Recently, the Internal Revenue Service (IRS) released Notice 2023-63 which has provided much needed insight as to the direction the IRS is leaning in terms of § 174 expenses. The treatment of specified research or experimentation (SRE) expenditures have changed for expenditures paid or incurred after December 31, 2021. Starting in 2022, SRE expenditures are now required to be capitalized and amortized over a 5-year period for activities within the US, and 15 years for foreign activities using the mid-year convention. Software development was a category that was specifically named in the list of expenditures that must be included when calculating § 174 expenditures. This has caused many businesses to reassess their strategic plans due to the changes in financial circumstances.
Notice 2023-63 makes it clear that further guidance will be provided but the current notice provides a preview of expected changes. Some key takeaways from the notice are as follows:
- 2023-63 provides definitions of what qualifies as a “specified research and experimental” (SRE) expense for costs incurred after December 31, 2021. These expenses cover the following when related to SRE activities:
- Labor costs for employees or contractors,
- Costs for materials, supplies, tools, and equipment that are not depreciable under § 168,
- Depreciation, amortization, or depletion allowances with respect to property (e.g.: depreciation with respect to a test bed),
- Expenses related to obtaining a patent, including attorney’s fees for patent applications.
- Certain operation and management costs like rent, utilities, insurance, and taxes.
On the other hand, expenses not considered SRE expenditures include:
- General and administrative department costs.
- Interest on debt financing for SRE activities.
- Costs related to putting content on a website.
- Expenses for website hosting involving regular fees to an Internet service provider for hosting.
- Costs for registering an Internet domain name or trademark.
- Amounts representing amortization of SRE expenditures or amortization of research or experimental expenditures incurred before January 1, 2022.
- What stands out is that software development is specifically added on top of activities listed in § 1.174-2. Exclusions and limitations are provided however it is understood that the lion’s share of common software development expenditures will fall under § 174.
- Taxpayers must allocate SRE expenditures based on the cause-and-effect relationship to the SRE activities. Though different allocation methods can be used for different types of expenditures, once applied the method must be used consistently.
- Contracted research must demonstrate financial risk and ownership rights in order to claim the credit under § 41 (the R&D tax credit). Under § 174 if either of these criteria are present, they must be included in the § 174 calculation.
- Disposition, abandonment, or retirement shall not constitute a valid reason for deducting the remainder of unamortized expenses. The IRS clarifies that the only time the amortization will no longer be applied is if the company ceases to exist.
- For long-term contracts, the IRS states “the portion of the contract price a taxpayer must report in a tax year corresponds to the ratio of incurred allocable contract costs to total estimated allocable contract costs”.
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