R&E expenses: Amortization if the company ceases to exist

Editor: Susan Minasian Grais, CPA, J.D., LL.M.

Cost recovery of specified research or experimental (SRE) expenditures is governed by Sec. 174. Subsection (d), added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, prevents taxpayers from deducting SRE expenditures upon the disposition, retirement, or abandonment of property for which those SRE expenditures are paid or incurred. Instead, taxpayers generally cannot recover costs before the end of the applicable Sec. 174 amortization period.

This item focuses on Notice 2023-63, in which the IRS outlines two rules for applying the amortization deduction to unamortized SRE expenditures for SRE property if that property is disposed, retired, or abandoned.

Under the first rule, a party disposing of SRE property, such as in a Sec. 1001 transaction (including a Sec. 1060 transaction) or Sec. 351 transaction, is generally prohibited from claiming any unamortized SRE expenditures as a result of these transactions, but the disposing party may continue to amortize the remaining unamortized SRE expenditures in a manner unaffected by the disposition, and the party acquiring the SRE property is not entitled to any such amortization.

The second rule provides an exception to the first rule in the case of corporate cessation transactions. If Sec. 381 applies (i.e., complete liquidations under Sec. 332 and certain acquisitive tax-free reorganizations described in Secs. 368(a)(1)(A), (C), (D), (F), or (G)), the transferee corporation steps into the shoes of the transferor corporation with respect to the unamortized SRE expenditures. If Sec. 381 does not apply, the transferor corporation generally immediately recovers any remaining unamortized SRE expenditures, and the transferee corporation is not entitled to any amortization of the unamortized SRE expenditures.

Taxpayers are not required to apply the rules in the notice but may apply them for tax years beginning after Dec. 31, 2021, provided they rely on all the rules and apply them consistently.

Some broader implications are explored below.

How disposing of SRE property affects amortization

Notice 2023-63 makes clear that a sale or other disposition of SRE property does not trigger an acceleration of the deduction of the transferor’s unamortized SRE expenditures (including in the context of an applicable asset acquisition under Sec. 1060(c) or a Sec. 351 transaction). Nor does it permit the use of the unamortized SRE expenditure amount in computing the transferor’s gain or loss on the transfer.

The notice illustrates how its operative rules apply in certain transactions by way of example. Significantly, as will be discussed later, these examples make clear that a separation exists between the SRE expenditure amortization and the SRE property.

Example 1: Company X, an accrual-method, calendar-year taxpayer, incurs SRE expenditures in 2023 for research performed in the United States. On Sept. 30, 2025, Company X sells the SRE property to Company Y and recognizes gain under Sec. 1001. In 2025 through 2028, Company X ratably amortizes the remaining unamortized SRE expenditures, notwithstanding Company X’s disposition of the SRE property.

Company Y does not amortize any portion of the SRE expenditures originally paid or incurred by Company X.

Company X does not factor its unamortized SRE expenditures into computing gain or loss under Sec. 1001 (§7.05(1)(b) of the notice; see also §7.05(1)(c), which provides the same result where the sale of SRE property is part of an applicable asset acquisition under Sec. 1060(c)).

In the following example, the notice illustrates what happens where the disposition of SRE property occurs in a Sec. 351 transaction:

Example 2: Company X, an accrualmethod, calendar-year taxpayer, incurs SRE expenditures in 2023 for research performed in the United States. On Sept. 30, 2025, Company X transfers the SRE property to Company Y in an exchange described in Sec. 351. In 2025 through 2028, Company X ratably amortizes the remaining unamortized SRE expenditures notwithstanding Company X’s disposition of the SRE property.

Company Y does not amortize any portion of the SRE expenditures originally paid or incurred by Company X (§7.05(1)(d) of the notice).

As noted in the “Implications” section below, this example is important because it presumably extends to similar provisions, such as Sec. 361.

Amortization rules if the corporation ceases to exist

Section 7.04 of the notice provides two special rules on the disposition, retirement, or abandonment of SRE property when a corporation ceases to exist. Which of these mutually exclusive rules should apply turns on whether the cessation arises in a transaction described in Sec. 381(a). Sec. 381(a) generally applies to a liquidation under Sec. 332 or a reorganization under Sec. 368(a). The application of Section 7.04 of the notice does not turn on whether there is gain recognition in the transaction (e.g., a Sec. 368(a) reorganization in which the target shareholder recognizes gain due to the receipt of cash or other property nevertheless is a Sec. 381(a) transaction).

Rule No. 1: If a corporation ceases to exist for federal income tax purposes in a transaction or series of transactions described in Sec. 381(a), the acquiring corporation will continue to amortize the distributor or transferor corporation’s unamortized SRE expenditures over the remainder of their applicable Sec. 174 amortization period, beginning with the month of transfer. Thus, the transferee or distributee inherits the ongoing amortization of the SRE expenditures even though Sec. 174 amortization is not an inheritable attribute listed in Sec. 381(c). See Section 7.04(1) of the notice; cf. Sec. 381(c)(6) (carryover of depreciation allowance); Sec. 381(c)(9) (carryover of bond amortization allowance); and Sec. 197(f)(2) (carryover of intangible amortization allowance).

To illustrate this point, the notice includes the following example in Section 7.05(2):

Example 3: Company X, an accrualmethod, calendar-year taxpayer, incurs SRE expenditures in 2023 for research performed in the United States. On Oct. 16, 2025, Company X is acquired by Company Z, an accrual-method, calendar-year taxpayer, in a transaction described in Sec. 381(a). In 2025, Company X amortizes a portion of the remaining unamortized SRE expenditures, and Company Z also amortizes a portion of the remaining unamortized SRE expenditures. In 2026 through 2028, Company Z ratably amortizes the remaining SRE expenditures.

Rule No. 2: A corporation that ceases to exist for federal income tax purposes in a transaction or series of transactions to which Sec. 381(a) does not apply may deduct the unamortized SRE expenditures in its final tax year. See Section 7.04(2)(a) of the notice. This special rule does not apply, however, if a principal purpose of these transactions is to claim a deduction for the unamortized SRE expenditures. This result contrasts with such seminal cases as Granite Trust Co., 238 F.2d 670 (1st Cir. 1956) (taxpayer permitted to undertake planning to qualify a liquidation under Sec. 331 in order to realize a stock loss).

Requests for comments

Section 11 of the notice requests comments on numerous areas that were and were not covered in the notice. The sole requests regarding Section 7 center on partnership transactions and anti-abuse considerations. Based on the comments requested, it appears the IRS believes it has properly addressed any Subchapter C considerations around dispositions, retirements, and abandonments of SRE property.

The deadline for submitting comments was Nov. 24, 2023, but the IRS will consider late comments if doing so will not delay the forthcoming proposed regulations, according to the notice.

Implications

Notice 2023-63 makes clear that disposing of SRE property does not accelerate the deduction of the transferor’s unamortized SRE expenditures, nor does it permit the use of the unamortized SRE expenditure in computing the transferor’s gain or loss on the transfer. The notice also makes clear that a transferee may succeed to unamortized SRE expenditures under Sec. 381(a).

Historical comparison: Aside from the aforementioned clear, mechanical results, some key transactional implications arise from Sec. 174(d) and the notice’s elaboration of them in Section 7. These trace to a single dynamic: the separation of the SRE expenditure amortization from the SRE property. This separation approach contrasts starkly with the pre-TCJA treatment of amortizable SRE expenditures under which unamortized SRE expenditures were reflected in the basis of the SRE property; cf. H.R. Rep’t No. 115-409, 115th Cong., 1st Sess., p. 283 (Nov. 13, 2017) (“In the case of retired, abandoned, or disposed property with respect to which specified research or experimental expenditures are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period”).

The reference in the legislative history to “remaining basis” is unclear; despite its implication, the text of Sec. 174(d) does not appear to contemplate the SRE expenditures being added to basis (e.g., under Sec. 1016, which was not revised in the TCJA with respect to Sec. 174(d)), so this language may be a nontechnical description of the cost recovery dynamic under Sec. 174(d) (e.g., that the SRE expenditures are reflected in an “account” rather than in one or more specific items of property); cf. Sec. 174(a)(2) (A) (treating SRE expenditures as chargeable to capital account).

Before the TJCA, Sec. 174(b) permitted elective amortization of SRE expenditures, with Sec. 1016(a)(14) and Regs. Sec. 1.1016-5(j) regarding such expenses as basis (i.e., connected to the SRE property through its capital account). Similarly, Sec. 59(e) permitted (and arguably still permits) an election to capitalize and amortize SRE expenditures, with Sec. 1016(a) (20) regarding these expenses as basis in the SRE property. See also Letter Ruling 200117006 (ruling that Sec. 59(e) expenses are treated similarly to former Sec. 174(b) deferred expenses and should be charged to capital account as an adjustment to the basis of the property to which they relate). Note that Regs. Sec. 1.1016-5 was issued before Sec. 59(e)’s enactment and is therefore silent on the capital account consequences thereof.

The following are some significant implications of this separation.

Divisive D transactions: For SRE property contributed by a distributing corporation to a controlled corporation under Sec. 361 in a divisive transaction described in Secs. 368(a)(1) (D) and 355 (i.e., a “divisive D transaction”), it would appear the Sec. 351 example above provides a close analogy. Applying this example, the distributing corporation would continue to amortize all the remaining SRE expenditures even though the controlled corporation holds some or all of the underlying SRE property. This contrasts with the IRS’s historic treatment of these expenditures. See Letter Rulings 200812005, 201033014, and 201308002, each of which provided for an allocation of unamortized SRE expenditures between the distributing and controlled corporations in the case of a Sec. 59(e) election; cf. Letter Ruling 200117006 (ruling that taxpayers can take into account the former Sec. 174(b) and Sec. 59(e) basis in determining gain or loss upon the disposition of property in a taxable transaction).

Relatedly, the notice implicitly rejects an alternative reading of Sec. 174(d), specifically, that an allocation of the unamortized SRE expenditures is permissible because the transferor is not claiming a current deduction “on account of such disposition,” but instead, the transferor and transferee are merely continuing to amortize them. Although it is unclear what the drafters of Sec. 174(d) may have intended, such an interpretation would be plausible, although the notice suggests otherwise.

The request for comments in Section 11 of the notice does not refer to divisive D transactions. Thus, it appears the IRS believes no substantial issue remains on this topic.

Clear-reflection-of-income principles: The separation of the SRE expenditure amortization from the SRE property would appear contrary to the general, and principal, accounting method goal of clear reflection of income (which includes avoiding artificial mismatches of income and deduction). For instance, in Rev. Rul. 95-74, the location of a deduction of a contingent liability assumed in a Sec. 351 transaction turned on whether the transferee succeeded to the underlying business assets from which the contingent liability arose. Separating the SRE expenditures from the SRE property in a Sec. 351 (or Sec. 361) transaction arguably is inconsistent with clear-reflectionof- income principles because the SRE property may generate income attributable to the SRE expenditures.

As another example, consider the implications of the sale of a U.S. target in a transaction in which a Sec. 338(h) (10) election is made. Under Sec. 338(h)(10), the U.S. target is generally treated as selling its assets in a transaction that is characterized as a Sec. 1060 applicable asset acquisition followed by a Sec. 332 liquidation, which results in the following:

• The U.S. target corporation’s unamortized SRE expenditures are not recovered in the transaction;
• The acquiring corporation does not succeed to the unamortized SRE expenditures despite owning all the SRE property (through its ownership of “new” U.S. target); and
• The corporate shareholder of the U.S. target, which had nothing to do with the SRE expenditures, succeeds to the unamortized SRE expenditures.

In the context of the clearreflection- of-income standard, the notice appears to permit greater distance between the location of the SRE expenditure incurrence and the SRE property. The same is true for other transactions treated as taxable asset sales followed by a Sec. 332 liquidation (see, for example, Rev. Rul. 69-6).

In the consolidated return context, the separation of SRE expenditures from SRE property may produce unusual consequences. For example, if consolidated group member S sells SRE property to consolidated group member B at no gain or loss, the SRE expenditure amortization will remain in S and will reduce the S stock basis under Regs. Sec. 1.1502-32(b)(3)(i) as the amortization occurs. The B stock basis, however, is not adjusted for the amortization, even though B’s prospective income or loss from the SRE property may be attributable in varying degrees to the SRE expenditures.

It does not appear the attribute redetermination rule of Regs. Sec. 1.1502-13(c)(1)(i) would apply to alter this result. For instance, Regs. Sec. 1.1502-13(c)(1)(i) only affects “attributes,” which do not include the location or amount of an item; thus, the relocation of any portion of S’s amortization to B seemingly is beyond the scope of Regs. Sec. 1.1502-13(c)(1)(i).

Anti-abuse rule: As noted previously, a corporation may generally deduct the unamortized SRE expenditures in its final tax year if it ceases to exist in a non–Sec. 381(a) transaction. Section 7.04(2)(b) of the notice, however, contains an anti-abuse rule that overrides the general rule if a principal purpose of the transaction is to claim a deduction for the unamortized SRE expenditures. Under the anti-abuse rule, as currently drafted, the IRS would completely disallow the otherwise permitted recovery of unamortized SRE expenditures under Section 7.04(2)(a) if it determined the corporate cessation transaction had, as a principal purpose, the claiming of a deduction for those expenditures.

Given that this rule applies outside Sec. 381(a) transactions and that the corporation’s existence has ceased, there seems to be no further opportunity for the SRE expenditures to be recovered, despite the continued existence of the SRE property in the tax system. This would permanently distort the ceased corporation’s lifetime income (i.e., it incurred actual, recoverable economic expenses, which were permanently denied). Hopefully, the IRS will revisit this decision under its request for comments in Section 11.01(4) of the notice (“What, if any, changes to the rules in section 7 … are appropriate to address potential abuses?”).

Treatment as basis or as a deferred expense: As noted previously, it is unclear whether SRE expenditures are considered basis in a separate intangible or a deferred expense. Treatment of the SRE expenditures as basis or as a deferred expense may have implications for other Code provisions. For example, treatment as basis or as a deferred expense can have implications under Sec. 382 for determining whether a loss corporation has a net unrealized built-in gain or net unrealized builtin loss and whether the SRE expenses are treated as recognized built-in deductions, which may be limited by Sec. 382. Other areas potentially affected by the uncertain basis status include Sec. 357(c) (excess liability assumptions); Sec. 361(b)(3) (basis ceiling on creditor transfers); and Sec. 362(e) transfers (loss importation/ duplication transactions).

Editor Notes

Susan Minasian Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C.

For additional information about these items, contact Grais at susan.grais@ey.com.

Contributors are members of or associated with Ernst & Young LLP.