An Alternative Perspective on 174 R&D Capitalization
No one imagined we would actually be capitalizing R&D expenses when the Tax Cuts & Jobs Act (TCJA) was signed into law in 2017 by President Donald J. Trump. But by not reversing the requirement to capitalize R&D, the United States government is telling corporations to stop doing research and development in America.
The IRC section 174 capitalization rules of the TCJA go into effect in 2022, and American companies are reeling from the impact of these new rules. The new rules force a company to reduce research and experimentation deductions (i.e., R&D costs) to as little as 10% for domestic research. This result is staggering compared to other countries, including China which provides a deduction 20 times higher than the U.S. Chinese companies are allowed a 200% deduction for R&D expenses.
Yes, it is as insane as it sounds. While other countries incentivize companies to conduct high-paying research and development activities within their borders, the United States now require capitalizing 174 expenses which penalizes companies for conducting R&D.
Accountant’s sound off
There is no limit to the number of articles from accounting firms addressing capitalization of 174 expenditures. But like most things produced by accounting firms, they all say the same thing.
Accounting firms are looking at the issue through the lens of the R&D tax credit in IRC section 41. For 30+ years accounting firms have been arguing that everything is research and development. Under the accounting firm definition, everything will qualify as an IRC 174 expenditure and your capitalized R&D expenditures will be overstated.
Accounting firms are so focused on arguing and disagreeing with the government over the definition of 174 expenditures that they cannot help themselves from finding 174 expenses to capitalize even when that is a bad answer for you. Every accounting firm article on the topic tells the same story, you have 174 costs lurking in every corner, they add up to a giant number, you better hire the accounting firm to find all your 174 costs. Oh, and they are smarter than the other firm so they can find even more 174 costs.
What is a 174 expenditure?
This can be a little technical, but we will keep it as light as possible.
Section 174 of the internal revenue code was enacted in 1954 “in order to eliminate the need to distinguish research from business expenses for deduction purposes, and to encourage taxpayers to carry on research and experimentation activities”.1
Before section 174, there was no authorized treatment of research and experimental expenditures in the law. Some of these costs were just stuck in accounting limbo. As congress explained,
“…to the extent that they are ordinary and necessary they are deductible; to the extent that they are capital in nature they are to be capitalized and amortized over useful life…However, where projects are not abandoned and where useful life cannot be definitely determined, taxpayers have had no means of amortizing research expenditures.
To eliminate uncertainty and to encourage taxpayers to carry on research…the bill provides…that expenditures may…be treated as deductible expenses”.2
Okay, we see why this was enacted, but what exactly is a 174 expenditure?
The U.S. Treasury and the IRS have rejected a bright-line definition. Instead, we have this.
“Research and experimental expenditures…are…expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”3
“Research or development…in the experimental or laboratory sense” means,
- “(T)he information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product (i.e., an uncertainty exists).”4
- “The activity is intended to discover information that would eliminate that uncertainty.”5
Exactly. Congress has effectively enacted an enormous disincentive with capitalized R&D.
Congress enacted section 174 to encourage taxpayers to conduct research by allowing them to deduct research costs stuck in accounting limbo. Capitalizing R&D expenses is a clear disincentive.
Then, Treasury and the IRS refused to provide a bright-line definition of 174 costs.
And your accountant wants to force all types of “ordinary and necessary” business expenses into this vague definition so that you can capitalize R&D and pay more tax.
Where is congress in all this?
On July 27, 2023, while the clock ticks down for filing 2022 tax returns, and while there are multiple bills before congress to fix this mess with 174 capitalization congress had a hearing on UFOs and technology from outer space.
Perhaps congress is destroying your R&D efforts because it has alien technology hidden on Air Force bases that they are excited to pull out and give you to use in your business.
Again, accounting firms get paid to find 174 expenditures. So, they expand the definition of research and development or research and experimentation. This is the wrong approach here.
The courts have been narrowing the definition of 174 expenditures.
The Treasury and IRS have brought several 174 and R&D credit cases to the courts over the years. There have been over 80 such cases. A few of these cases have been big wins for taxpayers and the broad definition of 174 and R&D. These are the cases that accounting firms read and adopt. But other cases have been wins for the government and narrow the definition of 174 and R&D. These are the cases the accounting firms ignore.
Here is just one of those cases.
In the Little Sandy Coal case, the court states,
“Put a different way, a manufacturer may not simply “add a few new bells and whistles” on a pre-existing product and claim uncertainty as to the whole.
If summed up in one word, expenses deductible under section 174 must be ‘investigative.’”6
It is time to look at the 174 expenditures from a new, more narrow perspective.
The government has been trying to narrow and reduce the definition of 174 expenditures for 30+ years. This is the time to embrace a narrow definition and reduce your capitalized 174 expenditures.
The accountants do not like this approach because it cuts in their fees. They will tell you that if you have been filing R&D credits in the past you have to continue to apply the same definition going forward. They will tell you that you have no choice but to pay them to accumulate all the 174 expenditures that they can find.
However, the Little Sandy Coal case decision was handed down in March 2023. The case has a long explanation narrowing the definition of 174 costs. This is a new factor that you may be able to use to re-evaluate your prior position on 174 costs. It is certainly worth exploring.
Reducing your 174 expenditures will reduce your R&D tax credit as well.
SPRX provides an alternative, AI driven process to computing R&D credits. Learn how you can reduce the hidden costs of the status quo R&D credit process used by every accounting firm. Schedule a quick introductory chat today.
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1 S. Rep. No. 99-313, at 693 (1986)
2 S. Rep. No. 83-1622 at 33 (1954), see also H.R. Rep. No. 83-1337 at 28 (1954)
3 Reg. subsection 1.174-2(a)(1)
6 Little Sandy Coal v Commissioner, (Mar 2023) US Court of Appeals, 7th Cir, No. 21-3145