The Blog is written by Michael De Prima, Mark Hall and Jennifer Boese
Are you a physician developing a new medical device? A pharmaceutical company working on a new drug? Perhaps you’re a biotechnology company researching precision medicine or a technology company creating new digital therapeutics. If you are a taxpayer and have research and experimental (R&E) expenses then, yes, you should care about changes to Section 174.
What is IRS Section 174?
Section 174 was enacted in 1954 and taxpayers historically had three options for how they handled R&E expenses, including deducting in the year incurred—that was up until enactment of the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA made a major change to Section 174 by eliminating the ability to currently deduct those expenses. In its place, Section 174 now requires taxpayers to capitalize and amortize their R&E expenses. The amortization period is five years for domestic expenses and 15 years for foreign expenses.
While there was hope Congress would defer or amend this requirement in the Consolidated Appropriations Act of 2023 (enacted December 2022), it did not. As such, this change went into effect for tax years beginning on January 1, 2022. There’s still some hope that Congress will address this problem soon and restore full R&E expensing with retroactive effect back to January 1, 2022. However, hope is quickly fading as we approach the major tax deadlines in March and April and Congress has not signaled an intention to take up the issue.
What is an R&E expenditure?
R&E expenditures mean expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.
The TCJA also added software development to the definition of what is considered an R&E expenditure. This applies to software intended for internal or external use.
Is Section 174 different than the R&D credit (Section 41)?
They are connected but are not the same. Section 41 R&D tax credit expenses are only a subset of research-based expenses that fall under Section 174. Section 174 is much broader in scope and applies to many expenses not eligible for the research credit.
Consider the case of foreign-based labor: these costs do not qualify for the research credit but are still subject to capitalization under Section 174. Even worse, these costs will be amortized over 15 years as mentioned above. This whipsaw result will be all too common for U.S. businesses beginning in 2022.
While the R&D credit itself is not directly impacted by the Section 174 capitalization requirement, anyone claiming an R&D credit has Section 174 expenses. Therefore, understanding and analyzing this change is a first step.
What types of health care or life sciences companies could be impacted?
Section 174 is industry agnostic and would apply to all types of companies—from manufacturing, transportation, technology, agribusiness and beyond.
For health care or life science companies, here are a few examples:
- Example 1: You are a technology company. You are developing a solution that uses Artificial Intelligence to analyze various physiologic data related to chronic health care conditions.
- Example 2: You are a medical device company. You are developing a novel device to prevent brain aneurisms. You may also be building out a manufacturing process to produce the device at scale.
- Example 3: You are a biotechnology company. You are developing novel biologics used in the study and production of vaccines.
- Example 4: You are a pharmaceutical company. You are bringing a drug to market and heavily engaged in trials to gauge efficacy and safety.
What else should I know?
There are many potential implications with the Section 174 change. Those will likely include higher taxable income due to capitalized costs and impacts to estimated taxes, your tax planning and your financial reporting. Many taxpayers that were not historically taxable may consume available net operating losses and generate taxable income for the first time. Additionally, there is potential for a foreign and state tax implication depending on whether you have any R&E expenses overseas and/or your state follows federal tax rules.
Finally, the Section 174 change has been added to the IRS’s list of automatic accounting method changes taxpayers can make on Form 3115. This method change is made on a “cutoff” basis. However, if a taxpayer fails to adopt the new method in year one, a method change in a subsequent year will require a taxable income adjustment that considers R&E expenses arising in tax years beginning after December 31, 2021. The IRS guidance does provide an option for taxpayers to file a statement in lieu of Form 3115 but only in the first year of adoption. This guidance was released in the IRS Revenue Procedure 2023-8 (later modified by Revenue Procedure 2023-11).
What are my next steps?
- Review our full Section 174 article by Michael De Prima.
- Reach out to your CLA advisor to determine any tax and financial impacts.
- Review and model with your CLA advisor what this tax change means to your financial position.
- Prepare for the future.
We are here to help.