The Tax Cuts and Jobs Act (TCJA) amended U.S. tax code Section 174 by removing the option to expense specified research or experimental (R&E) expenditures. Instead, taxpayers must now capitalize and amortize R&E expenditures over a period of five years (for domestic research) or 15 years (for foreign research).
The significant revisions to Section 174 have affected businesses across various industries — the transportation and distribution (T&D) industry has not been immune.
The T&D industry relies heavily on technological advancements to improve efficiency and meet evolving consumer demands. The industry has seen the development of cutting-edge solutions for more efficient logistics, advanced tracking systems, fuel alternatives and more. These new technology solutions have helped streamline operations and fostered a technologically advanced sector, but they have also created unforeseen tax consequences from a Section 174 perspective.
What lessons have we learned?
Lesson 1: T&D companies are often subject to Section 174
Many taxpayers believed that their software development activities, and the underlying costs tied to those activities, would not meet the definition of “research or experimental expenditures.” Perhaps they had not historically claimed the Research and Development (R&D) tax credit, or they felt their software development activities did not compare to the work of a “technology” company.
However, T&D companies often pay for software development activities that should be classified as Section 174 costs. The language in Section 174 is broad, and does not exclude specific industries. As long as the activities performed were “intended to discover information that would eliminate uncertainty concerning the development or improvement of a product (or software),” the cost will be subject to Section 174.
“Recently, we were talking with a transportation company that said ‘we don’t have significant R&E spend,’” recalled Grant Thornton Corporate Tax Solutions Partner Kristen Chapman. “We often hear that from transportation companies. However, as we started to discuss the company’s transportation management system and development of advanced route optimization algorithms, a light bulb went off. Not only did they have R&E expenses for these types of activities, but the amount was significant. What went from an otherwise deductible expense, now became a multi-million-dollar amortizable asset that created a million-dollar tax liability.”
Lesson 2: R&D credit versus Section 174
Section 174 casts a far wider net than the qualified research expenditures (QREs) that can be captured for the R&D credit.
The R&D credit is designed to only factor in direct R&D costs like wages, supplies and certain third-party contractor costs. Many taxpayers, especially those already claiming the R&D credit, have mistakenly assumed that the QREs captured for the R&D credit were in fact the Section 174 cost subject to capitalization.
Although QREs are, by definition, Section 174 costs, they are only a portion of what should be captured under Section 174. Several differences must be considered. First, section 174 includes foreign research and internal-use software development that is not eligible for the R&D credit. Perhaps most importantly, Section 174 includes both direct and indirect costs incurred in connection with the taxpayer’s development work. This includes, among other things, utilities, depreciation and employer-paid benefits. Taxpayers without departmental accounting (in which indirect costs are tied to departments engaged in development work) are now forced to develop unique allocation methodologies when calculating the portion of indirect costs tied to R&D activities.
Lesson 3: Not all software development activities are subject to Section 174
Section 174(c)(3) currently reads that “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” However, the regulations provided no further context as to what constitutes software development.
While most practitioners and taxpayers looked to apply historical guidance from other code sections (that is, Sec. 263(a), Section 41, Rev. Proc. 2000-50), and excluded costs pertaining to maintenance-related software activities, there was no certainty in these assumptions. Fortunately, the recently released Notice 2023-63 aligned with the thinking of most taxpayers, stating that activities like maintenance, data conversion, routine upgrades do not constitute software development under Section 174. The notice also provided clarity surrounding purchased software, clarifying that the costs of purchasing and installing computer software, including the configuration of pre-coded parameters, as well as any planning, designing or other development activities with respect to the software purchase, are not activities that would constitute software development under Section 174.
Lesson 4: Documentation and record-keeping are crucial
Proper documentation, as laid out in numerous tax court cases, has always been essential in substantiating a taxpayer’s Section 174 activities, particularly given the interplay with the valuable R&D credit under Section 41.
However, given the new rules result in an unfavorable adjustment for most taxpayers, it’s just as important to document, or have a sound methodology, for why certain costs should not be subject to Section 174. Companies in the transportation and distribution industry should maintain meticulous records of R&D activities, including project plans, progress reports and financial statements.
Take advantage of the next opportunities
Now that we have concluded the 2022 tax return filing season, it is imperative to reflect on the tax and financial impacts of Section 174 and plan for future development efforts. With lessons learned and the newly released guidance, taxpayers should re-evaluate their 2022 computations and plan ahead for 2023. Due to the continuous nature of the software development lifecycle, it is critical for T&D companies with software development activities to carefully analyze the nature of the activities and distinguish between those that do and do not fall under the Section 174 umbrella.
The new IRC Section 174 regulations present both challenges and opportunities for the T&D industry. By gaining a clear understanding of eligible activities and costs, maintaining thorough documentation, and developing a proper allocation methodology for overhead and indirect costs, taxpayers will be well positioned in their Section 174 capitalization analysis for the 2023 tax year.
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