R&D Tax Credit News

The intersection of IRC 174 and software development represents an unfavorable tax position and is a critical juncture in tax policy and its impact on software innovation.

On September 8, 2023, the IRS issued Notice 2023-63 which contains guidance clarifying the application of Section 174 to the costs of software.  The Notice states that businesses must capitalize and amortize all software development expenses including those not qualified under Section 41.  Furthermore, companies that opt not to claim the Research Tax Credit must still adhere to the mandatory amortization and rules outlined in Section 174.  Companies must now deduct research expenses over a period of 5 years for costs incurred in the US and 15 years for costs incurred elsewhere. These changes have far-reaching implications for any taxpayer that has developed software, including companies whose main activity is not developing software for sale or use by others.

As a result of recent changes to tax legislation, taxpayers are now facing higher taxable income and newfound liability for federal and state taxes.  The liability is due to the narrowing of the scope of allowable deductions, which has left many businesses unable to offset their expenses as they once could.  The impact of this change has been particularly acute for companies that are unprofitable, as this increased tax burden has put a strain on their finances, making it difficult to invest in growth and expansion.  To add insult to injury, because they lost deductions, they can’t afford the tax they are now subject to.  In some instances, companies have had to make tough decisions about layoffs and implement cost-cutting measures to stay viable.

What is software development under IRC 174?

The new IRC 174 software development guidelines encompass costs such as

• Planning, designing, coding, and testing software including salaries for software engineers and other technical personnel;
• Software development tools and platforms; and
• Costs related to enhancing or improving existing software.
  • Adding new features and making other changes to ensure that the software is up-to-date and meets the needs of users.
  • Developing and implementing documentation for software, including user manuals or technical specifications.

What has been done about this?

These IRC 174 changes have been looming since 2017 with the long-held assumption that Congress would change the law before it took effect.  Several legislative proposals have tried to delay or repeal the new requirements in the past few years, but to date, none have passed.

In October 2022, a group of over 150 U.S.-based businesses issued a plea encouraging Congress to approve a repeal or a multi-year delay of the amortization requirement. In June 2023, the Build It In America Act was introduced by Representative Jason Smith of Missouri, Chairman of the House Ways & Means Committee.  The legislation proposes to delay amortization until 2025 and reinstates immediate deductibility, but it is still going through the legislative process.  Additionally, on November 29, a group of nearly 150 House Republicans sent a letter to House Speaker Mike Johnson to urge the passing of tax reform including reinstating the deduction under IRC 174 .

What can you do?

While it is unclear whether legislation will reverse this change, companies must proactively prepare to comply with IRC 174 requirements by evaluating their current situation, review IRS guidance, anticipate the potential business implications, and seek expert tax advice moving forward, despite the potential negative consequence.  Early assessment and proactive measures will enable businesses to navigate the complexities of IRC 174 and mitigate its adverse effects.

Evaluating the Research Tax Credit is now crucial for companies that have increased R&D expenses under IRC 174.  The credit is more valuable than ever due to its ability to offset a portion of the increased tax liability.  Claiming the credit can help to improve cash flow and make it more affordable to invest in R&D.

Need Assistance?

Contact our experts for more information on calculating IRC 174 Research Expenses or to evaluate your Research Tax Credit opportunity to ensure it is being maximized.