What You Need to Know About IRC 174
Learn about how Section 174 Amortization may affect the R&D Tax Credit and cause you to rethink your tax strategy for tax year 2022.
On December 29, 2022, the IRS released Rev Proc 2023-11 with stringent guidelines on the treatment of Section 174 for tax year 2022, this article will outline the guidelines covered in that update and our recommendation for how to navigate the changes.
Overview of Section 174
Section 174 was codified in 1954 and was originally written for long-term research and experimentation activities that a business performed. For a long time, few paid attention to Section 174 because it lacked any treatment differences from Section 162 ordinary business expenses.
Now Section 174 seems to be on every business and CPA’s tax radar. Why? Because expenses that in the past were incorrectly filed as Ordinary Business Expenses (Section 162) are now required to be Section 174 expenses and amortized over five years (per the latest guidelines as outlined in Rev-Proc 2023-11).
A few big expenses that were classified as “Ordinary Business Expenses” that are now classified as Section 174 expenses and amortized over five (5) years:
- Payroll for research expenses (labor)
- Materials and supplies related to research
- Qualified research expenses
- And more
This means if your business (up until 2022) has paid taxes on profits and has used Ordinary Business Expenses to offset tax liability, these new guidelines could significantly raise your taxable income.
Per the new guidelines outlined in Rev-Proc 2023-11, Section 174 expenses must now be amortized (a fancy way of saying gradually deducted) over a five (5) year period (15 years if research expenses are tied to foreign research).
How Does Section 174 Impact the R&D Tax Credit?
Qualified research activities must meet certain requirements for a business to claim the federal R&D tax credit. This credit was created as an incentive by the US government to spur business innovation and advancement and in exchange, reduce tax liability.
With these new requirements, taxable income will increase significantly, and while the R&D Tax Credit will offset some of the resulting tax liability, the tax increase will be felt by businesses.
ABGi believes that if the new guidelines stay in place, the IRS is likely to target known industries that take the R & D credit and verify they are following the new amortized changes in the 174 guidelines.
ABGi’s Section 174 Recommendations
While ABGi speculates that these new Section 174 guidelines may revert back to the way they were before, taxpayers should take steps to ensure compliance.
Here are our recommendations:
- If you (or a company in your portfolio) have claimed R&D expenses in the past, you are now subject to these new amortization rules:
- Do not “Skip a year,” as that will likely flag your return and could put you on the IRS’s radar. It is widely accepted that significant changes to positions on a tax return affect a return’s IRS score, increasing the likelihood of an examination.
- Remember, the IRS views section 174 from an industry perspective. If there is an industry that historically qualifies for R&D credit, the IRS will expect those businesses to separate 174 and 162 (business expenses).
- Proceed with the R&D Credit, and remain in close contact with your ABGI representative to ensure compliance with this constantly changing section 174 situation for tax year 2022.
Leverage These Tax Strategies
Tax years 2019, 2020, and 2021 are unchanged, which could provide an opportunity to amend past tax filings. Doing so could help offset the increase in taxable income and generate cash flow.
- Additionally, “carryforwards,” which means unused general business credits from past years, could also help offset the increase in taxable income.
If the new guidelines to section 174 do not revert to “normal” and remain permanent, then by year three, the numbers will mathematically balance out. You’ll have at least 50% of the qualified research expenses amortized, even if you have significant changes in labor.
Final Section 174 Takeaways
This can get tricky quickly, making it difficult for business owners or CPAs to know what to do with these changing guidelines.
ABGi is your resource! We are tax incentive experts who geek out over tax complexities and nuances.
ABGi has over 30 years of experience working with American businesses to reduce their tax liability by maximizing tax incentives that stimulate business growth, innovation, and advancement. Our expertise allows us to understand the minute details of tax code law and business sector activities that result in qualifying tax incentive programs.
Our approach to work is streamlined and efficient, minimizing client disruption while producing quality, compliant results that operate within the IRS’s ever-changing guidelines. ABGi, part of Visiativ, is a publicly-traded company; our business practices are reviewed annually, adding a level of compliance unseen in this industry. We stand behind our work, which is why all our work includes total audit defense at no additional cost.