The IRS recently released guidance (Rev. Proc. 2023-11), which modifies and supersedes the recently issued automatic procedures in Rev. Proc. 2023-08 for taxpayers that incur specified research or experimental (R&E) expenditures to change their method of accounting to comply with the new capitalization and amortization rules provided in Section 174, as revised by the Tax Cuts and Jobs Act (TCJA), referred to herein as the “new Section 174.”
The necessary, much-anticipated guidance provides administrative relief and allows taxpayers to file a statement with their federal tax return in lieu of a Form 3115, Application for Change in Accounting Method, provided the change is made in the first taxable year that the new Section 174 guidance is effective (i.e., the first taxable year beginning after Dec. 31, 2021).
The new procedures also provide favorable transition guidance for taxpayers that have already filed a federal tax return for a short taxable year for which the new Section 174 guidance was effective.
Background
The TCJA amended Section 174 relating to the federal tax treatment of research or experimental expenditures paid or incurred during the taxable year. The new Section 174 rules require taxpayers to capitalize and amortize specified R&E expenditures over a period of five years (attributable to domestic research) or 15 years (attributable to foreign research), beginning with the midpoint of the taxable year in which the expenses are paid or incurred. Under new Section 174(c)(3), software development costs are treated as R&E expenditures and must also be capitalized and amortized in accordance with the new rules.
As provided by the TCJA, a change to implement the new Section 174 rules is a change in method of accounting that is applied on a cut-off basis, applicable to specified R&E expenditures paid or incurred in taxable years beginning after Dec. 31, 2021.
The previously issued Rev. Proc. 2023-08 modified Rev. Proc. 2022-14 to provide new procedures for obtaining automatic consent to change a method of accounting to comply with new Section 174, as amended by the TCJA. Rev. Proc. 2023-11 predominantly restated the procedures in Rev. Proc. 2023-08, but modified them to encourage timely compliance with new Section 174 by limiting audit protection available for taxpayers that change their accounting method to comply with new Section 174 in the taxable year immediately subsequent to the first taxable year that new Section 174 is effective.
Automatic procedures
Rev. Proc. 2023-11 revised Section 7.02 of Rev. Proc. 2022-14 to apply to a taxpayer that wants to change its method of accounting for specified R&E expenditures paid or incurred to comply with the capitalization and amortization requirements of new Section 174 (referred to as the “required Section 174” method for purposes of Section 7.02). This accounting method change does not apply to a change in the treatment of acquired, leased, or licensed computer software under Rev. Proc. 2000-50 or R&E expenditures paid or incurred in taxable years beginning before Jan. 1, 2022, which are required to be accounted for under the former Section 174.
Similar to the former procedures for making method changes under Section 174, the required Section 174 change does not provide audit protection (as generally provided under Section 8.01 of Rev. Proc. 2015-13) for R&E expenditures paid or incurred prior to the date that the required Section 174 method is effective. The procedures administer two approaches for changing to the required Section 174 method, depending on the year of change.
Statement in lieu of Form 3115
Taxpayers making the change to comply with the required Section 174 method in their first taxable year beginning after Dec. 31, 2021, do so by filing a statement with their federal tax return in lieu of filing the Form 3115, Application for Change in Accounting Method, and are not required to file a duplicate copy with the IRS (as generally required under Section 6.03(1)(a) of Rev. Proc. 2015-13).
The following information must be included on the statement:
- Name and employer identification number or Social Security Number (as applicable).
- Beginning and ending dates of the tax year of change.
- Designated automatic accounting method change number (designated change number #265).
- Description of the type of expenditures included in the change.
- Amount of R&E expenditures paid or incurred during the year of change.
- Statement that the change in method of accounting is for specified R&E expenditures to capitalize such expenditures to a capital account and amortize such amounts over either a five-year period (domestic research) or a 15-year period (foreign research) beginning with the mid-point of the taxable year in which such expenditures are paid or incurred. The applicant must also state that the change is made on a cut-off basis.
Changes made via filing a statement in lieu of a Form 3115 are made on a cut-off basis. Additionally, the procedures temporarily waive the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13, which otherwise precludes taxpayers from filing an accounting method change for the same item within a five-taxable year period.
Grant Thornton Insight
Taxpayers that have changed their method of accounting for Section 174 expenditures within the prior five years benefit from the waiver of the general five-year limitation rule and can change their method of accounting to comply with the new Section 174 rules under the automatic procedures. However, taxpayers should be aware that this waiver only applies to the first taxable year beginning after Dec. 31, 2021.
When Form 3115 is required
Taxpayers with a year of change that is later than their first taxable year beginning after Dec. 31, 2021, are required to file a Form 3115 to change their method of accounting. In contrast to changes made in the first taxable year beginning after Dec. 31, 2021, via filing a statement, changes that are made by filing a Form 3115:
- Require the computation of a modified Section 481(a) adjustment that takes into account only specified R&E expenditures paid or incurred in years beginning after the required Section 174 method is effective
- Cannot be made under the automatic procedures if a change for Section 174 expenditures has been made in any of the prior five taxable years (i.e., the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 is applicable)
- Require a duplicate copy of the Form 3115 to be filed with the IRS in accordance with Section 6.03(1)(a) of Rev. Proc. 2015-13
Taxpayers also must include an attachment to the Form 3115 with information similar to the information required in instances when a statement is filed in lieu of a Form 3115. Taxpayers do not receive audit protection under Section 8.01 of Rev. Proc. 2015-13 with respect to expenditures paid or incurred in taxable years beginning on or before Dec. 31, 2021. Additionally, as modified by Rev. Proc. 2023-11, taxpayers with a year of change immediately subsequent to the first taxable year in which new Section 174 is effective do not receive audit protection with respect to expenditures paid or incurred in taxable years beginning after Dec. 31, 2021.
Grant Thornton Insight
Prior to the modifications made by Rev. Proc. 2023-11, the procedures under Rev. Proc. 2023-08 generally would have provided audit protection to taxpayers that made the change to new Section 174 in any taxable year following the first taxable year beginning after Dec. 31, 2021, for expenses incurred in taxable years beginning after Dec. 31, 2021. However, under the modified procedures, taxpayers that fail to make the change to comply with new Section 174 as required by the statute in 2022, and instead make the change in the next subsequent year, will not receive audit protection for expenses incurred in the first taxable year beginning after Dec. 31, 2021. It is therefore important that taxpayers timely comply with new Section 174 in the first taxable year in which the statute and guidance are effective.
Transition rule
The procedures provide a transition rule for taxpayers who have filed a federal tax return on or before Jan. 17, 2023, as modified by Rev. Proc. 2023-11, for a taxable year beginning after Dec. 31, 2021. Under this transition rule, such taxpayers are deemed to have changed their method of accounting to the required Section 174 method for specified R&E expenditures paid or incurred in the first taxable year beginning after Dec. 31, 2021, provided the taxpayers have both:
- Reported the amount of specified R&E expenditures on Part VI of Form 4562, Depreciation and Amortization, filed with the federal tax return
- Properly applied the provisions of the required Section 174 method by capitalizing and amortizing specified R&E expenditures
Grant Thornton Insight
Taxpayers that have already filed their federal tax return for the first taxable year beginning after Dec. 31, 2021, (e.g., due to a short-period tax year) should evaluate their analysis and reporting of Section 174 expenditures to determine if the transition rule guidance applies or if additional action is necessary.
Next steps
Rev. Proc. 2023-11 provides welcome administrative relief for taxpayers to comply with the new Section 174 capitalization and amortization requirements. Taxpayers that change their method of accounting in their first taxable year beginning after Dec. 31, 2021, will benefit from the simplified approach of filing a statement in lieu of a Form 3115 to effectuate the change. Taxpayers should evaluate their current methods for identifying Section 174 costs to determine the level of effort that will be required to comply with the new Section 174 rules and begin planning so the change to new Section 174 can be made in their first taxable year beginning after Dec. 31, 2021.
Taxpayers also should be aware that necessary substantive guidance with respect to the new Section 174 rules is anticipated to be forthcoming.
For more information, contact:
Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “§,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.
Our fresh thinking
No Results Found. Please search again using different keywords and/or filters.
Share with your network
Share