Back in 2017, as the holiday season was well underway, startups got what many consider the opposite of a gift. With the implementation of the Tax Cuts and Jobs Act (TCJA), companies lost the right to take a tax deduction for R&D expenses in the year in which those expenses were incurred.
As of December 2017, a TCJA Section 174 amendment laid out rules stating that taxpayers needed to capitalize and amortize their deductions over five (for domestic research) or 15 (for foreign research) years. The in-year deduction went away at the end of 2021, and companies have been navigating the change ever since.
That hasn’t necessarily gone smoothly, leading to multiple revenue procedure updates and substantive notices from the IRS over the last couple of years in an attempt to clarify things. In December 2023, they issued yet another clarification: Notice 2024-12.
What does it mean for your startup? There are three things you should note here.
#1: Changes to contracted R&D
Companies that conduct research to sell to a buyer had some alarm after the IRS issued Notice 2023-63 in September 2023. That Notice broadened the exposure to Section 174’s capitalization requirements. Essentially, it seemed to say that if the company had the right to use the results of specified research or experimental (SRE) activity, the expenses needed to be capitalized and amortized.
But the latest notice provides an extra measure of clarity here. Specifically, companies can continue to claim deductions for SREs when they:
- Don’t bear any risk based on the outcome of the research and experimentation
- Get what’s called an “excluded SRE product right,” meaning they have the right to the product for the purposes of performing the research or experimentation but the product rights ultimately go to the recipient
In other words, if you’re doing research but you don’t own it and are selling it to a buyer, you don’t have to apply Section 174 tax treatment to the resulting expenses.
#2: Clarity on pre-2022 software development costs
Unfortunately for a lot of tech startups, all of the updates issued by the IRS don’t change how you need to deal with software development expenses. Section 174(c)(3) included software development costs in its scope, meaning they need to be amortized over five or 15 years.
But Notice 2024-12 does offer a small bit of help here.
Specifically, it allows companies to apply Revenue Procedure 2000-50 to costs incurred before the end of 2021. There was some concern with prior notices that Section 5 of that revenue procedure made in-year deductions for pre-2022 expenditures obsolete.
But the latest Notice clarifies that you can apply Rev. Proc. 2000-50 to all software expenses up to December 31, 2021. That means that “all of the costs properly attributable to the development of software by the taxpayer are consistently treated as current expenses and deducted in full.”
#3: A boon during the interim: applying some but not all provisions
The software development deduction isn’t the only area in which recent clarifying guidance from the IRS threw founders and their finance teams for a loop.
Specifically, Notice 2023-63 (September 2023’s update) came with an all-or-nothing reliance provision. In other words, if companies wanted to apply any of the rules in Sections 3 through 9 of that Notice — basically, the meat of the document excluding the background, applicable date, and other administratively focused sections — they needed to apply everything contained in those seven Sections.
Taxpayers and their legislative representatives were not thrilled with that proposition. They pushed back with a slew of procedural challenges. It was enough for the IRS to respond fairly quickly. In just three months, the new Notice was released eliminating that all-or-nothing reliance provision.
Now, you can choose which provisions in Notice 2023-63 you want to implement for your own taxation. That can be a huge help since that Notice laid out some rules around the identification and allocation of costs that could be challenging to adhere to.
This isn’t necessarily a free pass, though. If you do choose to implement anything laid out in that Notice, you need to implement it consistently.
Talk with your accountant here. They can help you decide what you want to implement from Notice 2023-63 — if anything — and how to properly apply it to your filings.
The murky waters with interim guidance
It doesn’t necessarily look like the IRS is done issuing clarification around Section 174 compliance, nor does it seem that affected groups are done lobbying for the changes they want to see.
Unfortunately, that means companies that want to get a deduction for R&D expenses probably have a long and potentially bumpy road ahead.
Some companies are choosing to minimize what they allocate toward research and experimentation for the next few years as the dust settles.
If your company truly benefits from R&D, though, it’s worth navigating these murky waters to get the biggest tax benefit you can here. While capitalizing and amortizing your expenses doesn’t offer the same chunk of immediate tax savings, that’s still money your company doesn’t need to put toward its tax bill over the next five or 15 years.
There are a few keys to maximizing the deduction you can take (albeit an amortized one):
- Tracking deductible R&D activities — including payroll for people primarily focusing on these areas
- Capitalizing and amortizing them according to Section 174 and the latest clarifying guidance
- Filing the right documentation with each year’s tax return to maximize your deductions through the years
If you’ve filed taxes in any year after 2021, that means you’re currently subject to a Form 3115 filing requirement. Basically, that form informs the IRS of the change in accounting that you’re undertaking to adhere to Section 174.
Yes, that means extra paperwork. But no, you don’t need to do it alone. To get help from our team — which specializes in R&D tax deductions for startups and has been carefully tracking all of the IRS’s updates — contact us. All of this might feel like a convoluted mess, but we’re here to make it as easy as possible to navigate.