The IRS provided guidance on the automatic change issue for §174 but is silent on what should or should not be included in the §174 capitalization. We are watching this issue closely and want to share with you where it stands right now.

− By Mark Dunning, Partner, and Jamie Overberg, Partner, TaxOps Minimization

With the New Year come and gone, we entered 2023 without any further Congressional action taken to reverse §174 capitalization requirements. That means the current law stands, requiring all companies with §174 research expenses to capitalize these costs and amortize them over 5 years. This is causing a large increase in taxable income for the tax years beginning after December 31, 2021.

The IRS has moved forward under current law to provide guidance on the automatic change issue for §174 (see below). However, no assistance has been issued on what should or should not be included in the §174 capitalization. We’d like to share with you where the issue stands right now and assure you, we are following these issues closely.

Accounting Period and Method Changes

IRS Rev. Proc. 2023-11  provides a second option for electing the change made in the first taxable year after December 31, 2021, where a taxpayer does not complete an automatic election for 2022 tax year, thereby avoiding the full increase to taxable income hit in 2022. In this instance, the taxpayer files a Form 3115 in their 2023 tax return (or if their original 2022 tax return was a short year then the taxpayer’s 2nd 2022 tax return would have the Form 3115 in it) for a change to §174 using §481(a) to spread the increase to taxable income over four years. Furthermore, the Rev. Proc. does clearly state that there is no audit protection for skipping the (initial) 2022 year.

This limited guidance puts taxpayers in the awkward position of having to make a tax decision based on limited facts. We believe adopting this option is a risky position and advise against it. At this time, only on Big Four firm has been promoting this second option. We have personally spoken about this issue with other Big Four partners, who share our concern and advise against this option.

This §174 change is prompting real uncertainty and frustration due to its potentially significant financial impact on taxpayers. Unfortunately, with so few regulatory details to go on, §174 capitalization actions are unclear at this time.

As we await Congressional action on this issue, we will keep you apprised of the latest developments. Read more about the issue by clicking the links below, including updates on Congressional delays and our letter to the IRS requesting more guidance on §174. Reach out directly to Mark Dunning or Jamie Overberg with any questions as this issue plays out.

Mark Dunning
Jamie Overberg

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