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Significant Change To The Treatment Of R&E Expenditure Under Section 174 Now In Effect

Posted on January 2022January 2022 by info

Overview of Section 174

As 2022 kicks off and tax legislation continues to be stalled in Congress, the amendment to Internal Revenue Code (IRC) Section 174 originally introduced by the 2017 tax reform legislation, the Tax Cuts and Jobs Act (TCJA), is now in effect.

TCJA’s amendment to Section 174 requires U.S.-based and non-U.S-based research and experimental (R&E) expenditures to be capitalized and amortized over a period of five or 15 years, respectively, for amounts paid in tax years starting after December 31, 2021. Additionally, software development costs are specifically included as R&E expenditures under Section 174(c)(3) and, therefore, will be subject to the same mandatory amortization period of five or 15 years.

Prior to the TCJA amendment, Section 174 allowed taxpayers to either immediately deduct R&E expenditures in the year paid or incurred, or elect to capitalize and amortize R&E expenditures over a period of at least 60 months. Additionally, taxpayers were able to make an election under Section 59(e) to amortize R&E expenditures over 10 years. Similar options existed for the treatment of software development costs under Rev. Proc. 2000-50, which provided taxpayers the option to currently expense costs as incurred, amortize over 36 months from the date the software was placed in service, or amortize over not less than 60 months from the date the development was completed.

The statute specifies that amortization will begin with the midpoint of the taxable year in which expenses are paid or incurred, creating a significant year 1 impact. For example, assume a calendar-year taxpayer incurs $5 million of R&E expenditures in 2022. Prior to the TCJA, the taxpayer would have immediately expensed all $5 million on its 2022 tax return, assuming it did not make an election under Section 174(b) or Section 59(e) to capitalize the amounts. Under the new rule, the taxpayer will be entitled to amortization expense of $500,000 in 2022, calculated by dividing $5 million by five years, and then applying the midpoint convention in the first year of amortization to haircut the annual amortization amount in half.

In the House version of the Build Back Better Act passed in November 2021, the effective date for the amendment made by the TCJA to Section 174 was delayed until tax years beginning after December 31, 2025. While this specific provision of the bill enjoyed broad bipartisan support, comments made by Senator Joe Manchin (D-W.V.) in late December indicating his opposition to the bill effectively stalled progress on the Build Back Better Act, making the path forward on legislation unclear. Accordingly, as of the date of this publication, the original effective date (i.e., years beginning after December 31, 2021) for the mandatory capitalization of R&E expenditures remains in place.

Immediate Considerations for Taxpayers with R&E Expenditures

Due to the new capitalization requirements, taxpayers should ensure that R&E expenditures incurred are properly identified. Some taxpayers may be able to leverage from existing systems/tracking to identify R&E. For instance, companies may already be identifying certain types of research costs for financial reporting purposes under ASC 730, and/or calculating qualifying research expenditures for purposes of the research credit under Section 41. By definition, any costs included in the research credit calculation would need to be recovered under the five-year recovery period. As such, taxpayers with an existing methodology in place to calculate the research credit will likely be able to use such computations as a helpful starting point for determining R&E expenditures under Section 174.

However, it is important to note that the type of expenses eligible for deduction under Section 174 are generally broader than the type of expenses eligible for the credit under Section 41. While Section 41 only allows wages, supplies and contract research to be included in the computation of the credit, Section 174 expenses can include items such as utilities, depreciation, attorneys’ fees and other costs incident to the development or improvement of a product. Accordingly, even taxpayers that undertake a robust Section 41 analysis will likely need to examine additional costs outside of the amounts included in the credit calculation to determine whether other expenses meet the definition of R&E expenditures under Section 174.

Other taxpayers that are not currently identifying R&E expenditures in any fashion will need to consider what steps are necessary to assess the amount of expenditures subject to Section 174. For instance, taxpayers that include all of their salaries and wages in a single trial balance account should consider what mechanisms are readily available to them to allocate the single account balance between Section 174 and non-Section 174 amounts. In certain instances, it may be prudent to begin segregating R&E expenditure amounts in their own trial balance accounts (e.g., to have a separate trial balance account for R&E expenditure wages versus non-R&E wages), or employ the use of a departmental or cost-center based trial balance to capture R&E expenditure amounts. The determination of which specific costs should be included in the relevant R&E expenditure trial balance accounts or R&E expenditure cost centers/departments will likely involve interviews with a taxpayer’s operations and financial accounting personnel, in addition to the development of reasonable allocation methodologies to the extent that a particular expense (e.g., rent) relates to both R&E expenditure and non-R&E expenditure activities.

After identifying these costs, taxpayers will have to track amortization and make any necessary book/tax adjustments, as many of the costs that are required to be capitalized under Section 174 will likely continue to be expensed as incurred for book purposes. As such, companies should expect there to be a difference in the total cost basis of the property between their depreciation books maintained for financial reporting purposes versus tax reporting purposes. This may result in additional reconciliations that must be performed year after year.

From a procedural standpoint, the statutory language in TCJA indicates that while the amendment to section 174 is to be treated as a change in method of accounting, the new rule applies on a cut-off basis, meaning that any costs incurred in years before 2022 will remain as-is, with the capitalization requirement applying prospectively to costs incurred going forward. It is currently unclear whether taxpayers that previously were expensing the R&E expenditures will need to file an Application for Change in Method of Accounting (Form 3115) to begin capitalizing and amortizing these expenditures. We expect the IRS to release guidance specifically addressing how taxpayers must comply with the new rule for the 2022 tax year, presuming the effective date of the provision is not delayed by Congress. Taxpayers should, therefore, continue monitoring releases from the IRS and Treasury before filing their 2022 tax returns to ensure compliance with the latest guidance.

Other Effects of the New Section 174 Rule

While the most obvious impact of the new Section 174 is a temporary increase to taxable income (or temporary decrease to taxable loss) that will ultimately reverse in future years, there are other tax provisions for which the treatment of R&E expenditures and/or the determination of taxable income are relevant that could also be affected by the change. In certain instances, the difference could result in a permanent difference to a taxpayer’s lifetime taxable income, resulting in a difference to its effective tax rate. With the new capitalization requirement in place, some areas taxpayers should pay attention to as they begin to consider tax provision and taxable income projection implications for 2022 includes:

Section 250 Foreign Derived Intangible Income (FDII) deduction: FDII benefits may increase due to increased taxable income (and therefore deduction-eligible income and foreign-derived deduction-eligible income) as a result of capitalized R&E expenditures.
Section 163(j): Increased taxable income resulting from the capitalization of R&E expenditures may reduce disallowed business interest expense under Section 163(j) in a given year.
Section 250 Global Intangible Low-Taxed Income (GILTI) calculation: The requirement to capitalize and amortize foreign R&E expenses over 15 years may have a significant impact on the amount of tested income.
Section 861 allocations: Provisions involving the allocation of R&E expenditures, including FDII, GILTI and the foreign tax credit, should ensure that all costs identified as Section 174 amounts are allocated in accordance with the rules provided under Treas. Reg. §1.861-17.

As noted above, some of the ancillary effects of amended Section 174 may be taxpayer favorable in certain instances. Another potentially favorable development involves taxpayers that were previously capitalizing R&E expenditures under old Section 174(b). Under the new rule, taxpayers will start amortizing their capitalized R&E expenditures beginning with the midpoint of the taxable year in which the amounts were incurred, instead of having to wait until the first month in which they realize a benefit from the R&E expenditures, as was required under old Section 174(b). This may allow certain taxpayers with multi-year Section 174 projects to begin recovering their costs at an earlier point in time.

While the discussion above highlights many of the important issues that taxpayers should begin considering now, many questions linger as we await further guidance from the government. Several notable areas of uncertainty include:

How broad is the application of Section 174 to software development costs? For instance, does the new rule apply only to software development costs that also happen to meet the definition of Section 174, or does it include all costs associated with software development?
How should amortization expense related to capitalized R&E expenditures be treated under Section 263A (UNICAP)?
How are domestic and foreign research activities distinguished?
What procedures are necessary to implement the method change to required capitalization?
How should research expenses that are ultimately reimbursed by another party (e.g., under a cost-plus arrangement) be treated under Section 174?

Next Steps

Legislative action is required to change the treatment of R&E expenditures for tax years beginning after December 31, 2021 and thereafter. As mentioned above, the delay of the effective date to capitalize R&E expenditures has broad bipartisan support, and taxpayers remain hopeful that Congress will be able to enact a bill that will allow for uninterrupted expensing treatment of Section 174 costs, at least for the next few taxable years. In the meantime, taxpayers should start considering the implications of the Section 174 rule as currently enacted, and assess the impact of the changes to their 2022 taxable income for financial reporting and estimated tax payment purposes.

Guidance & FAQs On Information Needed For Valid Research Credit Refund Claims Released By IRS

Posted on January 2022January 2022 by info

The IRS has released two pieces of interim guidance on its revised administrative policy for valid research credit refund claims. On January 3, 2022, the IRS issued procedural guidance for applying the revised administrative policy. On January 5, the IRS published a corresponding set of frequently asked questions (FAQs) on the policy. Both the guidance and the FAQs are effective for all research credit claims filed on or after January 10, 2022.

Background

On October 15, 2021, the Office of Chief Counsel released Chief Counsel Advice Memorandum 20214101F releases its revised policy regarding research credit claims. The CCA mandates that taxpayers include certain information along with a research credit refund claim filed under Internal Revenue Code (IRC) Section 41 on or after January 10, 2022, or risk having such claims deemed “deficient” and, thus, rejected without further IRS inquiry. The IRS stated that the CCA is intended to improve tax administration by:

Providing clear instructions for eligible taxpayers to claim the Section 41 credit; and
Reducing the number of disputes over such claims.

The interim guidance regarding the application of the CCA sets out specific procedures. These procedures must be followed to determine if a claim is “valid,” including requiring a taxpayer to provide detailed information to the IRS on the grounds and facts upon which a research credit refund claim is based. The IRS will assess the validity of each claim filed after January 10, 2022. However, the interim guidance reflects other procedural exceptions the IRS may apply during its evaluation of the validity of a claim. The IRS has committed to make determinations on such claims within six months of receipt.

Determining the Validity of Refund Claims that Include a Claim for Credit for Increasing Research Activities

Existing Treas. Reg. § 301.6402-2(b)(1) requires taxpayers that are filing a tax refund claim to apprise the IRS of the basis for the claim. According to the CCA and the January 5 FAQs, taxpayers filing an amended research credit refund claim will also be required to provide, at a minimum, five essential pieces of information:

All business components that form the factual basis of the Section 41 research credit claim for the claim year;
A description of all research activities performed, by business component;
The first and last names or title/positions of all individuals who engaged in the research activity, by business component;
The information each individual sought to discover, by business component; and
The total qualified employee wage expenses, supply expenses and contract research expenses.

The above list is the minimum criteria that must be submitted. In addition, each taxpayer submitting an amended research credit refund claim must submit a declaration. This declaration must be signed under penalty of perjury verifying that the facts provided are accurate. For most taxpayers, the signature on Forms 1040X or 1120X serves this function.

The interim guidance also clarifies that taxpayers submitting a research credit claim begin explaining the information that each individual sought to discover by business component. Specifically, this information, included under criterion 4, may be submitted as a list, table or narrative. This is beneficial for taxpayers that may have anticipated challenges in reporting this information.

Transition Period and Time to Perfect

For amended research credit refund claims filed during the period January 10, 2022 through January 9, 2023 (“transition period”), taxpayers will be given 45 days to perfect a timely filed claim that is deemed deficient because it failed to provide the five minimum criteria listed above. Notably, this is an extension of the period previously mandated under the CCA, which originally granted only 30 days to perfect such a claim.

Taxpayers that fail to provide the required five minimum criteria will be notified via Letter 6428, Claim for Credit for Increasing Research Credit Activities – Additional Information Required. The 45-day perfection period will begin on the date Letter 6428 is issued. If a taxpayer does not submit sufficient information to perfect the claim pursuant to the process set forth in the letter, the claim will be considered deficient, and the taxpayer will be issued Letter 6430, No Consideration, Section 41 Claim. If the IRS does not receive a taxpayer’s information or the missing information is insufficient following the 45-day perfection period, the IRS will reject the research credit claim without further consideration.

Claims Filed After the Transition Period Ends

Taxpayers that file a research credit claim after the transition period will be subject to general rules of Section 6511(a). Then, will not have the opportunity to perfect a claim that is deemed deficient. The IRS will evaluate each research credit claim based on the same five minimum criteria outlined above and verify that each claim was signed under penalty of perjury. If a claim is determined to be deficient, examiners will issue Letter 6430, No Consideration, Section 41 Claim, to the taxpayer, and reject the research credit claim without further consideration.

Next Steps for Companies

The IRS’s revised administrative policy impacts many U.S. taxpayers that engage in research and development (R&D) activities. As a result, the American Institute of Certified Public Accountants (AICPA), American Bar Association (ABA), National Association of Manufacturers (NAM) and many others have commented on the need for the IRS to delay implementation and resolve potential uncertainty for taxpayers. However, taxpayers submitting amended research credit refund claims must be prepared to set forth the following in detail:

Each ground upon which a credit or refund is claimed; and
Facts sufficient to support the basis for the claim in accordance with the IRS’s new five minimum criteria.
A written declaration verifying such facts under the penalty of perjury.

While it is expected that taxpayers will continue to be able to uphold the validity of research credit claims that have previously been filed, taxpayers should consider the IRS’s five minimum criteria for future research credit claims and the potential need to perfect claims the IRS may deem as deficient for failure to meet these criteria.

We Can Help

We understand the challenges that companies face. Whether you’re a startup or an established company, we offer a breadth of integrated services tailored to your individual needs. We also have extensive experience assisting taxpayers of all industries and sizes. We help with evaluating their qualified R&D expenses, calculating their credit claim amount for filing and, when necessary, defending the position with the IRS. To ensure companies continue to efficiently and effectively file claims, we can provide comprehensive support in assisting companies with planning and complying with the IRS’s new administrative policy.

Worthless Stock Could Lead To Tax Benefit

Posted on December 2021December 2021 by info

The disruptions caused by the COVID-19 pandemic have driven significant losses for many businesses, causing some to permanently close. Owners of these and other distressed businesses should consider whether they are eligible for a deduction attributable to an investment in worthless stock.

Generally, if the stock is a capital asset and becomes wholly worthless during the taxable year, the investor may recognize a capital loss. The amount of the capital loss is the adjusted basis of the stock at the time of worthlessness.

However, a special rule applies to the worthlessness of stock in qualifying subsidiary corporations. Under this exception, it may be possible for the parent company to claim an ordinary loss on the worthlessness of a subsidiary company if certain requirements are met.

Deduction for worthless subsidiary stock

The complete worthlessness of stock in a subsidiary may generate an ordinary loss deduction equal to the basis of the stock of the subsidiary in the hands of its immediate corporate parent, as determined under the consolidated return basis adjustment rules. It should be noted that in certain cases, the otherwise allowable loss may be reduced or eliminated pursuant to other consolidated return rules.

The amount of deduction attributable to stock in a worthless foreign subsidiary is generally the investment made to acquire and fund the foreign subsidiary (with certain adjustments) and is unaffected by the consolidated return adjustment rules.

In addition to establishing worthlessness (see below), the subsidiary must meet the following tests as well as certain other requirements to qualify for the ordinary loss deduction:

Affiliation test: The taxpayer must directly own stock constituting 80% of the voting power and 80% of the value of non-voting stock but excluding certain limited preferred stock.
Gross receipts test: More than 90% of the aggregate gross receipts of the affiliated subsidiary corporation for all taxable years during which it has been in existence must be from sources other than royalties, rent (except rent from property rented to employees of the corporation in the ordinary course of its operating business), dividends, interest (except interest from the deferred purchase price of operating assets sold by the corporation), annuities and gains from the sale of stock or securities.

Establishing worthlessness

In addition to meeting the affiliation and gross receipts tests, the taxpayer must establish that the subsidiary stock is wholly worthless (meaning the stock has no liquidating or potential future value). Stock has no liquidating value when the fair market value of the business’ assets is less than its liabilities, which for this purpose includes intercompany liabilities owed to the immediate parent. All assets— including tangible assets such as machinery and equipment, as well as intangibles such as goodwill, going concern value, workforce in place, supplier-based intangibles, customer-based intangibles, trademarks, tradenames, etc.—must be considered in determining the value of the gross assets.

Once stock is deemed worthless, there must be an “identifiable event” to trigger the loss deduction for income tax purposes. Examples of an identifiable event include:

A legal dissolution of the subsidiary.
A formal or informal subsidiary liquidation.
A “check-the-box” election, or entity classification election, to treat a foreign subsidiary as a disregarded entity.
A state law formless conversion of the subsidiary from a corporation to an entity classified as a disregarded entity (i.e., a single-member LLC).

The continuance of a subsidiary’s business following a worthless stock deduction for any purpose other than winding down the business operations must be done in a manner that separates the circumstances supporting the deduction from subsequent events that allow the business to continue.

Coordination with NOL and disaster loss rules

A worthless stock deduction that is treated as an ordinary loss in the current year could create or increase a net operating loss (NOL) that can be carried forward or, in limited cases, carried back. The CARES Act temporarily reinstated the NOL carryback provisions by extending the carryback period to five taxable years for losses originating in 2018, 2019, or 2020. By carrying a loss back to taxable years prior to 2018, taxpayers may have the opportunity to receive a refund for taxes paid at tax rates as high as 35%, creating a permanent benefit as compared to otherwise carrying the loss forward to reduce taxes paid at a 21% rate. In some cases, a carryback can generate a refund sooner than would otherwise be available with the use of an NOL carryforward.

While most 2020 returns have already been prepared, certain losses attributable to COVID-19 in 2021 may be eligible for an election under Section 165(i) to be claimed on the preceding taxable year’s return. The determination of whether a taxpayer is eligible to make this election for a worthless stock loss should be made on a case-by-case basis.

Statute of limitations

Determining the timing as to when a corporation’s stock becomes worthless can be a very difficult task. In recognition of this challenge, the tax law provides a seven-year statute of limitations for deductions with respect to the worthlessness of a security.

How we can help

Worthless stock deductions can provide significant tax benefits and should be carefully considered given the economic harm caused to many businesses by the COVID-19 pandemic.