Proposed Regulations Change Definition of R&D Expenditures

Regulations

In proposed regulations, the IRS provided guidance on the treatment under Sec. 174 of research and development (R&D) expenditures incurred in connection with the development of tangible property, including pilot models (REG-124148-05). The proposed changes would, among other things, settle the question of whether the sale of a product resulting from otherwise qualifying research or experimental expenditures disqualifies those expenditures from Sec. 174 treatment. The IRS is proposing that if expenditures qualify as research or experimental expenditures, it will no longer matter if the resulting product is ultimately sold or is used in the taxpayer’s trade or business.

The IRS is also proposing a “shrinking-back” rule to address situations in which a component part of a larger product meets the requirements of Regs. Sec. 1.174-2(a)(1) (defining “research or experimental expenditures”), but the overall product itself does not. This rule will preserve Sec. 174 eligibility for component parts where the overall product does not meet the requirements of Sec. 174.

The regulations are proposed to be effective for any tax year ending on or after the date they are finalized; however, taxpayers may rely on the proposed regulations until then.