The IRS Large Business and International (LB&I) division provided advice in Field Attorney Advice (FAA) 20205301F on a taxpayer’s Section 59(e) election for research and experimental (R&E) expenditures allocated to long-term manufacturing contracts subject to the percentage of completion method (PCM) under Section 460.
Section 460(a) generally requires taxpayers to account for income from a long-term contract under the PCM. Under the PCM, the portion of the gross contract price that corresponds to the percentage of the entire contract price that has been completed during the taxable year must be included in gross income for such taxable year. The percentage of the contract completed is computed by comparing the allocable contract costs incurred to date to an estimate of total allocable contract costs. Certain R&E expenditures, including costs under Section 174, related to a contract are required to be included in the allocable contract costs.
Section 59(e) provides an optional election to capitalize and ratably deduct certain Section 174(a) R&E expenditures over a 10-year period beginning with the taxable year the expenditure was made. A Section 59(e) election may be revoked only with the consent of the Commissioner by submitting a letter ruling request to the IRS.
The taxpayer in the FAA entered into several long-term manufacturing contracts. During Year 1 of the contracts, the taxpayer incurred R&E expenditures (allowable as a deduction under Section 174(a)) allocable to its long-term manufacturing contracts. The taxpayer’s Year 1 federal income tax return included a Section 59(e) election to capitalize and deduct an unspecified amount of these R&E expenditures ratably over 10 years. Additionally, the taxpayer deferred a portion of the revenue from the long-term contracts that was attributable to the R&E expenditures. This “R&E revenue” for each of the long-term contracts was determined by computing a profit rate (estimated total contract price compared to estimated total contract costs) for each contract and multiplying this rate by the total allocable R&E expenditures subject to its Section 59(e) election.
Together, these computations resulted in the taxpayer deferring gross income by reducing taxable income for 90% of the R&E revenue and deferring R&E expense by reporting only 10% of the R&E expenditures in Year 1. The taxpayer cited Section 59(e) in support of this position to defer the portion of the long-term contracts attributable to R&E expenditures. Although it allocated the full amount of R&E expenditures to and used the PCM to recognize gross income from its long-term contracts, LB&I found that the taxpayer’s Section 460 calculations did not reflect any impact or adjustment from its Section 59(e) election.
LB&I advised the IRS exam team that the taxpayer is permitted to make a Section 59(e) election for its R&E expenditures allocable to long-term contracts, but that it did not properly implement the election. The FAA concludes that the taxpayer properly deducted 10% of its R&E expenses in Year 1, but improperly deferred the 90% portion of “R&E revenue” because Section 59(e) does not permit Taxpayer to defer revenue from long-term contracts or from any other source. Rather, the taxpayer is required to account for revenue associated with its long-term contracts under Section 460. LB&I further advised the IRS exam team that it is not permitted to revoke the taxpayer’s Section 59(e) election unilaterally or at the taxpayer’s request because the taxpayer did not submit a letter ruling to the Commissioner requesting such consent and did not demonstrate the rare or unusual circumstances required for a revocation under Treas. Reg. Sec. 1.59-1(c)(2).
The facts of FAA 20205301F are difficult to follow and may not represent a situation common to many taxpayers. Notwithstanding the lack of clarity in the memorandum, the FAA broadly concludes that “a [S]ection 59(e) election does not alter the income calculation required under [S]ection 460.” While the memorandum acknowledges that the amount elected under Section 59(e) is properly chargeable to capital account under Section 1016(a)(20), according to LB&I, an election to capitalize R&E or other qualified expenditures under Section 59(e) should be ignored for purposes of determining the amount of allocable contract costs incurred and included in the numerator or the completion factor (allocable contract costs incurred / total estimate contract costs) under the PCM.
Compare this outcome to software development costs that a taxpayer chooses to properly capitalize under Rev. Proc. 2000-50 and Section 263(a) and amortize under Section 167, rather than expense in the year incurred. To the extent such software costs are properly allocable to a long-term contract because the software is used in the production process, the taxpayer would allocate some or all of the annual amortization expense under Section 167 to the long-term contract in the year of amortization rather than the entire software development costs in the year incurred.
FAA 20205301F is the first published IRS guidance concerning the interaction of Sections 460 and 59(e), but it is unclear whether the IRS National Office supports the broader conclusions reached by LB&I in the FAA. Furthermore, the FAA does not address the interaction between Sections 460 and 174(b). Similar to Section 59(e), Section 174(b) generally permits taxpayers to capitalize and ratably amortize certain R&E expenditures over a period that is not less than 60 months subject to other terms and conditions.
Sharon Kay is the National Managing Partner of Grant Thornton LLP's Washington National Tax Office. Sharon has over 25 years of tax experience and primarily advises clients on federal income tax issues such as accounting method changes, income and expense recognition, inventories, tangible and intangible asset capitalization and recovery, and certain business credits.
Washington DC, Washington DC
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