The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, eliminated the option to currently deduct research and experimental (R&E) expenditures. For tax years beginning after Dec. 31, 2021, taxpayers are required to capitalize and amortize all R&E expenditures paid or incurred in connection with their trade or business under Sec. 174. The amortization recovery periods are five years for domestic and 15 years for foreign-incurred R&E. In addition, the Sec. 174 capitalization includes any costs paid or incurred in connection with the development of any software. As a result, software development costs that historically may not have been identified as qualified research expenditures for purposes of the Sec. 41 tax credit for increasing research activities need to be identified to comply with the capitalization requirement under Sec. 174.
Prior to the TCJA, R&E expenses could be expensed and potentially claimed as a Sec. 41 credit. Alternatively, taxpayers could elect to amortize certain R&E expenditures over various recovery periods. In addition, prior to the TCJA, software development was not specifically addressed within Sec. 174. Rather, Rev. Proc. 2000-50 provided that software development expenses closely resemble R&E expenditures and, as such, could be treated similarly to R&E expenditures under Sec. 174. Now, the revised statute specifically treats software development as an R&E expenditure (Sec. 174(c)(3)).
Since many taxpayers have been deducting software development expenditures, they will need to correctly identify the types of software development expenditures that must be capitalized under Sec. 174.
Defining software development under Sec. 174
Uncertainty exists as to the exact types of activities that may be included in the definition of “software development” under Sec. 174(c)(3). Taxpayers are awaiting further guidance from the IRS and Treasury to understand the specific types of activities that may be included in software development. For now, taxpayers may be able to look to Rev. Proc. 2000-50 to help to determine the types of costs that may be subject to the new capitalization requirements under Sec. 174. In Rev. Proc. 2000-50, the IRS noted that the costs of developing computer software so closely resemble the kind of research and experimental expenditures governed by Sec. 174 as to warrant similar accounting treatment. Rev. Proc. 2000-50 defined “computer software” in part as:
any program or routine (that is, any sequence of machine-readable code) that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. … Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translators, assembly routines and utility programs as well as application programs, are included. Computer software also includes any incidental and ancillary rights that are necessary to effect the acquisition of the title to, the ownership of, or the right to use the computer software, and that are used only in connection with that specific computer software.
This broad definition should be considered when applying Sec. 174.
Examples of software development costs that may need to be capitalized include:
- Software engineering, user experience (UX) design, and related project planning;
- Architecture and user interface (UI) design;
- Software coding;
- Quality assurance related to software development;
- Software deployment;
- Software support and maintenance;
- Software packages or subscriptions used in development;
- Legal fees for patents for and licensing fees associated with software development;
- Cloud hosting expenses for the development environment; and
- Enterprise resource planning (ERP) systems integration, to the extent that it involves development work, such as customization and integration.
Below are examples of software-related costs that might not be deemed Sec. 174 costs:
- Regular testing or inspection of software (quality control);
- Ongoing maintenance;
- Acquiring or licensing “off the shelf ” software;
- Configuring existing software; and
- Customer support.
Defining software costs eligible for deduction under Rev. Proc. 2000-50
Any software development costs that are not required to be capitalized under Sec. 174 can continue to qualify for immediate expensing under Rev. Proc. 2000-50. Costs of acquired software or licensed off-the-shelf software might not be required to be capitalized under Sec. 174. Acquired software would likely still need to be capitalized and depreciated as a fixed asset under Sec. 167, potentially over a quicker recovery period than under new Sec. 174. Payments for licensed software may potentially be currently deductible as Sec. 162 expenses.
Accounting method changes under Rev. Proc. 2023-11
Under Rev. Proc. 2023-11, taxpayers can receive automatic consent to change their method of accounting for R&E expenditures to comply with the required amortization provisions (see also Messner and Ivanova, “R&E Expenses: Automatic Accounting Method Change Procedures,” 54-5 The Tax Adviser 24 (May 2023)). Further, the guidance provides streamlined procedures by which taxpayers may attach a statement to their return in lieu of filing a Form 3115, Application for Change in Accounting Method, for their first tax year beginning after Dec. 31, 2021. The change is implemented on a cutoff basis for the first tax year beginning after 2021. Changes for later years are made with a modified Sec. 481(a) adjustment, considering only R&E expenditures paid or incurred in tax years beginning after Dec. 31, 2021. The procedural guidance waives the five-year eligibility rule only for changes made in the first tax year beginning after Dec. 31, 2021.
The statement effectuating the change in method of accounting must include:
- The applicant’s name and employer identification number or Social Security number;
- The beginning and ending dates of the first tax year of the change;
- The designated automatic accounting method change number (265);
- A description of the type of expenditures included as specified R&E expenses;
- The amount of specified R&E expenses paid or incurred during the year of change; and
- A declaration that the applicant is changing the method of accounting for specified R&E expenses to capitalize them to a specific R&E capital account and amortize them over either five years for domestic research or 15 years for foreign research (as applicable), beginning with the midpoint of the tax year in which the expenditures are paid or incurred. The declaration must also state that the change is being made on a cutoff basis.
Any change made after the first tax year beginning after 2021 must be made with a modified Sec. 481(a) adjustment, considering only specified R&E expenses paid or incurred in tax years beginning after 2021. A Form 3115 must be filed, and, in addition, the following information must be completed on an attachment to the Form 3115:
- A description of the type of expenditures included as specified R&E expenses;
- The tax years in which the specified R&E expenses were paid or incurred; and
- A declaration that the method of accounting for specified R&E expenses is being changed to capitalize them to a specific R&E capital account and amortize them over either five years for domestic research or 15 years for foreign research (as applicable), beginning with the midpoint of the tax year in which the expenditures are paid or incurred. Also, the declaration must state that the change is being made with a modified Sec. 481(a) adjustment that takes into account only specified R&E expenses paid or incurred in tax years beginning after 2021.
A taxpayer will not receive audit protection for the change for expenditures paid or incurred in tax years beginning before 2022. Additionally, no audit protection is available for specified R&E expenses paid or incurred in tax years beginning after 2021 if the change in accounting method is made for the tax year immediately after the first tax year in which the changes to Sec. 174 were effective.