Sec. 174 Tax Impact

What are the changes to Section 174, and do they affect the R&D expenses? Among the major changes to the U.S. tax system was an amendment to Section 174 of the IRC.

This has made many startups confused - specifically how it may increase their tax bills.

The Sec. 174 deduction now requires capitalizing specified R&D expenditures and amortizing them over 5 years (15 for foreign R&D) after TCJA amendments.

Until 2022, businesses could choose between two options for handling their R&D expenditures:

For software development costs, businesses had the following choices:

Under the TCJA’s changes, businesses can no longer deduct their R&D expenses in the year they’re incurred. Instead, they must spread out such expenses over five years for expenses incurred in the United States and 15 years for those incurred outside the country. This spreading out is called amortization. Even if the underlying property is disposed of, retired, or abandoned during that period, the amortization will still continue. The TCJA also requires that software development costs be treated as section 174 expenses, regardless of whether the software is intended for internal or external use.

The Sec. 174 amendment also requires a change in accounting method. The agency recently released guidance that adds the Sec. 174 change to its list of automatic accounting method changes taxpayers can make on IRS Form 3115, “Application for Change in Accounting Method.” And instead of filing Form 3115, a taxpayer can file a statement with their tax return for the first year of adoption only.

The term research or experimental expenditures, as used in section 174, means expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense.

This generally includes all such costs as:

1. Costs for making a product after you've figured out how to develop or improve it don't count as research expenses under rule 174. The term "product" here means anything like a new model, method, invention, or similar things, whether it's for the business's own use or to sell, lease, or license.
2. If the whole product doesn't meet the criteria for research expenses, then the costs can be considered at the level of its parts or components.
3. Certain costs don't count as research expenses, such as quality control tests, efficiency studies, management or consumer surveys, advertising, buying someone else's patent or model, or research for non-technical projects like literary or historical works.

Research costs must be reasonable, meaning similar to what others would spend in similar situations.

Rule 174 also applies to money paid to others for research on your behalf, but not for costs related to buying or improving land or items you end up owning and using in the research.

Here is an example of how a SaaS company might apply Section 174 of the IRC:

XYZ SaaS Inc. is a company that develops cloud-based project management tools. During the 2023 fiscal year, XYZ SaaS Inc. incurred $500,000 in software development costs (70% is the US and 30% in Israel). These costs were primarily related to the salaries of software engineers, cloud infrastructure costs used for development and testing, and expenses related to prototype development. XYZ SaaS Inc. is evaluating how to apply Section 174 to optimize its tax position.

XYZ SaaS Inc.might choose to deduct the entire $500,000 of development costs in the fiscal year 2023. This decision was based mainly on the cash flow considerations, aiming to reduce taxable income for the year, thereby lowering the current year's tax liability.

XYZ SaaS Inc. has to capitalize the $500,000 of development costs and amortize them over a 60-month or 180-month period starting with the month the benefits of the expenditures are first realized. This approach would spread the tax benefit over five years or fifteen years, which could be advantageous if the company expects to be in a higher tax bracket in future years or wishes to smooth out its taxable income but it the current situation it maily impact the cash position of a startup.

To calculate the profit for XYZ SaaS Inc. under both strategies, we'll start with the basic information provided and the additional assumption that 30% of the company's R&D is done in Israel and must be deducted over 15 years. Let's assume the total R&D expense is $500,000, as mentioned earlier. We'll also need to make some assumptions for the purpose of this example:

• Total Revenue for the year: $500,000
• Total R&D Expenditure: $500,000
• Percentage of R&D in Israel: 30% ($150,000)
• Remaining R&D Expenditure in the US: 70% ($350,000)

Under the immediate expensing strategy, XYZ SaaS Inc. deducts the entire $500,000 of U.S.-based R&D costs in the current year.

Under the deferral and amortization strategy, XYZ SaaS Inc. capitalizes and amortizes the U.S.-based R&D costs over 60 months (5 years), in addition to the 15-year amortization of the Israeli R&D costs.

• Annual Amortization for U.S. R&D: $350,000 / 5 = $70,000
• Annual Amortization for Israeli R&D: $150,000 / 15 = $10,000