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Planning for Section 174 in Uncertainty
A year ago, we published an article Will Companies Expense R&D Again? - Hughes Pittman & Gupton, LLP (hpg.com) and I remember thinking, with the bipartisan support that it had at the time to defer or repeal the requirement to capitalize research and development (“R&D”) costs, it felt absurd to write a warning that there may not be a fix for this issue by the end of 2022. Now, a year later and many client conversations later, our landscape of uncertainty has not changed much in terms of guidance on how to calculate many aspects of the law change. Bipartisan support to defer or repeal these changes remains; so again, there is still a chance that this change which was enacted on January 1, 2022 could get retroactively changed, leaving tax practitioners uncertain as to how to advise clients. The same article from last year could be published again this year, with the caveat that now even extended tax returns from the 2022 tax year are coming due, so action has to be taken by companies to follow the enacted law, which is very detrimental to many companies who had planned on Congress acting in time.
Companies have had to take their best guess as to whether this would be changed prior to the filing deadline. Many believed so strongly that it would be changed that they deferred making what seemed like extraneous tax payments for estimated taxes to the IRS to account for the tax that would be due in the scenario where they would be required to capitalize their R&D expenses on their filed tax returns. Given that there is no choice but to follow the enacted law, unless legislation moves through quickly before the calendar year-end filing dates of September 15th and October 16th, these companies will not only have to come up with the tax payments, but they will also be subject to underpayment penalties.
Where tax practitioners had hoped that extending returns would allow some time for additional guidance to be issued on how to calculate overhead and other costs that could be considered required to be capitalized as R&D, that guidance has not been put forth. The IRS has provided guidance only on the method change that is required with this law change, most recently in an Rev. Proc. 2023-11 which supersedes previous guidance under Rev. Proc. 2023-08. While this helps direct how to implement the change on a tax filing, it does not provide any reassurance on how to determine the actual capitalized amounts.
As a result, in anticipation of the looming due dates, companies are having to move forward and prepare their tax returns under the current law, capitalizing these expenses without specific rules and with many unanswered questions. If Congress makes a retroactive change to either provide actual guidance or to repeal or delay its implementation, that will likely require companies to amend their returns to reflect the changes. A repeal or delay would be a welcome relief to those taxpayers who are forced to pay income tax that they would not normally be required to pay due to the mismatching of expenses, but would also come at the time, effort and cost of having to amend their returns. The state income tax treatment of this item varies, so that cost and effort for amending may not only be at the federal level but also for state tax returns as well.
While a year ago it felt absurd to think that we would file returns following this new requirement to capitalize R&D, today it is the reality. Any action to change this bad tax policy, unless it takes place almost immediately, will still have the unwanted taxpayer implications we had all hoped to avoid.
We will continue to monitor the situation and provide timely updates. If you have any questions, please contact your HPG tax advisor to discuss the right course of action based on your situation.