Expenses & Deductions
Costs incurred by businesses are generally categorized as either deductible during the current period or capitalizable to be deducted upon a later event. Sec. 174, however, separates research and experimentation (R&E) expenses into a category that a taxpayer may either deduct currently or capitalize and amortize. While Sec. 174 is not new—it was initially enacted in 1954—the accompanying regulations have recently been revisited. Revisions to the regulations (the final regulations), initially proposed in September 2013 and finalized in July 2014 (T.D. 9680), provide clarity through enhanced definitions and numerous additional examples to assist taxpayers in determining what are includible as R&E expenditures.
Sec. 174 provides for two accounting method treatments for R&E expenditures. Under paragraph (a), a taxpayer may treat research or experimental expenditures that are paid or incurred during a tax year in connection with a trade or business as expenses that are not chargeable to a capital account and deduct the expenditures in the current year. Alternatively, under paragraph (b), a taxpayer may elect to treat R&E expenditures as capitalizable and amortize them over 60 months. Sec. 174 does not define R&E, although it specifically excludes from R&E treatment the costs of land and land improvements, as well as the costs of exploration for mineral and gas resources, under paragraphs (c) and (d), respectively. Regs. Sec. 1.174-2(a)(1) provides that, for the purposes of Sec. 174, R&E expenditures:
- Are incurred in connection with a trade or business;
- Represent research and development costs in the experimental or laboratory sense; and
- Represent costs in the experimental or laboratory sense if they are incurred with the intent to discover information that would eliminate uncertainty concerning the development or improvement of a product.
They include all such costs incident to the development or improvement of a product.
As clarified in the final regulations, "[t]he ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174" (Regs. Sec. 1.174-2(a)(1)). Rather, the overriding objective that determines whether costs are R&E expenditures under Sec. 174 is eliminating uncertainty within the taxpayer's particular set of facts and circumstances. Further, the revisions point out that even if production has begun, as long as uncertainty concerning the development or improvement of the product has not been eliminated, costs can still be R&E expenditures.
Throughout the regulation, the item about which an uncertainty exists is referred to as the product. The existing regulations (prior to revision by the final regulations) defined "product" as "any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license" (Regs. Sec. 1.174-2(a)(3)). The final regulations refine this definition by explaining that a pilot model is "any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term includes a fully-functional representation or model of the product or . . . a component of the product" (Regs. Sec. 1.174-2(a)(4)). Also, the final regulations expand this definition by adding a new subsection addressing components of a product, which explains that "the presence of uncertainty concerning the development or improvement of certain components of a product does not necessarily indicate the presence of uncertainty concerning the development or improvement of other components of the product or the product as a whole" (Regs. Sec. 1.174-2(a)(5)). Therefore, even if uncertainty has been resolved with regard to an overall product, a taxpayer can relate costs to its respective components and individually consider the uncertainty surrounding each of these components to determine if those costs are R&E expenditures for the purpose of Sec. 174.
To illustrate these changes, the final regulations add 11 new examples. Eight of the examples support the definition of R&E expenditures under paragraph (a) of the regulation. These examples relate to pilot models, components, and revisions to existing products/processes. The notable points in these examples are:
- Material and labor costs incurred to build a pilot model as well as costs incurred to use the pilot model for R&E purposes qualify as R&E expenditures.
- A pilot model can be constructed for a component of a product.
- There is no limit on the number of pilot models that may be constructed.
- If a pilot model is later sold or put to an unrelated use, this does not preclude treating the initial cost of constructing the model as an R&E expenditure under Sec. 174, as the ultimate use of the pilot model is not considered when classifying costs as R&E expenditures.
- R&E costs may arise in creating a variation to an existing product if the information available with regard to the existing product does not resolve the uncertainty related to the revisions needed to create the variation.
- Costs of testing a new process may qualify as R&E expenditures under Sec. 174.
The other three examples relate to depreciable property excluded from R&E expenditures, as explained in paragraph (b) of the regulation. The notable points in these examples are:
- When a subcontractor performs both R&E and production activities, the costs incurred by the taxpayer for the R&E portion of the work can qualify as R&E expenditures under Sec. 174. The costs related to the production do not.
- If an asset is constructed and no R&E expenditures are incurred, then the entire cost of the asset should be capitalized and depreciated. If the asset is then used for R&E relating to a different product, then the depreciation expense arising from that asset is an R&E expenditure deductible under Sec. 174.
The final regulations are effective for tax years ending after July 20, 2014, and may be applied to any previous years for which the statute of limitation is still open.
EditorNotes
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-422-7244 or mcook@singerlewak.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.
