February 14, 2024 What the proposed changes to domestic research and experimental expenditures in H.R. 7024 mean for taxpayers' returns for tax years beginning after December 31, 2021
The Tax Relief for American Families and Workers Act of 2024 (H.R. 7024), which was recently passed by the US House of Representatives, would temporarily allow current deductibility, or elective capitalization, of domestic research and experimental expenditures. The bill would also:
New IRC Section 174A, its retroactive application, the permissive provisions allowing late elections and revocations, and the explicit and implied manners in which to apply the law retroactively would provide several opportunities and implications for taxpayers to consider. A more detailed discussion of the bill's provisions, opportunities and implications follows.
Section 201(a) of H.R. 7024 would delay the application of IRC Section 174, as amended by the TCJA (TCJA IRC Section 174), to domestic research and experimental expenditures paid or incurred in tax years beginning after December 31, 2025. Therefore, the requirement to capitalize and amortize domestic research or experimental expenditures paid or incurred in tax years beginning after December 31, 2021, would not apply. The TCJA provisions requiring taxpayers to capitalize and amortize foreign research or experimental expenditures paid or incurred in tax years beginning after December 31, 2021, would continue to apply. Implications: The different treatment for domestic and foreign research or experimental expenditures would require taxpayers to continue to track the recovery of research costs separately, depending on the location of the conduct of the research.
Section 201(b) of H.R. 7024 would establish new IRC Section 174A, which would apply to domestic research or experimental expenditures paid or incurred in tax years beginning after December 31, 2021. If enacted, IRC Section 174A would reinstate expensing of domestic research or experimental expenditures. Taxpayers could also elect to capitalize and amortize, or capitalize (but not amortize), those expenditures. Unlike TCJA IRC Section 174, IRC Section 174A would not contain a provision disallowing a deduction on account of disposition, retirement or abandonment. New IRC Section 174A(c) would mirror pre-TCJA IRC Section 174(b) by allowing taxpayers to elect to charge certain domestic research or experimental expenditures to a capital account and amortize those costs over at least 60 months (beginning in the month in which the taxpayer first realizes benefits from those expenditures). New IRC Section 174A(d) would also allow taxpayers to elect to charge domestic research or experimental expenditures to a capital account (without any provision for amortization). Elections under IRC Section 174A(d) would apply for all domestic research or experimental expenditures unless a taxpayer received approval from the Secretary to apply the election to only part of the year's expenditures. IRC Section 174A contains "special rules" that would exclude land acquisitions, land improvements, depreciable property and exploration expenditures from IRC Section 174A expenditures. The special rules also contain a specific provision to treat software development expenditures as research or experimental expenditures (similar to a provision under TCJA IRC Section 174). Observation: IRC Section 174A differs from pre-TCJA IRC Section 174 in two respects: first, IRC Section 174A would allow taxpayers to elect to treat domestic research or experimental expenditures as chargeable to a capital account; second, IRC Section 174 would include a specific provision on software development expenditures. The accounting treatment to charge research or experimental expenditures as chargeable to a capital account was the default accounting method for research or experimental expenditures that were neither (1) deducted under pre-TCJA IRC Section 174(a) in the year paid or incurred, nor (2) treated as capitalizable and amortizable under pre-TCJA IRC Section 174(b). See Treas. Reg. Section 1.174-1. The inclusion of the special rule in IRC Section 174A to treat software development expenditures as research or experimental expenditures would likely mean that taxpayers could not apply Section 5 of Revenue Procedure 2000-50, or make a method change for software development costs under Revenue Procedure 2000-50 (or Section 9 of Revenue Procedure 2023-24) to obtain any other accounting method treatment. See also Revenue Procedure 2024-9, which obsoletes Section 5 of Revenue Procedure 2000-50, and related Tax Alert 2024-0129. IRC Section 174A would apply retroactively to amounts paid or incurred in tax years beginning after December 31, 2021. For amounts paid or incurred in tax years beginning after December 31, 2025, IRC Section 174A would terminate. IRC Section 174A's termination and the reversion to treating domestic costs under TCJA IRC Section 174 would be treated as a change in method of accounting initiated by the taxpayer and authorized by the Secretary, applied on a cut-off basis. Implications: The retroactive effective date for IRC Section 174A means that a taxpayer that applied an accounting method to comply with TCJA IRC Section 174, for any tax year beginning after December 31, 2021, would be using an impermissible method of accounting for domestic research and experimental expenditures. Taxpayers that have not filed more than one tax return using that impermissible method of accounting for domestic research or experimental expenditures, however, have not adopted the impermissible method of accounting. See also Treas. Reg. Section 1.446-1(e)(2)(ii)(a) and Revenue Ruling 90-38; see also LB&I Concept Unit, General Rule for Methods of Accounting (Permissible v. Not Permissible), COR-C-033 (Jan. 2, 2023) and Internal Revenue Manual, Part 4.11.6.3. For information on how to address an impermissible method of accounting in these circumstances, see section 3 of this Alert.
Section 201(f) of H.R. 7024 would establish transition rules for Section 201's provisions. Section 201(f)(2) would allow certain taxpayers to elect to treat amendments made by Section 201 of H.R. 7024 as a change in method of accounting for the second tax year beginning after December 31, 2021. If elected, taxpayers would make the change in accounting method on a modified cut-off basis that takes into account the domestic research or experimental expenditures (as defined in IRC Section 174A) that are (1) paid or incurred by the taxpayer in its first tax year beginning after December 31, 2021, and (2) not allowed as a deduction in that year. Taxpayers could treat the amendments made by Section 201 of H.R. 7024 as a change in accounting method only if they had adopted an accounting method under TCJA IRC Section 174 for the first tax year beginning after December 31, 2021. The transition rules would also permit a taxpayer to elect to take the modified cut-off amount into account over two tax years, starting with the second tax year beginning after December 31, 2021. Implications: Treating the amendments as a change in method of accounting would help taxpayers that received other tax benefits from capitalizing and amortizing expenditures under TCJA IRC Section 174, in their first tax year beginning after December 31, 2021, as the IRC Section 481(a) adjustment takes into account "only the domestic research or experimental expenditures paid or incurred in the taxpayer's first taxable year beginning after December 31, 2021, and not allowed as a deduction." The specific language of this rule implies that any correlative adjustments that would be required to be made if a taxpayer amended its return for the first tax year beginning after December 31, 2021, would not be included in the IRC Section 481(a) adjustment that would be computed if the taxpayer filed a change in method of accounting. That is, the election to treat the statutory amendment as a change in method of accounting would allow taxpayers to accelerate the recovery of unamortized domestic research or experimental expenditures without disturbing the effect of capitalization and amortization of domestic research or experimental expenditures in the first tax year beginning after December 31, 2021. Section 201(f)(1) of H.R. 7024 would allow a taxpayer to make late elections to capitalize and amortize domestic research or experimental expenditures under IRC Section 174A(c) or capitalize (but not amortize) domestic research or experimental expenditures under IRC Section 174A(d) for a taxpayer's first tax year beginning after December 31, 2021. Section 201(f)(3) of H.R. 7024 would establish a late election under IRC Section 59(e) for certain taxpayers' first tax year beginning after December 31, 2021. IRC Section 59(e), as amended by Section 201(c)(3) of H.R. 7024, would allow taxpayers to elect to amortize otherwise deductible domestic research or experimental expenditures over 10 years. Section 201(f)(3) of H.R. 7024 would only allow taxpayers to make a late election to amortize domestic research or experimental expenditures under IRC Section 59(e) if they did not elect to treat the amendments made by Section 201 of H.R. 7024 as a change in method of accounting under Section 201(f)(2) of H.R. 7024. Although Section 201 of H.R. 7024 does not explicitly permit taxpayers to amend their returns to implement IRC Section 174A(a) for the first tax year beginning after December 31, 2021, the late IRC Section 59(e) election included under Section 201(f)(3) of H.R. 7024 implies that taxpayers could amend their returns to implement IRC Section 174A(a). Because of the specific cross references to IRC Section 174A(a) in the amendment to IRC Section 59(e) by Section 201(c)(3) of H.R. 7024, the late election to amortize domestic research or experimental expenditures under IRC Section 59(e) would only be possible if an eligible taxpayer could amend its return to apply IRC Section 174A(a) to domestic research or experimental expenditures. Similarly, taxpayers could infer from Section 201(f)(2) of H.R. 7024 (election for treating statutory amendments as a change in method of accounting) that not electing to treat the statutory amendments as a change in method of accounting would require them to amend their return to comply with the retroactive application of the law. Because a taxpayer is not treated as adopting an accounting method if the method was impermissible and applied on only one tax return, a taxpayer that applied an accounting method to comply with TCJA IRC Section 174 for only its first tax year beginning after December 31, 2021, and has not yet filed its second tax return on that same method, has not adopted a method of accounting. Taxpayers may generally amend a tax return to correct an impermissible method of accounting that has been applied for only one tax year. Implications for taxpayers with multiple short tax years beginning after December 31, 2021: Taxpayers that have already filed tax returns for more than one tax year beginning after December 31, 2021, should examine how the transition rules apply so they can understand what elections and method changes may be available or required given their specific facts. Section 201(f)(4) of H.R. 7024 would allow a late election (or revocation of an election) on an amended return for an eligible taxpayer's first tax year beginning after December 31, 2021, under IRC Section 280C(c)(2) (an election to take a reduced IRC Section 41 credit in lieu of reducing capitalized qualified research expenses). Implications: This provision of Section 201 of H.R. 7024 could allow taxpayers to recover 21% of a research credit claimed in the first tax year beginning after December 31, 2021, if they made a reduced credit election for that year under IRC Section 280C(c)(2). Some taxpayers were uncertain about Congress' intent in its conforming amendment to IRC Section 280C in the TCJA, which allowed most taxpayers to claim their entire computed IRC Section 41 credit without reducing the current year's amortization of qualified research expenses or the capitalized amount of qualified research expenses. Because of that uncertainty, some taxpayers elected to reduce their IRC Section 41 credit, even though it did not appear to be required under the amended language. Section 201(e)(4) of H.R. 7024 indicates that an amendment to IRC Section 280C(c)(2) by Section 201(c)(1)(B) of H.R. 7024 "shall not be construed to create any inference with respect to the proper application of Section 280C(c) for taxable years beginning before January 1, 2023." The amendment would require taxpayers to reduce the domestic research or experimental expenditures otherwise taken into account under IRC Section 174 or 174A by the amount of the IRC Section 41 credit, but not until tax years beginning after December 31, 2022. Taxpayers would have a limited time to make (1) a late election under IRC Section 59(e), (2) a late election (or revocation of an election) under IRC Section 280C(c)(2), or (3) an election to capitalize and amortize domestic research or experimental expenditures under IRC Section 174A(c) or capitalize (but not amortize) domestic research or experimental expenditures under IRC Section 174A(d). Taxpayers would need to make those elections on an amended return (for their first tax year beginning after December 31, 2021) during the one-year period beginning on the date of enactment. Implications for taxpayers with multiple short tax years beginning after December 31, 2021: The transition rules on making IRC Section 174A(c) or (d) elections, late elections for IRC Section 59(e), or late elections or revocations under IRC Section 280C(c)(2) would apply only to amended returns for the taxpayer's first tax year beginning after December 31, 2021. Therefore, taxpayers that have filed tax returns for multiple short tax years beginning after December 31, 2021, would potentially not be able to take advantage of the transition rules for any short tax year that occurs after their first tax year beginning after December 31, 2021.
Section 201(c) of H.R. 7024 would amend several other tax provisions referencing IRC Section 174 to either replace the reference with "section 174A" or "section 174A(a)" or add a reference to IRC Section 174A. The significant amendments are discussed below. Section 201(c)(1)(B) would amend IRC Section 280C(c)(1) to require that "domestic research or experimental expenditures otherwise taken into account under [IRC Section] 174 or 174A (as the case may be) shall be reduced by the amount of the credit allowed under [IRC Section] 41(a)." This amendment would be effective for tax years beginning after December 31, 2022. Therefore, the amendment would not change the statutory language in effect for tax years beginning after December 31, 2021, and before January 1, 2023, which requires taxpayers to reduce capitalized qualified research expenses only if their IRC Section 41 credit exceeds the qualified research expenses allowable as a deduction for the tax year. Observation: The amendment to IRC Section 280C(c) would remove current references to the tax treatment of the domestic research or experimental expenditures (e.g., "allowable as a deduction"; "chargeable to capital account"). It also would replace references to "qualified research expenses" with a reference to amounts "otherwise taken into account under section 174 or 174A." Taxpayers that did not elect to take a reduced IRC Section 41 credit for any tax year beginning after December 31, 2021, and before January 1, 2023, would not need to reduce domestic research or experimental expenditures by the amount of their credit, even if they amended their return for the first tax year beginning after December 31, 2021, to change their treatment of domestic research or experimental expenditures to conform with IRC Section 174A, unless the IRC Section 41 credit for that year exceeds the amount allowable as a deduction for the taxpayer's qualified research expenses for that year. Section 201(c)(3) would amend IRC Section 59(e)(2)(B) to remove the reference to "section 174(a) (relating to research and experimental expenditures)" and insert "section 174A(a) (relating to temporary rules for domestic research and experimental expenditures)." Implications: Although this amendment appears to only be changing the references from "section 174(a)" to "section 174A(a)," the change would affect the categories of research or experimental expenditures that are eligible for the IRC Section 59(e) election. The reference to "section 174(a)" does not distinguish between foreign and domestic research or experimental expenditures. The amended reference to IRC Section 174A would only allow domestic research or experimental expenditures to be treated as amortizable under an IRC Section 59(e) election, as expenditures deductible under IRC Section 174A(a) would be limited to "domestic research or experimental expenditures." Section 201(d)(1) of H.R. 7024 includes conforming amendments that would strike Section 13026(b) of the TCJA (relating to change in accounting method); Section 201(e)(3) of H.R. 7024 provides that the amendment "shall take effect as if included in [the TCJA]." Implications Taxpayers should consider modeling the implications of amending returns versus treating the changes made by H.R. 7024 as a change in method of accounting, as each option for complying with the retroactive reinstatement of current deductibility of domestic research or experimental expenditures has different consequences that may go beyond timing differences in cost recovery. Similarly, since IRC Section 174A would reintroduce optionality for deducting versus capitalizing domestic research or experimental expenditures, taxpayers should consider assessing what method of accounting for domestic research or experimental expenditures is likely to benefit them most in tax years beginning in 2022 through 2025. Although the Treasury Department and IRS will likely issue additional accounting-method-change guidance to implement the changes proposed by H.R. 7024, it is uncertain whether that guidance will mirror the method-change provisions in the current regulations (Treas. Reg. Sections 1.174-3 and -4). Taxpayers should carefully consider the new elective capitalization under IRC Section 174A(d), as they could only make the election for all of the tax year's domestic research or experimental expenditures (unless they receive approval from the Secretary). Taxpayers that benefit from deferring cost recovery should consider making a retroactive IRC Section 59(e) election for otherwise deductible domestic research or experimental expenditures paid or incurred in the first tax year beginning after December 31, 2021. The ability to continue making the election for domestic research or experimental expenditures incurred annually, until tax years beginning in 2026, may also provide a benefit under other tax provisions. Taxpayers that elected a reduced credit under IRC Section 280C(c)(2) for the first tax year beginning after December 31, 2021, could consider revoking the election on an amended return for that year. Revoking that election could result in a recovery of 21% of the taxpayer's IRC Section 41 credit. Taxpayers should be aware, however, that a special IRS administrative practice, as outlined in Field Advice 20214101F (Sept. 17, 2021), applies to research-credit-related refund claims filed on an amended return.
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