Just because you perform research doesn’t mean all your expenses are subject to Section 174. It’s much more nuanced than that!
For over 40 years I’ve been a CPA specializing in government contract grant and contract accounting. I have not prepared a corporate tax return for several years and I am not a tax lawyer! This blog is not authoritative, but hopefully, it’s helpful.
During my professional career, I’ve been blessed to work with some incredibly smart people. Most recently I had the pleasure to work with Kenan Ezal, a senior scientific researcher with Toyon Research Corporation, who is also a licensed attorney in California but is quick to say that he is not a tax attorney either.
The court case cited below comes from Kenan’s excellent research, as well as emails and conversations we had working together with www.SBTC.org. In addition, we’ve been on several conference calls with SBTC members discussing this issue at length – and the perspective from Kenan, Jere Glover, and many other active members helped to really educate me on the nuances.
The purpose of this blog is to give you a better understanding of the Section 174 issue and provide you with some authoritative court cases that you should be aware of. Please invest the time to read the references in this blog about the court’s opinion on Sections 162 and 174, as well as the IRS’s perspective of these cases. Hopefully, you can share this blog with your tax preparer and, possibly, a tax attorney.
Overview of Section 174 and 162
I believe these two links are a great place to start:
- Changing Research Tax Break Rules Will Harm Fewer Than Predicted, Bloomberg Tax, September 19, 2022
- Office of Chief Counsel, Internal Revenue Service, Memorandum, Number 20055203F, December 20, 2005
In the IRS’s Chief Counsel’s Memorandum, please begin with a focus on paragraph A:
Distinction Between Sections 162 and 174 Section 162(a) permits taxpayers to deduct all ordinary and necessary business expenses paid or incurred during a taxable year in “carrying on any trade or business.” In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court defined a trade or business as an activity conducted with continuity and regularity and with a primary purpose of making income or a profit. Groetzinger, 480 U.S. at 35. This definition remains in force. By allowing the taxpayer to deduct expenses under Section 162, Exam implicitly acknowledged that Taxpayer operates a trade or business with continuity, regularity, and with the primary purpose of making a profit.
Specifically, this memo does a very good job of summarizing the prior cases surrounding Section 162 and Section 174:
- Snow v. Commissioner of Internal Revenue, 416 U.S. 500 (1974)
- Kantor v. Commissioner of Internal Revenue, 998 F.2d 1514 (1993)
- Scoggins v. Commissioner of Internal Revenue, 46 F.3d 950 (1995)
The Court’s Interpretation
“The courts have held that Section 174 “in connection with” language allows a taxpayer to deduct R&E expenses prior to the actual commencement of a trade or business, while under Section 162, a taxpayer must be “carrying on” or already engaged in a trade or business.”
Notice that where Section 174 is established in these cases – the Taxpayer was formed to undertake a new and separate business of engaging in the joint development and commercialization of inventions and funded its own R&E efforts at its own risk.
Other Things to Consider
The cases don’t really talk about where the taxpayer wanted to take Section 162 instead of Section 174, probably because a business gets R&D tax credits for 174 and not for 162. Most cases are about a taxpayer wanting to take advantage of the 174 deduction. This is illuminating. If a taxpayer’s expenses qualified under 162, why focus on 174? The implication is that they did not qualify for 162, so they had to argue for 174.
“The idea behind Section 174 is to encourage research and experimentation by small, new enterprises and to place them on an equal footing with established businesses, which may deduct under Section 162(a) the expenses incurred while carrying on a trade or business. Consequently, taxpayers whose only “business” at the time they incur the research expenditures is the research itself are eligible for the expense deduction under Section 174. Kantor, 998 F.2d at 1518. Thus, while new businesses must capitalize their “start-up” or “preoperational” expenses because they are not deductible under Section 162, Section 174 alters this requirement by permitting new, pioneering businesses, which are not yet selling goods or services, to deduct immediately expenditures incurred for research and experimentation.” [Scoggins at p. 954]
The above cases differentiate Section 162 (“ordinary and necessary” expenses in “carrying on” any “trade or business”) and Section 174 (“research” expenses “in connection with” a “trade or business”) based on whether the expenses relate to some future business (a “start-up”) or as part of the regular business of the company.
Section 162 or Section 174? An Example
Let’s pretend that you and I own a profitable car wash. While working in the car wash, we decide that we can build a better robot to wash the cars and can sell the robots for a profit.
In my opinion, it is pretty clear that the expenses of running the car wash are deductible under Section 162. The expenses incurred to develop the robots (pre-revenue generation) are what’s in question.
Some of your businesses are simple. You perform contract and grant research for a profit. How is this different from the car wash?
Now if you’re subsidizing your SBIR work (say you bill NIH 20% for your overhead/F&A costs, but actually incur 65%), you may be entering the “I need a tax lawyer” area. In my opinion, there are two ways of looking at it. Some could argue that the amount that you’re “investing” is subject to Section 174. However, I might also argue that you are not a good businessperson – that your intention was to make a profit, you just didn’t. A car wash that runs at a loss would still claim all its deductions under Section 162.
Over the past two decades, many of our clients have worked with Hull & Knarr, R&D Tax Credit experts. H&K would typically claim the overspending on an FFP phase I or the indirect rate “investment” example given above as costs subject to Section 174 and would claim the Section 41 credit on those costs.
There is considerable evidence that some expenses could be classified under either 162 or 174. What part of the Code or Regulations suggests that Section 174 has priority over Section 162? We have not discovered such language.
Ed Jameson, CPA
Ed Jameson, CPA, Managing Member
With over 40 years of experience as a government funding award accounting specialist, Ed is a recognized national expert in the field. In addition to helping hundreds of clients navigate FAR Part 31 compliance. he has been an active speaker and panel moderator at Tech Connect's National SRIR/STTR conferences since 2011. presents at the DOD's Mentor Protégé Summit and presents regularly for several state and local organizations.