Before 2022, taxpayers who incurred research and experimental (Section 174) costs could fully deduct them in the year incurred. The Tax Cuts and Jobs Act of 2017 required these costs to be capitalized and amortized over five years for domestic research and 15 years for foreign research for tax years beginning after December 31, 2021.
The new requirement caused a misalignment between the cash outlay for research and experimental expenses and the tax benefit derived from incurring those costs. Specifically, for instance, taxpayers using the percentage-of-completion method for long-term contracts recognize income based on the progress of the contract. Historically, research and development costs were included in the calculation of the completion factor (both numerator and denominator) to determine the percentage of completion each year. As a result of the interaction between the two code sections, the percentage of completion calculated by these taxpayers was based on costs that were not deducted during the year, thereby overstating the percentage-of-completion ratio.
On September 8, 2023, the IRS released Notice 2023-63 providing administrative guidance on how to treat R&D costs in relation to long-term contracts. The guidance allows taxpayers to use amortization deductions related to Section 174 costs as allocable contract costs rather than the full amount of capitalized research and experimental costs when calculating the percentage-of-completion ratio. For affected taxpayers, this corrects the misalignment between the costs not permitted to be deducted and the costs included in the numerator of their percentage-of-completion calculation. In some cases, the result of this adjustment can yield a more favorable result than the unfavorable Section 174 effect on taxable income.
Implications
There are other considerations to evaluate when implementing these changes, such as determining the taxable year to implement the changes and making the required adjustments if a long-term contract ends during a shorter timeframe than the five-year amortization period. The IRS issued Revenue Procedure 2024-23 to address some of the uncertainty surrounding these issues, incorporating specific examples of costs permitted to be included in the numerator and denominator, as well as alternative methods and whether these changes can be made on a cutoff basis.
The recent IRS guidance provides an opportunity for taxpayers to review their current percentage-of-completion methodology and identify changes that are available based on Section 174 capitalization requirements. Many taxpayers will be required to file a change of accounting method adopting the automatic change available.
For a deeper discussion of how this issue might affect your business, contact a member of the SD Construction Industry Group team or Janelle Merlo at [email protected].
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