Tax Extender Bill Offers Relief for Certain Sec 174 R&D Expenses

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Congress has traditionally reviewed a tax extenders bill at the end of each year. The legislation is designed to temporarily extend the expiration date of certain popular tax provisions (i.e., bonus depreciation). Since November 2023, Congress has been debating comprehensive extender legislation designed to address several provisions of the Tax Cuts and Jobs Act (TCJA). These include COVID-19 era tax changes (i.e.100% meal deduction), business deduction limits for interest expenses, and the requirement to capitalize and amortize Section 174 research and development (R&D) expenses. Since Congress did not pass a bill before year-end, many provisions expired, and others were left in place.

Despite not passing legislation last year, Congress continues to work towards legislation that will, amongst other things, reinstate the prior Section 174 expense rules. Thus, taxpayers may soon be able to resume fully deducting R&D amounts in the current tax year. IRS Notice 2023-63 clarifies the types of software development costs that need to be included. To help clients, prospects, and others, JLK Rosenberger has highlighted the activities and costs that can be included and other optimized deductions in the new Section 174 guidance.

What Costs Can Be Included?

Labor Costs for employees or contractors performing activities related to the development of a Specified Research and Experimental (SRE) product (i.e., a new or improved product, software, process, etc.), such as:

• Wages (box 5) and other compensation, such as:
• Stock-based, vacation & sick pay, payroll tax, and similar costs.

Fees paid to outside contracted parties if the taxpayer has Rights and Financial Risk in the SRE product being developed:

• Financial Risk is determined by the party who bears the cost if the SRE product fails or cannot be developed.
• Rights to the SRE are determined by who has the rights to use or exploit the SRE product developed under the contract.

Materials and supplies directly related to SRE product development that are not depreciable under Sec. 168 can be included, as well as certain cost recovery allowances (i.e., depreciation, amortization, depletion) for property used to perform activities to develop the SRE product. Patent costs and certain operation and management expenses, such as rent, utilities, insurance taxes, repairs and maintenance, and travel costs can also be included.

It is important to note that the cost must reasonably relate to the development of the SRE product, and you must be consistent with allocation methods used to calculate costs and the types of SRE expenses included from year to year.

What software development activities are included?

Activities that began after December 31, 2021, related to the development of a new or improved software SRE product can be included. These include new software development activities or those geared towards adding new functionalities or improvements that materially increase the efficiency or speed of existing software. All software product development, such as system, program, application, embedded, or software storage in all media forms, are included.

Individuals performing SRE activities or directly supporting software development can be included. Some SRE activities related to software development include designing the software, building a software model, writing or converting source code, testing the software, and developing improvements. If software is developed for sale or licensed to outside parties, then costs to produce the masters can also be included.

What software development activities are excluded?

General administrative or payroll services, interest on debt to finance SRE development, routine quality control or inspections, efficiency or management studies, consumer marketing surveys, and literary, historical or research in similar fields are excluded. Also excluded are costs to acquire someone else’s patent or SRE product and certain website costs, such as maintenance, hosting fees, domain registration, trademark fees, and maintenance activities.

The following software development activities are also excluded from Section 174 costs:

• Database or information bases (i.e., customer/business lists, files, books, records, etc.)
• Training employees or others to use the software
• Software installation or costs related to putting the software in service
• Data Conversion activities to translate the data into a different format for system compatibility
• Costs that relate to activities that took place after development or when the software is placed in service or is ready to market to others
• Other post-development activities, such as maintenance, bug fixes, and marketing

Contact Us

The opportunity to once again expense eligible R&D expenses in the year incurred is welcome news for many companies. Unfortunately, the bill is still working its way through Congress and will require additional time before passage. We will keep you updated on any changes. If you have questions about the information outlined above or need assistance with an R&D study, JLK Rosenberger can help. For additional information, call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.