IRS revises automatic method change for RE capitalization

January 2023

In brief

The 2017 tax reform reform act amended Section 174, effective for amounts paid or incurred in tax years beginning after December 31, 2021, to require taxpayers to charge research and experimental (R&E) expenditures to a capital account. Capitalized Section 174 costs must be amortized over five years (15 years for expenditures attributable to foreign research) beginning with the midpoint of the tax year in which the expenditures are paid or incurred.

The IRS previously issued Rev. Proc. 2023-8, which allows taxpayers to change their method of accounting for Section 174 costs for tax years beginning after December 31, 2021, using the automatic method change procedures. The IRS now has issued Rev. Proc. 2023-11, modifying the audit protection terms and conditions and transition rule under Rev. Proc. 2023-8. This Insight discusses these modifications. For additional information on the automatic method change procedures of Rev Proc 2023-8, see the PwC Insight IRS provides automatic method change to capitalize R&E expenditures.

For consideration: Although Congress has considered legislation to extend expensing of Section 174 expenditures, to date no action has been taken. Accordingly, taxpayers should review their Section 174 costs and may want to consider other accounting method planning that may mitigate the increase in taxable income.

In detail

Audit protection

Rev. Proc. 2023-8 provided an automatic change in method of accounting for taxpayers to capitalize and amortize Section 174 expenditures paid or incurred in tax years beginning after 2021. This change was implemented on a cut-off basis for a method change made for the first tax year beginning after December 31, 2021 (first Section 174 year, e.g., 2022 for a calendar year taxpayer) and on a modified cut-off basis (i.e., with a Section 481(a) adjustment for costs incurred after 2021) for a method change made after the first Section 174 year (later Section 174 year, e.g., 2023 for a calendar year taxpayer).

Rev. Proc. 2023-8 denied audit protection for a taxpayer’s characterization or classification of expenditures paid or incurred before 2022, under former Section 174, explaining in the background section that this determination could affect the proper amount of expenditures paid or incurred in tax years beginning after 2021. However, Rev. Proc. 2023-8 did not deny general audit protection for costs incurred in any tax year beginning after 2021 if the method change was made for a later Section 174 year.

Observation: Audit protection generally prevents the IRS from requiring the taxpayer to change its method of accounting for the same item for a tax year prior to the requested year of change. Audit protection typically is provided for voluntary method changes as an incentive for taxpayers to voluntarily comply with proper methods of accounting. Denial of audit protection often occurs when a method change is implemented on a cut-off basis as opposed to with a Section 481(a) adjustment, because the treatment of the item in prior years has not been changed.

Rev. Proc. 2023-11 modifies Rev. Proc. 2023-8 to deny general audit protection for expenditures paid or incurred in tax years beginning after December 31, 2021 (e.g., for 2022 for a calendar year taxpayer) for a method change made for a later Section 174 year. As a result, a taxpayer that changes its method in a later Section 174 year will be denied audit protection for all prior years.

Observation: A literal reading of Rev. Proc. 2023-8 could have allowed a calendar year taxpayer to expense its Section 174 costs in its first Section 174 year, e.g., calendar year 2022, and obtain audit protection for that impermissible method by changing its method of accounting to properly capitalize Section 174 costs for a later Section 174 year, e.g., 2023 calendar year. The Rev. Proc. 2023-11 denial of audit protection if a taxpayer makes the change for a later Section 174 year essentially eliminates that position, compelling taxpayers to comply with Section 174 for its first Section 174 year, i.e., the first tax year beginning after 2021.

Transition rule

Rev. Proc. 2023-8 included a transition rule that applied to Section 174 method changes made for tax returns filed on or before January 9, 2023, for a tax year beginning after 2021. Rev. Proc. 2023-11 changed this filing date to January 17, 2023.