New IRS Procedural Guidance Unveiled

innovation

By
Deborah Roth, CPA
on
July 25, 2023

On December 12th, 2022, the IRS released Rev. Proc. 2023-8, providing procedural guidance for taxpayers adopting accounting methods for specified research or experimental expenditures under Code section 174 as modified by the Tax Cuts & Jobs Act. The revenue procedure allows for an automatic change on a cut-off basis for the first taxable year after December 31, 2021, using a statement in lieu of Form 3115. Taxpayers who already filed their 2022 return may be considered to have made an automatic method change under certain conditions. Additionally, a "modified" section 481(a) adjustment is introduced for post-2022 method changes.

Background

In 2017, the Tax Cuts & Jobs Act (TCJA) was passed by Congress, including revenue-raising provisions that impacted Research and Experimental (R&E) costs. The Joint Committee on Taxation (JCT) projected that these changes would generate $119.7 billion over the following ten years. Section 13206 of the TCJA introduced two modifications to R&E-related provisions for expenses incurred in tax years commencing after December 31, 2021:

  • All costs associated with software development are now classified as R&E expenditures.All R&E expenses must be capitalized and amortized over five years (fifteen years for foreign research).
  • These revisions have implications for businesses engaging in software development and conducting research activities, as they affect the treatment and deduction of R&E expenses, aligning with the objectives of the TCJA's revenue-raising measures.

Standard Application Protocols

Taxpayers can now initiate Designated Change Number 265 to capitalize specified research or experimental expenditures incurred in tax years starting after December 31, 2021. The new section 7.02 added to Rev. Proc. 2022-14 governs this change, applying to post-2021 tax year expenditures, including software development costs.

The change is implemented on a cut-off basis without adjustments for prior year expenses, and a statement can be used instead of Form 3115.

The statement must include essential details for each applicant:

  • Name and EIN (or SSN) of each applicant
  • Beginning and ending dates of the year of change
  • Designated change number (DCN 265) for this modification
  • Description of the type of expenditures included as specified research or experimental expenditures
  • Amount of specified research or experimental expenditures paid or incurred during the year of change by the applicant
  • Declaration that the applicant is changing the accounting method for specified research or experimental expenditures to capitalize and amortize them over either a 5-year period for domestic research or 15-year period for foreign research (as applicable), starting from the mid-point of the taxable year in which the expenses are incurred, following the method permitted under §174 for the year of change.
  • The declaration must also confirm that the applicant is implementing the change on a cut-off basis.

Successive-Year Filers

For tax years subsequent to the first tax year commencing after December 31, 2022 (post-2022 filers), taxpayers making the accounting method change must file a Form 3115. The attached statements to the Form 3115 should include:

  • A description of the type of expenditures considered as specified research or experimental expenditures.
  • The taxable year or years in which the specified research or experimental expenditures subject to the change were paid or incurred by the applicant.
  • A declaration that the applicant is modifying its accounting method for specified research or experimental expenditures to capitalize them to a specified research or experimental capital account, amortizing the amount over either a 5-year period for domestic research or 15-year period for foreign research (as applicable), starting from the mid-point of the taxable year in which the expenses are incurred, following the method permitted under § 174 for the year of change. Additionally, the declaration must indicate that the applicant is making the change with a modified §481(a) adjustment, considering only specified research or experimental expenditures paid or incurred in taxable years beginning after December 31, 2021.
  • The post-2022 change necessitates a modified section 481(a) adjustment, which entails accounting for all specified research or experimental expenditures paid or incurred in taxable years starting after December 31, 2021.

Brief Tax Year Filers

Taxpayers who file a Federal tax return on or before January 9th, 2023, for a tax year starting after December 31, 2021, will be considered to have fulfilled the automatic method change requirements if they meet the following conditions:

  • The amount of specified research or experimental expenditures paid or incurred for that taxable year is correctly reported on Part VI of Form 4562, Depreciation and Amortization, submitted with the Federal tax return.
  • The specified research or experimental expenditures are appropriately capitalized and amortized in accordance with the required § 174 method for that taxable year.
  • By adhering to these criteria, eligible taxpayers will be deemed to have fulfilled the automatic method change, ensuring compliance with the relevant tax regulations for specified research or experimental expenditures.

Additional Procedural Issues

For the taxpayer's initial taxable year commencing after December 31, 2022, the usual five-year item eligibility rule stated in Rev. Proc. 2015-13 is waived. This means that taxpayers have the flexibility to modify their accounting method for specified research or experimental costs in 2022, even if they had previously changed the method for these expenses within the prior five years. However, it's important to note that taxpayers won't receive audit protection for costs incurred or paid in tax years before 2022. This change allows taxpayers to adjust their accounting methods more freely for specified research or experimental expenditures without being constrained by the usual five-year rule.

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