What CPAs Must Know About Rev. Proc. 2023-11 And The Mandatory Amortization Of Section 174 Expenses

Summary

174 Research and Experimentation (“R&E”) Expenses paid or incurred in taxable years beginning after 12/31/2021 cannot be immediately deducted. They must be amortized over 5 years, or 15 years in the case of foreign R&E. There are several implications to this change:
1) This mandatory change will result in a short-term increase in taxable income;

2) Since there was previously no difference between Section 162 and Section 174 deductibility, many businesses will not even realize they are now affected;

3) Taxpayers have a limited time to take advantage of Rev. Proc. 2023-11 and avoid filing the complex Change of Accounting Form 3115;

4) While a change in these rules is generally expected eventually, in the immediate term taxpayers will have to account for these changes on their 2022 tax returns; and

5) The Section 41 Research and Development (“R&D”) Tax Credit is an excellent way to mitigate the effects of mandatory amortization under Section 174.

The Background: Section 174 and Section 41

In order to understand the impact of this legislation, it’s crucial to understand the relationship between Section 174 Expenses and Section 41 Expenses.

Section 174 Expenses are known as Research and Experimentation, or R&E Expenses. The expenses that fall under Sec. 174 can be divided into two categories, based on how essential each is to the activity being performed.

Section 41 Expenses are known as Research and Development, or R&D Expenses. These are known as “Direct Research Expenses,” and are what usually come to mind when you imagine research and development. Wages, supplies/materials, cloud hosting, and fees paid to 3rd party contractors are expenses integral to the research process.
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