010); and PLR 201308002 (October 25, 2012), each of which provided for an allocation of unamortized SRE expenditures between the distributing and controlled corporations in the case of an IRC Section 59(e) election. Cf. PLR 200117006 (ruling that taxpayers can take into account the former IRC Section 174(b) and IRC Section 59(e) basis in determining gain or loss upon the disposition of property in a taxable transaction).
10 See footnote 8, supra.
11 It does not appear the attribute redetermination rule of Treas. Reg. Section 1.1502-13(c)(1)(i) would apply to alter this result. For instance, Treas. Reg. Section 1.1502-13(c)(1)(i) only affects "attributes," which do not include the location or amount of an item; thus, the relocation of any portion of S's amortization to B is beyond the scope of Treas. Reg. Section 1.1502-13(c)(1)(i).
12 Nick Gruidl, Eric Braurer and Joseph Weiner, Unamortized Research Costs and Loss Corporations, Tax Notes (May 22, 2023). Other provisions potentially impacted by the uncertain basis status include IRC Section 357(c) (excess liability assumptions), IRC Section 361(b)(3) (basis ceiling on creditor transfers) and IRC Section 362(e) transfers (loss importation/duplication transactions).