New guidance on section 174 research expenditures

ARTICLE | January 05, 2024

Authored by RSM US LLP

Executive summary

The IRS released Notice 2024-12 to favorably clarify proposed section 174 research and experimental rules under Notice 2023-63 and to broaden taxpayers’ ability to rely on such rules. Simultaneously, the IRS released Revenue Procedure 2024-9, providing modified and new procedures for changing accounting methods for the capitalization and amortization of research or experimental expenses (SRE expenses), including SRE expenses allocable to section 460 long-term contracts. The new guidance items provide favorable and much-needed provisions to assist taxpayers wishing to rely on one or more of the proposed rules in Notice 2023-63 for their 2023 tax years.

New guidance on section 174 research expenditures

The IRS and Treasury rung in the new year with new guidance on the capitalization and amortization of section 174 specified research and experimental expenditures (SRE expenses). In late 2023, the IRS and Treasury released Notice 2023-63, providing proposed, interim guidance under the new section 174 rules that require capitalization and amortization of SRE expenses. Notice 2024-12 clarifies certain of the interim guidance in Notice 2023-63, while Revenue Procedure 2024-9 modifies and expands procedures to obtain automatic consent for accounting method changes to implement one or more of the proposed rules in Notice 2023-63, including providing a new automatic method change for SREs allocable to long-term contracts accounted for under the percentage of completion method (PCM). See our previous  for more information on prior guidance the IRS has released with respect to section 174 capitalization.

Notice 2024-12

Notice 2024-12 provides taxpayer-favorable clarifications and modifications of proposed, interim rules in Notice 2023-63. Specifically, Notice 2024-12 clarifies and modifies Notice 2023-63 in the following ways:

• Favorable modification of reliance provisions – Notice 2024-12 removes the requirement that a taxpayer must apply all of the proposed rules in Notice 2023-63 in order to rely on any of the rules in the notice. Thus, a taxpayer may now choose to rely on only the proposed rules in Notice 2023-63, as modified by Notice 2024-12, that benefit it.
  
• Favorable clarification of contract research rules – Notice 2024-12 clarifies the proposed rules in Notice 2023-63 to determine whether a research provider under a research contract has SRE expenses, by providing that if the research provider does not bear financial risk under the contract but obtains a right to exploit or otherwise use the resulting SRE product, the research provider does not have to treat its research service costs as SRE expenses as long as the obtained right qualifies as an “excluded SRE product right.” Notice 2024-12 provides that an excluded SRE product right is a right that is separately bargained for and that arises from consideration other than the cost paid or incurred by the research provider to perform the SRE activities under the research contract.
• Clarification of applicability of Rev. Proc. 2000-50 – Notice 2024-12 clarifies that rules allowing for current deduction of software development costs, as provided in Rev. Proc. 2000-50, are obsolete for costs paid or incurred in tax years beginning after Dec. 31, 2021, but remain in effect for costs paid or incurred in earlier periods.

Rev. Proc. 2024-9

Rev. Proc. 2024-9 expands earlier procedural guidance issued Rev. Procs. 2023-8 and 2023-11 to obtain automatic consent for method changes related to SRE expenses, in order to facilitate taxpayers’ reliance on one or more of the proposed rules in Notice 2023-63, as modified by Notice 2024-12. Rev. Proc. 2024-9 modifies earlier procedures in the following, significant ways:

• Waiver of prior five year limitation – Rev. Proc. 2024-9 extends the waiver of the prior five year limitation on automatic method changes to the second tax year beginning after Dec. 31, 2021. Thus, a taxpayer that made a method change to apply the new section 174 rules for its 2022 tax year generally may make another automatic method change to apply one or more of the proposed rules in Notice 2023-63, as modified by Notice 2024-12, for its 2023 tax year.
• Limited audit protection available for 2023 method changes – Rev. Proc. 2024-9 now provides limited prior-year audit protection for a taxpayer making a method change for SRE expense for its second tax year beginning after Dec. 31, 2021. Previously, audit protection was not allowed for changes made for such year to encourage timely compliance with the new section 174 rules. However, given that Notice 2023-63 was not released until shortly before the deadline for many taxpayers’ 2022 returns, the IRS has modified this limitation. A taxpayer making a change to apply one or more rules in Notice 2023-63, as modified by Notice 2024-12, for its second tax year beginning after Dec. 31, 2021 (e.g., for the 2023 calendar tax year) is provided with limited audit protection as long as the taxpayer made a change to comply with the new section 174 rules for its first tax year beginning after Dec. 31, 2021. Audit protection continues to be unavailable for years in which the former section 174 rules apply and to taxpayers that failed to make a change to comply with the new rules in their first tax year beginning after Dec. 31, 2021.
• New automatic change for SRE expenses allocable to long-term contracts – Rev. Proc. 2024-9 provides a new automatic method change for SRE expenses allocable to long-term contracts under section 460. Specifically, taxpayers that apply the PCM under section 460 to their long-term contracts and wish to rely on the proposed, interim guidance provided in section 8 of Notice 2023-63 (providing that only the amortized portion of allocable SRE expenses must be included in the numerator of the completion factor) may make an automatic method change to apply such guidance to their existing long-term contracts. Unlike typical section 460-related method changes, this change applies to long-term contracts entered into prior to the year of change, but only applies to allocable SRE expenses paid or incurred in tax years beginning after Dec. 31, 2021. The change also allows taxpayers to choose to include either the entire amount of allocable SRE expenses in the denominator of the completion factor or only the portion that will be amortized during the contract term.
• Cut-off change allowed in certain cases – For both changes, Rev. Proc. 2024-9 allows taxpayers to choose to make the change on a cut-off basis as long as the section 481(a) adjustment would otherwise be negative. In this case, taxpayers will apply the subsequent change only to costs paid or incurred in the year of change and going forward.
• No change in method allowed in the case of certain 351 transactions – Finally, Rev. Proc. 2024-9 clarifies that a change to SRE expenses transferred in a section 351 transaction to go from treating the expenses as amortizable by the transferee to treating such the expenses as amortizable by the transferor, in line with the proposed, interim guidance under Notice 2023-63, is not a change in method of accounting. Thus, such change must be implemented through amended returns.

The bottom line

The new guidance generally means good news for taxpayers, particularly as it allows taxpayers to selectively choose which, if any, provisions of Notice 2023-63, as modified by Notice 2024-12, to apply and permits an automatic change for SRE expenses allocable to section 460 long-term contracts. Clarifications with respect to the proposed contract research rules in Notice 2023-63 are likely to favorably impact research providers that may have interpreted the provisions of Notice 2023-63 as requiring them to treat otherwise deductible costs as SRE expenses. However, taxpayers should keep in mind that any changes for the 2023 tax year generally must be made with a Form 3115 and cannot be implemented merely through attaching a statement to the return. Additionally, the IRS and Treasury still plan to issue proposed regulations providing more substantive guidance under section 174. It is anticipated that these regulations will be issued sometime in late Spring and may impact taxpayers’ treatment of SRE expenses further.

Taxpayers that undertake research activities, whether on their own behalf or under contract, should discuss with their tax advisers whether reliance on one or more of the provisions in Notice 2023-63, as modified by Notice 2024-12, is advisable, and the required steps in order to implement such provisions.