IRC Section 174 Updates: Navigating R&D Software Development Cost Capitalization Impacts

Posted June 17, 2024

Have you heard of a change in Section 174 of the US tax law that kicked in a few years ago? This exploration of Section 174’s impact on software development cost capitalization hinges on two key developments: the introduction of the new IRC 174 statute in late 2017 and the subsequent IRS Notice 2023-63 published Sept. 8, 2023, which provides additional guidance in connection with the amortization of Specified Research or Experimental (SRE) expenditures under IRC Section 174, as amended by the Tax Cuts and Jobs Act. The Notice states that the provisions contained in Sections 3 through 9 are applicable for taxable years ending after Sept. 8, 2023.

The Tax Cuts and Jobs Act (TCJA) of 2017 brought about a wave of transformative changes that significantly altered the tax landscape for businesses nationwide. One of the most notable changes introduced by this comprehensive legislation was the revision in the treatment of research and development (R&D) expenses, which has a direct bearing on the complex considerations surrounding internal software development.

The TCJA’s amendments to Section 174 of the Internal Revenue Code (IRC) have had a profound impact on taxpayers, necessitating a strategic reevaluation of their approach to R&D expenditures. These changes, which came into effect at the start of 2022, are still resonating in the business community, underscoring the urgency for companies to adjust and harmonize their practices with the evolving regulatory landscape.

At the heart of these revisions lies a fundamental shift in the treatment of R&D costs, transitioning from the traditional immediate expensing approach to a mandatory capitalization and amortization process. This paradigm shift has far-reaching consequences, particularly for businesses engaged in internal software development, where the interplay between innovation, intellectual property, and tax implications is intricate and multifaceted.

Understanding the changes to Software Development Costs:

Before the Tax Cuts and Jobs Act (TCJA) of 2017, companies could deduct the entire cost of developing internal software used for core functions like claims processing and customer enrollment in the year those expenses were incurred.

However, the TCJA amended Section 174. This means most research and development (R&D) expenses, including qualified software development for internal use, now need to be capitalized (treated as an asset) for tax purposes. These capitalized costs are then amortized (expensed gradually) over five years (or fifteen years for foreign expenditures).

The law includes another big change. The Evergreen Small Business blog wrote about how the tax law now wants to treat software development costs as a SRE expenditure. Quoting the statute, Section 174(c)(3), says this:

“For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.”

Here’s the new reality: most software development costs for internal use need to be capitalized, meaning they’re treated as an asset on your books. This capitalized amount is then amortized, which is a fancy way of saying it’s gradually expensed over a set period.

Imagine you spend $1 million developing a critical piece of software. Under the old rules, you might have deducted that entire $1,000, 000 amount right away. Now, you’ll likely capitalize that cost and amortize it, potentially deducting:

$200,000 per year over 5 years (for domestic development)
$66,666 per year over 15 years (for foreign development)

The key takeaway? Software development costs may not be fully deductible upfront anymore. This can impact your cash flow and tax liability.

Software startups got unexpectedly high tax bills out of nowhere

Pragmatic Engineers wrote an article that stated In a twist of events that caught many US software businesses off guard, 2023 brought a wave of surprisingly high tax bills, seemingly materializing from nowhere. The culprit behind this unexpected financial burden? A tax change that took effect in July 2022, a revision that remained largely unknown to many small companies until the finalization of their 2022 tax returns.

The root cause of this tax dilemma lies in an anticipated repeal of the amendment to Section 174 of the Internal Revenue Code, which was widely expected to occur in December 2022. This assumption led many accountants to refrain from informing their clients of the impending change, a decision that ultimately backfired when the repeal failed to materialize.

As a result, businesses were caught off guard when the first tax payments fell due last April. They were left in disarray as they scrambled to adapt to the new reality imposed by the Section 174 amendment, a significant challenge for these small companies.

The amendment to S174 means that, unlike the norm globally, employing software engineers can no longer be accounted for as a direct cost in the year they are paid.

Let’s talk about Acme Corp., a bootstrapped software company generating $1 million annually through its SaaS service. They have a lean team of five engineers, each earning $200,000, bringing their total labor cost to $1 million.

For simplicity, we’ll ignore other expenses like servers and hosting, which can also be subject to amortization under the new R&D rules.

The Profit Paradox: 2021 vs. 2022

Under the old tax code (pre-2022), Acme Corp.’s profit would simply be their revenue minus expenses, likely resulting in zero profit in 2021 after accounting for employee costs.

However, things changed in 2022 with the introduction of Section 174 amendments. Now, most software development costs, including employee salaries, need to be capitalized and amortized over five years. Here’s how amortization typically works:

Year 1: 10% of the cost is deducted.
Years 2-5: 20% of the cost is deducted each year.
Year 6: The remaining 10% is deducted.

Critical components of R&D under Section 174

The definition of research and development or experimental expenditures is quite broad, making it challenging for most businesses to determine how to categorize or re-categorize expenses related to research.

However, in September 2023, the Internal Revenue Service provided more guidance that addressed several issues, including the definition of software and the treatment of research performed under contract. Some of these issues included:

Technological information — Technology or software companies may have a greater challenge than some as they sort through the complexities of understanding that all expenses, in theory, incurred in connection with software development must now be amortized. Many technology and software companies will face significant increases in their taxable income because they are no longer allowed to deduct certain expenses.

Business component — For any research related to a new function of a current business component or one used to improve on an existing function (such as a software update), it must be proved that the update will increase the product or service performance, make it more reliable, and in general increase its quality.

Process of experimentation — The activities must involve a process of experimentation. This means there should be an evaluative process to identify and consider alternatives to achieve a result. This process must be technological in nature and must fundamentally rely on principles of physical or biological sciences, engineering, or computer science.

Elimination of uncertainty—Companies will have to document and report the purpose of the research. The report must show that the research must eliminate uncertainty concerning a product’s development or improvement, including uncertainty about the appropriate design of a product or process.

Not All Research Qualifies: Understanding Section 174 Exclusions

While Section 174 offers tax benefits for research and development (R&D) expenses, it’s important to understand what activities fall outside its scope. Here are some key exclusions:

Marketing and Sales Activities: Market research, advertising, and sales promotions are not considered R&D under Section 174.
Post-Production Research: Research conducted after a product’s commercial launch doesn’t qualify.
Quality Control Testing: Routine quality checks don’t fall under the R&D umbrella.
Contract Research: If another party funds the research and retains substantial rights, it’s not eligible for Section 174 deductions.
Foreign Research: Research conducted outside the U.S. may have different tax treatment.

Maximizing the Benefit

To leverage Section 174 effectively, companies should:

Maintain Detailed Records: Carefully document R&D activities and ensure expenses directly relate to qualified research.
Embrace Technology: Utilize technology to streamline record-keeping and ensure compliance with tax regulations.

By understanding exclusions and maintaining proper documentation, businesses can optimize their R&D tax benefits under Section 174.

Conclusion

With the new Section 174 requirements in effect, it’s crucial to ensure your accounting system reflects these changes. Here’s how to be proactive:

Schedule a Consultation with Your Tax Advisor: Discuss your software development costs and how they should be treated under Section 174.
Work with Your Bookkeeper: Ensure your bookkeeper understands the new amortization rules and can accurately track your software development expenses.

By taking these steps now, you can avoid potential tax filing errors and ensure you’re maximizing any available deductions for your software development costs. Have questions, feel free to reach out to Huckabee CPA for a free consultation.