Although the Tax Cuts and Jobs Act (TCJA) was signed into law in 2017, its full impacts and consequences are currently roiling certain U.S. leading industries. Cutting edge industries that fuel America’s competitive advantage through innovation resulting from research and development are among those hardest hit by TCJA. Taxpayers should review their software development expenses to ensure that they are accounting for them properly and to determine if they qualify for a R&D tax credit.
TCJA Change to Research and Experimental Expenditures
Starting with tax year 2022, i.e., those tax returns currently being prepared and filed, TCJA requires companies to amortize research and experimental expenditures over five years (15 years if the research and experimental expenditures are attributable to foreign research), instead of immediately deducting such expenditures in the year incurred.
TCJA added a provision that expressly mandates software development costs be included in the definition of research or experimental expenditure and thus are subject to five or 15-year amortization. Taxpayers can no longer rely solely on Rev. Proc 2000-50 to currently deduct software development expenses; software development activities must be evaluated to determine if work performed would represent research and development cost in the experimental and laboratory sense under Section 174 based on established case law and current guidance. Even if a taxpayer disposes, retires, or abandons research and experimental amortized “property” that has not been fully amortized, amortization must continue instead of a current year deduction.
R&D Tax Credit Inclusion of Software Development
TCJA amended Section 41(d)(1)(A) to define “qualified research” as research “with respect to which expenditures may be treated as specified research or experimental expenditures under section 174.”
To qualify for the tax credit, the expenditures must be “qualified research” under Section 41(d). This requires the research to be eligible for treatment under Section 174, intended to discover technological information, performed in a process of experimentation, and intended to improve a business component of the taxpayer.
Internally Developed Software
Developing software internally helps companies take advantage of market opportunities and improve internal operations. Despite including software development expenses as subject to amortization, the TCJA failed to define “software development” leaving taxpayers to decipher what is included in software development.
Section 174 does not make a distinction between software developed for internal or external use. Under Section 41, however, activities related to software developed for internal general and administrative functions generally do NOT qualify for the R&D credit unless they are both “qualified research” and satisfy the “high threshold of innovation test.” To achieve a “high threshold of innovation,” Treas. Reg. Section 1.41-4(c)(6) provides that the software must be innovative, the development must involve significant economic risk, and the software must not be commercially available for use by the taxpayer. As such, taxpayers might be able to reduce the burden of the Section 174 amortization requirement by claiming the R&D tax credit for their software development activities.
The Time is Now to Evaluate Software Development Costs
Despite bipartisan support to repeal the required amortization of research and experimentation expenditures, companies should not wait to see if Congress repeals the amortization of research and experimentation expenditures. Instead, now is the time to evaluate software development expenditures and other research and experimentation expenditures to ensure that these expenditures have been appropriately reviewed.
For help in understanding the requirements of Section 174, or to determine if your internal software development activities qualify for an R&D tax credit, please contact us.