On December 12, 2022, the IRS released Rev. Proc. 2023-8 containing long-awaited procedural guidance concerning the 2017 amendment to Section 174, which requires the capitalization and amortization of specified research or experimental (R&E) expenditures paid or incurred in taxable years beginning after December 31, 2021.
Although guidance has been released, all eyes are currently on Congress and whether the effective date of these new rules will be delayed. Should eleventh-hour negotiations stall, however, Rev. Proc. 2023-8 provides taxpayers the roadmap to change their existing methods of accounting for R&E costs to the new Section 174 regime.
Highlights of Rev. Proc. 2023-8 are as follows:
1. Grant of automatic consent
Taxpayers may use this new automatic accounting method change procedure to secure the IRS consent necessary to change from their present Section 174 accounting methods to the new capitalization and amortization regime.
2. Statement in lieu of Form 3115 for changes made in the first effective year
For changes made in the first taxable year beginning after December 31, 2021, the revenue procedure waives the requirement to file a Form 3115, Application for Change in Accounting Method. Instead, taxpayers request and implement the change by attaching a statement to their original federal income tax return. The statement must contain the following information for each applicant:
The name and EIN (or SSN) of the applicant that has paid or incurred R&E costs after December 31, 2021;
The beginning and ending dates of the year of change (the first taxable year in which the change to the required Section 174 method takes effect for the applicant);
The designated automatic accounting method change number (DCN 265);
A description of the type of expenditures included as R&E costs;
The amount of R&E costs paid or incurred by the applicant during the year of change; and
A declaration that the applicant is changing the method of accounting for R&E costs to capitalize such expenditures to a R&E capital account, and amortize such amount over either a five-year period for domestic research or 15-year period for foreign research (as applicable) beginning with the mid-point of the taxable year in which such expenditures are paid or incurred in accordance with the method permitted under Section 174 for the year of change. The declaration must also state that the applicant is making the change on a cut-off basis.
3. Delayed changes require a Form 3115 and modified Section 481(a) adjustment
When the change is made for years later than the first taxable year beginning after December 31, 2021, the requirement to file a Form 3115 to secure the necessary consent is not waived. For these delayed changes, the revenue procedure requires a modified Section 481(a) adjustment, which would consider only those R&E costs paid or incurred in taxable years beginning after December 31, 2021.
This modified Section 481(a) rule serves to reduce the opportunity for strategic delay in implementing the new regime. As an example, if an accrual basis taxpayer continues to immediately expense its domestic R&E costs in accordance with its historic method, deducting $100,000 that it had incurred during the 2022 tax year, that taxpayer would have a $90,000 unfavorable Section 481(a) adjustment were it to request this accounting method change for the 2023 taxable year (the original $100,000 expense, less the first year amortization based on the midpoint approach, calculated as of the beginning of the 2023 year of change).
4. Favorable transition rule
For taxpayers who have already filed 2022 tax returns (or who do so prior to January 9, 2023), the revenue procedure deems such taxpayers to have effectively changed their methods of accounting as long as the taxpayer (i) properly capitalized and amortized its R&E costs in accordance with the new rules, and (ii) properly reported its R&E costs incurred on Part VI of Form 4562, Depreciation and Amortization.
5. Waiver of eligibility rule
Also limited to changes made in the first post-2021 year, the revenue procedure waives the general rule prohibiting a taxpayer’s use of automatic consent procedures for subsequent changes sought on the same item within a five-year window.
Taxpayers who have changed their R&E cost method within the last five years (perhaps with the aim of maximizing deductions prior to the amendment’s effective date) should take particular note of the limitation on this waiver. If such taxpayers do not change to the new rules for their first tax year beginning after December 31, 2021, they will be scoped out of the automatic change procedures until that five-year window has lapsed. Taxpayers scoped out of Rev. Proc. 2023-8 will need to file their accounting method changes to comply with the Section 174 amendment under the more burdensome and costly advance consent procedures.
Taxpayers should also note that Rev. Proc. 2023-8 does not waive the general restriction against filing automatic accounting method changes in the final year of a trade or business.
The official bulletin containing Rev. Proc. 2023-8 is not set for release until after the new year; however, an advance copy of the revenue procedure has been made available.
As a final note, the guidance described above is only the first component of what we expect to be a two-part guidance package. Rev. Proc. 2023-8 contains only the procedural component.
Substantive guidance on applying the Section 174 amendment (definitions, explanations, examples, etc.) remains outstanding.