Interim guidance for SRE expenditures

Editor: Jeffrey N. Bilsky, CPA

The days immediately preceding a federal holiday, calendar year end, or return deadline are often days to watch for new IRS guidance, and this past holiday season did not disappoint. Interestingly falling on the sixth anniversary of the 2017 amendment to Sec. 174, the latest interim guidance on specified research or experimental (SRE) expenditures dropped mere hours before the Dec. 25 holiday. However, the release was largely taxpayer-favorable and highly responsive to practitioner comments, which perhaps supports an interpretation of it as a modest holiday gift from the IRS to taxpayers.

The release contained both procedural guidance (Rev. Proc. 2024-9) and substantive guidance (Notice 2024-12) on the 2017 amendment, which removed the ability to expense SRE expenditures, requiring them instead to be capitalized and amortized. The two new items of IRS guidance bring the Sec. 174 amendment’s timeline to the following:

• Dec. 22, 2017: Sec. 174 amendment;
• Jan. 1, 2022: Amendment’s effective date for calendar-year taxpayers;
• Dec. 12, 2022: Release of Rev. Proc. 2023-8 (procedural);
• Dec. 29, 2022: Release of Rev. Proc. 2023-11 (procedural);
• June 15, 2023: Release of Rev. Proc. 2023-24 (procedural);
• Sept. 8, 2023: Release of Notice 2023-63 (substantive); and
• Dec. 22, 2023: Release of Rev. Proc. 2024-9 (procedural) and Notice 2024-12 (substantive).

As the timeline suggests, the Sec.174 amendment is proving particularly challenging for the IRS to administer and interpret and, as a result, for taxpayers to implement. Plenty of questions and complexities remain; however, the latest guidance is a step toward the clarity all parties desire, while practitioners continue to monitor Congress for legislative action.

Substantive revisions

As noted above, the Service’s original, interim, substantive guidance on SRE expenditures was released last September in Notice 2023-63. Notice 2024-12 clarifies and modifies the earlier guidance in three key areas:

Contract research and excluded SRE product rights: Under Notice 2023-63, for research performed under contract, the research provider’s exposure to capitalization under Sec. 174 was fairly broad and generally triggered by either financial risk or any right to use or exploit the SRE product. Notice 2024-12 limits this exposure for research providers that (1) do not bear financial risk under their contract terms and (2) obtain only an “excluded SRE product right,” which is either separately bargained for or acquired for the limited purposes of performing SRE activities for the research recipient.

Limited reliance permitted for Notice 2023-63: As initially released, Notice 2023-63 contained an all-ornothing reliance provision: To rely on any of the rules in Sections 3 through 9, taxpayers had to rely on them all. In response to resulting procedural challenges, Notice 2024-12 removes the all-or-nothing requirement; taxpayers may now choose the provisions of Notice 2023-63 on which they would like to rely.

Rev. Proc. 2000-50 available for pre-2022 software development costs: Notice 2024-12 clarifies that Section 5 of Rev. Proc. 2000-50 regarding costs of developing computer software is obsoleted only for expenditures paid or incurred in tax years beginning after Dec. 31, 2021, not for earlier expenditures.

Interestingly, in addition to the substantive updates in Notice 2024-12, the IRS addressed a narrow substantive issue in Rev. Proc. 2024-9, the procedural portion of the December guidance.

Percentage-of-completion method, completion percentage denominator: For taxpayers with SRE expenditures allocable to long-term contacts accounted for under the percentage-of-completion method (PCM), the Service clarified in Notice 2023-63 that the numerator of the completion ratio contained the amortization of the SRE expenditure, not its gross amount. That prevented the whipsaw effect of contract revenue acceleration accompanied by a deferral of the corresponding expenses.

While addressing the PCM numerator, earlier guidance was silent on the denominator. Oddly contained in the description of the change for the new designated change number (DCN) 271, Rev. Proc. 2024-9 gives taxpayers two choices for the PCM denominator: (1) include all estimated amortization of allocable SRE expenditures — that is, the gross expenditure, or (2) include only that portion of the amortization expected to be incurred and deducted during the term of the contract.

Those options have meaningful trade-offs. Option 1 will generally maximize the revenue deferral but can carry an administrative burden of repetitive lookback interest computations. Option 2 should be administratively simpler but at the cost of a more moderate revenue deferral. Additionally, even under Option 1, all remaining unrecognized contract price must be included in gross income for the tax year following contract completion.

Procedural revisions 

Rev. Proc. 2024-9 is the fourth iteration of procedural guidance granting automatic IRS consent for accounting method changes to comply with the Sec. 174 amendment. The new procedural guidance introduced automatic method changes to conform with Notice 2023-63 as modified by Notice 2024-12 and is effective for Forms 3115, Application for Change in Accounting Method, filed on or after Dec. 22, 2023. There are several key differences between the newest iteration and prior versions:

New DCNs: Prior iterations of the procedural guidance created DCN 265, providing automatic IRS consent for taxpayers to change their methods of accounting to comply with the Sec. 174 amendment. While maintaining the availability of DCN 265, Rev. Proc.2024-9 creates a second automatic change — DCN 270 — that is specific to compliance with Sections 3 through 7 of Notice 2023-63. Given that those sections of Notice 2023-63 are themselves nonmandatory interpretations of the Sec. 174 amendment, it is not entirely clear what circumstances would compel taxpayers to file a change under this second DCN 270 versus the original DCN 265.

As mentioned above, Rev. Proc.2024-9 also created a third DCN granting automatic IRS consent for taxpayers to conform with Section 8 of Notice 2023-63 concerning the interaction of Sec. 174 and the PCM. As with all DCNs implementing the Sec. 174 amendment, DCN 271 is made on a cutoff basis if filed for the taxpayer’s first tax year beginning after Dec. 31, 2021. This particular cutoff is important because it is based on when the expenditure is incurred, not on the contracting date. For DCN 271s filed for subsequent years, however, the new guidance allows a modified Sec. 481(a) adjustment, which is a welcome surprise, given that the Service typically requires cutoff treatment for all PCMrelated changes.

Historic treatment as inventory or depreciable property: Rev. Proc.2024-9 clarifies that a present method of errantly capitalizing SRE expenditures to either inventory or depreciable property would not place a taxpayer outside the scope of either DCN 265 or 270.

Optional cutoff treatment: Under prior iterations of the procedural guidance, DCN 265 required a modified Sec. 481(a) adjustment for changes made after a taxpayer’s first tax year beginning after Dec. 31, 2021. Rev. Proc. 2024-9 gives taxpayers the choice of implementing such changes on a cutoff basis if the modified Sec. 481(a) adjustment would be negative — that is, representing an income reduction. This optional cutoff treatment is available for all three DCNs: 265, 270, and 271.

Expansion of the five-year restriction waiver: As a broad prohibition under Rev. Proc. 2015-13, a taxpayer generally cannot use automatic consent procedures to change its method of accounting if it made or attempted an earlier accounting method change for the same item within a fiveyear window. In earlier iterations, the IRS waived this five-year restriction for DCN 265s filed for a taxpayer’s first tax year beginning after Dec. 31, 2021. Rev. Proc. 2024-9 expands this waiver for one additional tax year and allows the same waiver for DCNs 270 and 271. Additionally, the Service said during informal discussions at the American Bar Association’s January 2024 midyear meeting that it is considering again expanding the waiver period for taxpayers who had multiple short tax years in either 2022 or 2023 and are precluded from filing another automatic method change.

Limited audit protection for some year 2 changes: DCN 265 and now DCN 270 contain a rather unusual provision under which the audit protection that normally accompanies the filing of Form 3115 is generally withheld if such change is made for a taxpayer’s second tax year beginning after Dec. 31, 2021. Under earlier iterations of DCN 265, this rule was absolute for all year 2 changes. Rev. Proc. 2024-9 softens this restriction, allowing audit protection to attach to year 2 changes so long as the taxpayer made or attempted to make a change to comply with the Sec. 174 amendment in its first tax year beginning after Dec. 31, 2021.

Form 3115 filing requirement: While actually an area of consistency with prior iterations, taxpayers should note that the IRS did not choose to extend the simplified statement-in-lieu filing procedures to DCN 271 or to tax years after the taxpayer’s first tax year beginning after Dec. 31, 2021.

Legislative outlook

Any discussion of the Sec. 174 amendment would be incomplete without a reminder to continue monitoring Congress for legislative action, as this area has seen frequent debate. While attempts at delay or repeal have not yet been successful, these efforts continue to enjoy strong bipartisan support, including a bipartisan agreement under consideration when this item was drafted.

Editor notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta. Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Bilsky at jbilsky@bdo.com.