During the 2022 tax return season, companies engaging in research and development activities were made aware of the new capitalization and amortization requirements. Late in the tax return season, the IRS released Notice 2023-63, which provided interim guidance on the application of these capitalization rules.
The Notice states that it is, “addressing (1) the capitalization and amortization of specified research or experimental (SRE) expenditures under § 174 of the Internal Revenue Code (Code), as amended by Public Law 115-97, 131 Stat. 2054 (Dec. 22, 2017), commonly referred to as the Tax Cuts and Jobs Act (TCJA), (2) the treatment of SRE expenditures under § 460, and (3) the application of § 482 to cost-sharing arrangements involving SRE expenditures.”
In summary, the Notice provides clarification in three areas:
- More specific definitions on cost subject to § 174 amortization and costs not subject, including increased clarity on funded research’s treatment for § 174 purposes.
- How the law treats the percentage-of-completion method of accounting for income from long-term contracts and R&D costs under § 460.
- How the law handles cost sharing under § 482.
Any returns extended and not filed before the Notice’s release date in early September should have considered the impact of these clarifications. One area that we specifically focused on was the allocation of “overhead” costs to the research and development expenses capitalized. Based on this most recent guidance, this article is a brief summary of what we interpret as the costs that should and should not be capitalized under the applicable rules:
SRE Activities Definition
- Activities in the experimental or laboratory sense intended to discover information that would eliminate uncertainty concerning the development or improvement, or appropriate design of a product or a component or subcomponent of a product; or
- Software development activities.
Direct SRE Costs
- Direct labor (employees or contractors): The costs of those that perform, supervise, or directly support SRE activities.
- This includes basic compensation, stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan. However, this does not include severance pay.
- Direct materials and supplies.
- Patent costs: The costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application.
- Direct travel costs: The costs for the performance of SRE activities or the direct support of SRE activities.
- Software development costs:
- Planning the development of the computer software (or the upgrades and enhancements to such software), including identification and documentation of the software requirements.
- Designing the computer software (or the upgrades and enhancements to such software).
- Building a model of the computer software (or the upgrades and enhancements to such software).
- Writing source code and converting it to machine-readable code.
- Testing the computer software (or the upgrades and enhancements to such software) and making necessary modifications to address defects identified during testing, but only up until the point in time.
Allocable Costs (Overhead)
- This includes, depreciation, amortization, or depletion.
- Certain operation and management costs (facility related overhead), such as:
- Rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs with respect to facilities, equipment, and other assets.
Costs That Are Not Treated as SRE Expenditures
- G&A costs that only indirectly support or benefit SRE activities.
- Examples: Services of payroll personnel in preparing salary checks of research personnel, services of human resources personnel who hire research personnel, or services of accounting personnel who account for research expenses.
- Interest on debt to finance SRE activities.
- Costs to input content into a website.
- Costs for website hosting that involve the payment of a specified, periodic fee to an internet service provider in return for hosting a website on its server(s) connected to the internet.
- Costs to register an internet domain name or trademark.
- Training employees and other stakeholders that will use the computer software.
- Maintenance activities after the computer software is placed in service that do not give rise to upgrades and enhancements. For example, corrective maintenance to debug, diagnose, and fix programming errors.
- Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion.
- Installing the computer software and other activities relating to placing the computer software in service.
- Quality control testing, efficiency surveys, consumer surveys, and advertising or promotion.
- The acquisition of another’s patent, model, or process.
- Research in connection with literary, historical, or similar projects.
What’s Next
Whether a taxpayer’s returns were filed at a time where the guidance from the Notice could be implemented or not, capitalization calculations should be revisited for future tax periods. With little guidance during the bulk of the tax compliance season, taxpayers and their advisors were forced to over-capitalize expenses and, therefore, have an opportunity to lessen this tax burden going forward.
Although there were no relief procedures outlined for those taxpayers that may have been conservative in their capitalized expenses, the calculations should be revisited before and/or during the 2023 tax compliance season.
If you have any questions regarding the Notice and its guidance on the application of these capitalization rules, please contact a member of Wolf’s Tax team.
