Unique Impacts of IRC Sec. 174 Changes on the Software Industry

Update: Congress is currently considering legislation that would impact IRC Sec. 174. For more details, please see here.

The Tax Cuts and Jobs Act (TCJA) had numerous provisions with effective dates much farther into the future than 2018, when the act took effect. One such provision was the amendment to IRC Sec. 174, which governs how businesses can treat research and experimental (R&E) expenditures. This provision became effective for tax years beginning on or after Jan. 1, 2022.

What Counts as R&E Expenses?

The definition of R&E expenditures is much broader than may be expected. Research and experimental expenditures include any expenditure “incurred in connection,” even incidentally, to the “development or improvement of a product.” This can include salaries, models, attorneys’ fees, drawings, utilities, and more. The term “product” is also quite broad and includes products used internally by the company, as well as some intangible concepts such as a technique or process.  

Changes to the Law

The TCJA made significant amendments to the way businesses may treat R&E expenditures. Since 1954, these expenditures could be fully deducted as an expense in the year in which they were incurred, though taxpayers could elect to amortize them over a period of at least 60 months if they wished. Under the amended code section, businesses are now required to charge the R&E expenditures to a capital asset and amortize the asset over a 5-year period (15 years in the case of foreign R&E expenditures). These expenditures must also be amortized using the mid-year convention, meaning that in the first year, taxpayers will only be allowed to deduct 10% of the total R&E expenditures.

Unique Considerations for Software Companies

While the law will cause headaches for many industries, the software industry is particularly impacted. The TCJA added IR.C Sec. 174(c)(3), which explicitly states that any expenses incurred in connection with software development must be treated as an R&E expenditure (capital asset) and therefore amortized. 

Previously, software development expenses were not explicitly under the purview of IRC Sec. 174. Instead, Rev. Proc. 2000-50 provided that software development expenditures “in many respects so closely resemble the kind of R&E expenditures” that fall under IRC Sec. 174 that it warranted “similar accounting treatment.” Thus, a taxpayer could elect to deduct 100% of these expenses under IRC Sec. 174, amortize the expenses over a five-year period, or amortize the expenses over a three-year period under IRC Sec. 167(f). However, software development expenses did not fall under the definition of “research and development expenditures” under IRC Sec. 174. The TCJA changed this by formally defining software development expenditures as an R&E expenditure subject to IRC Sec. 174. 

The impact of this change on software and technology companies cannot be overstated. Many companies have had their taxable income increase dramatically because they can no longer deduct expenses. In fact, some companies have gone from being unprofitable to profitable and liable for federal and state taxes due to the change.  

To illustrate the impact: Suppose Taxpayer X is a software company developing accounting software. In 2021, X had $15 million in revenue. X also had $8 million in salary expenses, of which $6 million were for software developers and engineers. X spent an additional $2 million in rent and utilities, half of which were allocated to R&E expenditures. In 2021, X can deduct all $8 million in salaries and $2 million in rent and utilities, leaving $5 million in taxable income. In 2022, X is only able to fully deduct the $2 million in salaries and $1 million in rent and utilities that are not connected to software development. X must now capitalize the $6 million in salaries and $1 million in rent and utilities that are attributable to software development, and then may only deduct 10% ($700,000) for 2022 due to the mid-year convention requirement. X’s taxable income in 2022 would be $11.3 million – more than twice X’s taxable income in 2021. 

New Guidance Provides Some Clarity

One issue compounding the difficulties for companies has been the lack of clear guidance around these changes. Although IRC Sec. 174 was changed in 2017, the IRS did not release any guidance on the changes until September 8, 2023, when they released a notice of proposed rulemaking. This lack of clear guidance has led to questions over how to apply the current regulations and their definitions to software development expenditures for the past 18 months.

Computer Software Defined

The Notice generally adopts the definition of computer software previously used in Notice 2000-55; and defines it as “any computer program or routine (that is, any sequence of code) that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine.” The definition has also been updated to reflect today’s technological world, and now includes any software that can be “accessed remotely via a private computer network or the Internet,” which includes cloud computing.

Treatment of Testing

The guidance provides answers to a few major outstanding questions. For instance, taxpayers had been unsure on how to treat expenses related to quality control testing. Under the current regulations, quality control is not considered to be an expenditure. It was unclear if this included quality control testing for software, which typically leads to the identification of “bugs” (defects), which then leads to “bug fixes.” These bug fixes could be considered “improvements,” which would fall under R&E expenditures under current regulations. Section 5.03(5) of Notice 2023-63 clarifies that software testing and the “necessary modifications to address defects, identified during testing” are considered “software development” for the current IRC Sec. 174, up to the point where the computer software is either placed in service for use by the taxpayer in its trade of business or it “is ready for sale or licensing to others.” 

Activities Not Considered Software Development

The Notice also provides some clarification on what activities will not be considered activities treated as software development. For software that is developed for use in a taxpayer’s trade or business, training on use of the software; maintenance (including diagnosing and debugging) on the software that does not rise to the level of an upgrade or an enhancement; data conversion; and software installation are not considered software development activities. For software that is developed for sale or licensing to others, marketing and promotional activities; maintenance on the software that does not rise to the level of an upgrade or enhancement; distribution activities (such as allowing remote access); and customer support are not considered software development activities.

Reliance and Applicability Dates for Notice 2023-63

While not binding, taxpayers can generally rely on the information in Notice 2023-63 for tax years ending on or after December 31, 2021, with the exception that taxpayers may not rely on Sec. 7 (dealing with the disposition, retirement, or abandonment of property) of the Notice for SRE expenditures paid or incurred with respect to any property that is contributed to, or distributed or transferred from, a partnership. The Notice states that forthcoming proposed regulations should be applicable for taxable years ending after September 8, 2023. The Notice also makes Section 5 of Rev. Prov. 2000-50 obsolete. 

Don’t Wait for a Congressional “Fix”

While these changes to IRC Sec. 174 went into effect on January 1, 2022, many have continued to hold out hope that Congress will retroactively repeal the changes. Most taxpayers who are impacted have until October 15, 2023, (with extensions) to file their 2022 returns reflecting the new rules. Taxpayers who have not already taken steps to comply with the new rules should reach out to a trusted tax advisor.