2017 Tax Law Eliminates Immediate Deduction of R & E Expenditures Paid or Incurred in Tax Years Beginning After 2021

Section 13206 of the 2017 Tax Cuts and Jobs Act ( the “ Act ”) amended IRC Sec . 174 , for research and experimental ( R & E ) expenditures paid or incurred in tax years beginning after 2021 .

Old Law Under the old law , a taxpayer could treat R & E expenditures paid or incurred during a tax year in connection with the taxpayer ’ s trade or business as expenses — which were allowed as a current deduction .

New Law Sec . 174 ( a )( 1 ) no longer allows current deductions for specified R & E expenditures for any tax year except for the amortization deduction allowed under Sec . 174 ( a )( 2 )— which provides that these expenditures be :

• Charged to a “ capital account ”; and

• Amortized ratably over five years , or 15 years if attributable to research conducted outside the U . S ., Puerto Rico or any U . S . possession [ Sec . 41 ( d )( 4 )( F )], beginning with the midpoint of the tax year in which the expenditures are paid or incurred . This capital account must be a separate one for these expenditures .

Specified R & E expenditures are those paid or incurred by the taxpayer for a tax year in connection with the taxpayer ’ s trade or business [ Sec . 174 ( b )]. R & E expenditures include amounts paid or incurred to develop software [ Sec . 174 ( c )( 3 )].

Treatment Upon Disposition , Retirement or Abandonment If any property , with respect to which specified R & E expenditures are paid or incurred , is disposed , retired or abandoned during the period these expenditures are being amortized , no deduction is allowed for these expenditures on account of that disposition , retirement or abandonment . However , the amortization deductions continue for those expenditures [ Sec . 174 ( d )].

Change in Method of Accounting Under Act Section 13206 ( b ), the Act ’ s amendments to Sec . 174 are treated as an accounting method change for Sec . 481 purposes and that this change is : ( 1 ) Treated as initiated by the taxpayer ; ( 2 ) Treated as made with IRS consent ; and ( 3 ) Applied only on a cut-off basis for any R & E expenditures paid or incurred in tax years beginning after 2021 . Also , no Sec . 481 ( a ) adjustments are made . Rev . Proc . 2023-11 , Section 2.03 ( 4 ), pertinently states that when an accounting method change is made on a cut-off basis , no amounts are duplicated or omitted , and therefore , a Sec . 481 ( a ) adjustment is not necessary or permitted .

Automatic Method Change Section 3 of Rev . Proc . 2023-11 contains procedures for an automatic change in method of accounting to comply with amended Sec . 174 . Under these procedures , a statement must be filed with the taxpayer ’ s original federal income tax return for the first tax year beginning after 2021 — in lieu of Form 3115 . This statement must contain the six categories of information required to make this accounting method change set forth in Rev . Proc . 2023-11 , Section 3.02 ( 4 )( a )( ii ).

Other rules apply if the year of change is later than the first tax year beginning after Dec . 31 , 2021 . [ See Rev . Proc . 2023-11 , Section 3.02 ( 4 )( b ).]

Transition Rule Rev . Proc . 2023-11 , Section 3 , also provides a transition rule for taxpayers who filed a federal income tax return on or before Jan . 17 , 2023 , for a tax year beginning after 2021 . Under this transition rule , those taxpayers are deemed to have complied with the accounting method change procedures under Sec . 446 and the relevant rev . procs ., if the taxpayer properly reported the amount of specified R & E expenditures on Form 4562 , Part VI , filed with that return , and properly capitalized and amortized those expenditures in accordance with amended Sec . 174 .

Audit Protection A taxpayer that changes the method of accounting for specified R & E expenditures will receive limited audit protection under Section 8.01 of Rev . Proc . 2015-13 . But audit protection will not apply for expenditures paid or incurred in the years beginning :

• Before 2022 ; and

• After 2021 — if a change in method is made for the tax year immediately subsequent to the first tax year for which Sec . 174 becomes effective , which generally is the tax year beginning after 2021 .

Despite these rules , the IRS may still change the characterization or classification of expenditures as specified R & E expenditures to apply Sec . 174 and the change in accounting method procedures under the relevant rev . procs . to determine the proper amount of expenditures paid or incurred in each tax year beginning after 2021 .

Inapplicability This automatic method change does not apply to a change in the treatment of :

• Acquired , leased or licensed computer software .

• R & E expenditures under old Sec . 174 , or software development expenditures , paid or incurred in tax years beginning before 2022 .

Stuart R . Josephs , CPA has a San Diego-based Tax Assistance Practice that specializes in assisting practitioners in resolving their clients ’ tax questions and problems . Josephs , a past chair of the Federal Subcommittee of CalCPA ’ s Committee on Taxation , can be reached at ( 619 ) 469-6999 or stuartrjosephs @ yahoo . com . www . calcpa . org JUNE 2023 CALIFORNIA CPA 23