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IRS (finally) Issues Section 174 Guidance

September 12, 2023 / Ed Jameson / Blog Posts
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With the final deadline to file your 2022 corporate tax return just days away, the Treasury Department finally issued initial guidance – defining their position on Section 174.

SECTION 174 GUIDANCE BACKGROUND

The Tax Cuts and Jobs Act (TCJA) passed in December of 2017 made significant changes to Internal Revenue Code (IRC) Section 174 – Amortization of Research and Experimental Expenditures. R&D costs were previously considered an ordinary business expense, immediately deductible for tax purposes. The TCJA completely eliminated the ability to currently deduct R&E expenses, forcing taxpayers to capitalize and amortize these costs – typically over a 5-year period. This change went into effect for taxable years beginning after December 31, 2021.

This past week, after more than five years of waiting, the Treasury finally issued guidance – defining their position of Specified Research or Experimental Expenditures (SRE):

Guidance on Amortization of Specified Research or Experimental Expenditures under Section 174 (irs.gov) 

Virtually all Jameson & Company’s clients use government funding to further their businesses, so this article will focus primarily on Section 6 of the IRS’ Guidance.

SECTION 6. RESEARCH PERFORMED UNDER CONTRACT

First, several obvious bullet points:

1. The guidance clearly applies whether you are a prime or subcontractor performing funded services.
2. The guidance defines financial risk to mean – the risk that the research provider may suffer a financial loss related to the failure of the research to produce the desired SRE product.
3. The term Specified Research or Experimental Expenditures (SRE) product means any pilot model, process, formula, invention, technique, patent, computer software, or similar property (or a component thereof) that is subject to protection under applicable domestic or foreign law. “For example, mere know-how gained by a research provider through the performance of research services for a research recipient that is not subject to protection under applicable domestic or foreign law does not give rise to an SRE product in the hands of the research provider”.

MOST CONCERNING IS THE LANGUAGE IN SECTION 6.04

Treatment of costs paid or incurred by the research provider. If the research provider bears financial risk under the terms of the contract with the research recipient, then costs paid or incurred by the research provider that are incident to the SRE activities (see section 4.03 of this notice) performed by the research provider under the contract are SRE expenditures.

However, even if the research provider does not bear financial risk under the terms of the contract with the research recipient, if the research provider has a right to use any resulting SRE product in the trade or business of the research provider or otherwise exploit any resulting SRE product through sale, lease, or license, then costs paid or incurred by the research provider that are incident to the SRE activities performed by the research provider under the contract are SRE expenditures of the research provider for which no deduction is allowed except as provided in § 174(a)(2), regardless of whether the research recipient is required to treat its costs as SRE expenditures under section 6.03 of this notice.

For purposes of the preceding sentence, a research provider will not be treated as having a right to use the SRE product in the trade or business of the research provider or otherwise exploit the SRE product through sale, lease, or license if such right is available to the research provider only upon obtaining approval from another party to the research arrangement that is not related to the research provider within the meaning of § 267 or § 707.

EFFECT OF THIS GUIDANCE ON SMALLER SBIR/STTR COMPANIES IF UNCHANGED

We believe that if you’re performing basic research and discover nothing worth protecting, you will write off all your expenses, as there is nothing to “protect” under the law.

But what if you’ve had some success and want to keep “exploiting” what you’ve learned? The Bayh-Dole Act grants data rights to all SBIR awardees. Are these data rights alone enough to trigger Section 174?

Assuming data rights are not enough to trigger section 174 – clearly, if you file a patent or start to have commercial sales, you will need to think through exactly when and where the IP was discovered.

Jere Glover, Executive Director of the Small Business Technology Council (SBTC.org), comments “The more successful the company, the more catastrophic this guidance is”.

CONCLUSION ON SECTION 174 GUIDANCE

The IRS has taken liberties to redefine Section 174 and is taking a giant step in altering the SBIR program with this guidance!

If the phrase “has a right to use any resulting SRE in the trade or business” (without financial risk) is not refined in the final regulations in a more favorable way – this will place a massive tax on small, government-funded businesses – who do not qualify for an IRC Section 41 R&D credit because they are not at financial risk.

We need an enormous outcry by the SBIR/STTR community during the commentary period to help draw attention to some of this egregious overreach!

In the meantime, it is not unreasonable to continue to file your 2022 corporate tax return as we discussed in our previous blogs as we wait for final regulations later this year. If you’ve misstated your taxable income, there is a three-year statute of limitations to amend them.

Assuming Congress does not repeal this tragedy we will be working with our clients and tax experts to explore reasonable stances for claiming lower amounts of 174 R&E costs, build written substantiation, and claim R&D credits for costs where the rules allow. We anticipate needing to tease out which sub-tasks in a Section 174 project do not rise to the level of R&E, which would make for a smaller amortization total.

The IRS will be taking comments before they publish final regulations on this topic, so if you have questions, please use this SBDC drop box to help us accumulate comments and questions for the IRS!

Jameson & Company, CPAs

Ed Jameson, CPA, Managing Partner

I’ve been in practice for over 40 years helping our small business clients procure, manage, and survive audits on more than $6 billion in federal government contract and grant funding. We’ve been featured presenters and panel moderators at Tech Connect’s National SBIR/STTR conferences since 2010, and I’ve presented at the DOD’s Mentor Protégé Summit and present regularly for several state and local organizations.