R&E expenses: Automatic accounting method change procedures

Editor: Kevin Anderson, CPA, J.D.

In December 2022, the IRS released guidance explaining the procedures for taxpayers to request automatic accounting method changes for specified research or experimental (R&E) expenses to comply with the 2017 amendments to Sec. 174. This item dissects that guidance, provides a broad overview of the procedures, and highlights potential foot faults.

Background

As amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, Sec. 174 no longer allows taxpayers to choose how to account for their R&E expenses — that is, whether to immediately deduct them or capitalize and amortize them. Taxpayers must capitalize and amortize those expenses ratably over five years if research is performed in the United States and 15 years if the expenses are attributable to foreign research, beginning with the midpoint of the tax year in which the expenses are paid or incurred. Further, software development expenses are now considered R&E expenses and are subject to mandatory capitalization and amortization. Under the relevant pre-TCJA rule (Rev. Proc. 2000-50), a taxpayer could choose whether to immediately deduct or capitalize and amortize software development expenses. Amended Sec. 174 is effective for expenses paid or incurred in tax years beginning after Dec. 31, 2021.

Given the vast difference between the new rules and historic Sec. 174, taxpayers with an established method of accounting for R&E expenses will typically require an accounting method change to comply with the TCJA amendments. Generally, taxpayers must file Form 3115, Application for Change in Accounting Method, to make an accounting method change. Rev. Proc. 2015-13 sets forth the general procedures governing changes in accounting method, including eligibility for automatic accounting method changes and the terms and conditions for making an accounting method change.

In part, a taxpayer generally cannot make an automatic accounting method change if it has made or requested a change for the same item during any of the five tax years ending with the year of change. Further, when a taxpayer timely files a Form 3115 in compliance with Rev. Proc. 2015-13, the IRS will not require a taxpayer to change its method of accounting for the same item for a tax year prior to the requested year of change; this is known as audit protection. For automatic accounting method changes, the general rules of Rev. Proc. 2015-13 are supplemented by change-specific rules the IRS issues and updates in its list of automatic changes, which are found in Rev. Proc. 2022-14.

Recent guidance

On Dec. 12, 2022, the IRS added a new automatic method change for conformity with the Sec. 174 amendments by releasing Rev. Proc. 2023-8, which modified the list of automatic changes in Rev. Proc. 2022-14. However, in what appears to be an atypically swift reaction to specific tax planning strategies arising from that initial guidance, the IRS released superseding guidance (Rev. Proc. 2023-11) just 17 days later. The primary difference between the revenue procedures is that Rev. Proc. 2023-11 provides less favorable terms for the accounting method change if the taxpayer does not implement the change in the first required year. Specifically, a taxpayer that defers making an accounting method change for R&E expenses until its tax year following the first year in which it is subject to amended Sec. 174 will not receive audit protection for the first tax year.

Rev. Proc. 2023-11 provides procedures for automatic method changes for R&E expenses in three situations.

Situation 1: A change in accounting method is made for a taxpayer’s first tax year beginning after Dec. 31, 2021, for which its federal tax return was filed on or before Jan. 17, 2023 (the date Rev. Proc. 2023-11 was published in the Internal Revenue Bulletin).

This is a transition rule. Under the rule, if the taxpayer reported the amount of R&E expenses on Part VI of Form 4562, Depreciation and Amortization, (filed with its federal tax return) and properly capitalized and amortized those expenses in accordance with the required Sec. 174 method, it is deemed to have complied with the method change procedures, and no further action is required. A taxpayer that did not file its first tax year federal tax return in compliance with those specifications will need to follow the procedures discussed below for a year of change later than its first tax year beginning after Dec. 31, 2021.

Situation 2: A change in accounting method is made for a taxpayer’s first tax year beginning after Dec. 31, 2021, for which its federal tax return is filed after Jan. 17, 2023.

In this situation, the guidance allows a taxpayer to file a statement with its federal tax return in lieu of Form 3115 and considers that statement a Form 3115 for purposes of the automatic consent rules of Rev. Proc. 2015-13. Generally, for an automatic accounting method change, a taxpayer must file its original Form 3115 with its timely filed federal income tax return implementing the requested automatic change and file a duplicate copy of Form 3115 with the IRS in Ogden, Utah.

For Situation 2, however, the requirement to file a duplicate copy of the automatic Form 3115 is waived. The required statement must include the following information for each applicant: the applicant’s name and employer identification number or Social Security number; the beginning and ending dates of the year of change; the designated automatic accounting method change number, which is 265; a description of the type and amount of specified R&E expenditures paid or incurred by the applicant during the year of change; and a declaration that the applicant is changing its method of accounting for specified R&E expenditures to capitalize and amortize them over a five-year period for domestic research or a 15-year period for foreign research, applying the midpoint convention.

The declaration must also state that the applicant is making the change on a cut-off basis, under which the R&E expenses incurred in the first tax year beginning after Dec. 31, 2021, will be accounted for under the amended Sec. 174 method, and expenses incurred in prior tax years will continue to be accounted for under the method used in those years. No Sec. 481(a) adjustment, which is usually required for an accounting method change, is allowed.

If a change is made for a taxpayer’s first tax year beginning after Dec. 31, 2021, limited audit protection applies — specifically, a taxpayer does not receive audit protection for expenses paid or incurred in tax years beginning before Dec. 31, 2021. That is not surprising. Because taxpayers had other options for how to treat R&E expenses in years before amended Sec. 174 took effect, and this accounting method change does not change the treatment of those prior costs, no audit protection is provided.

Rev. Proc. 2023-11 waives the eligibility rule of Rev. Proc. 2015-13 that requires that the taxpayer has not made or requested an accounting method change for the same item during any of the five tax years ending with the year of change. That waiver will allow a taxpayer that recently changed its pre-amendment Sec. 174 method for R&E expenses to file the accounting method change to comply with amended Sec. 174 using the automatic procedures and avoid having to file a nonautomatic change.

Situation 3: Changes in accounting method are made in years later than the taxpayer’s first tax year beginning after Dec. 31, 2021.

In this situation, the accounting method change is made by filing Form 3115 and using a modified Sec. 481(a) adjustment. The modified adjustment should take into account only R&E expenses paid or incurred in tax years beginning after Dec. 31, 2021. For example, if a taxpayer used an accounting method that immediately deducted R&E expenses and continued to follow that method in the first tax year beginning after Dec. 31, 2021, it would be required under the modified Sec. 481(a) adjustment to include those expenses in income and then capitalize and amortize the costs under the new required method. In effect, a taxpayer will be unable to continue its prior tax treatment for R&E expenses by delaying the required accounting method change.

Form 3115 must include an attachment that describes the type of expenditures included as specified R&E expenditures and the tax year(s) they were paid or incurred by the applicant and declares that the applicant is changing its method of accounting for specified R&E expenditures to capitalize and amortize them over five years for domestic research or 15 years for foreign research, applying the midpoint convention for the tax year in which those expenditures are paid or incurred. The declaration must also state that the applicant is making the change with a modified Sec. 481(a) adjustment that takes into account only specified R&E expenditures paid or incurred in tax years beginning after Dec. 31, 2021.

The taxpayer does not receive audit protection for R&E expenses paid or incurred in tax years beginning after Dec. 31, 2021, if the change in accounting method is made for the tax year immediately following the first tax year in which Sec. 174 becomes effective. That denial of audit protection appears to have been added to encourage taxpayers to implement the change to comply with amended Sec. 174 in the first year they are subject to it. Audit protection would apply for years after the immediately subsequent tax year — that is, for a taxpayer’s third and later tax years.

Under Rev. Proc. 2023-11, the previously discussed eligibility rule in Rev. Proc. 2015-13, which requires that the taxpayer not have made or requested an accounting method change for the same item during any of the five tax years ending with the year of change, is no longer waived for accounting method changes made after the first tax year beginning after Dec. 31, 2021. Therefore, a taxpayer that recently changed its preamendment Sec. 174 method for R&E expenses will have to file a nonautomatic accounting method change to comply with amended Sec. 174 if it does not make the change in its first tax year.

Rev. Proc. 2023-11 notes that despite the audit protection rules of Rev. Proc. 2015-13, the IRS can change the characterization or classification of expenses as R&E expenses to apply Sec. 174 and the automatic accounting method change to the proper amount of expenditures paid or incurred in each tax year beginning after Dec. 31, 2021.

Finally, the new automatic accounting method change procedure does not apply to changes in the treatment of R&E expenses under Sec. 174 before its amendment or software development expenses paid or incurred in tax years before Jan. 1, 2022 (amended Sec. 174 does not change the treatment of R&E expenses and software development expenses in those prior years). Rev. Proc. 2023-11 also explicitly excludes changes to the treatment of acquired, leased, or licensed computer software under Rev. Proc. 2000-50 (amended Sec. 174 does not change the treatment of that software).

Editor notes

Kevin Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Anderson at 202-644-5413 or kdanderson@bdo.com.