Section 174 Changes Impact R&D Tax Credits for Software
The new changes to Section 174 have a significant impact on software development costs. For tax year 2022, any cost that has been paid or incurred related to software development is now considered a Section 174 R&E expenditure. This means it must be capitalized and amortized over 5 years (15 years for foreign software development).Â
Many favorable provisions are made temporary due to the budgeting constraints of Congress, making yearly extensions normal and expected. It is important to note that the research expenses being addressed by this provision in the TCJA are not just the same as those provided for in the R&D tax credit rules. These general research costs are much broader.Â
If the current unfavorable tax treatment of research expenses does not get fixed, companies could see larger tax bills and therefore need the benefits of R&D tax credits even more. Â
Which Software Development Costs fall under the new Section 174 R&E Amortization rules?
While guidance related to what costs constitute Section 174 Expenditures is still vague, potential expenditures can include:Â
- Salaries and wages including employer costs
- Software licensing
- Equipment rental costs
- Occupancy costs, including office rent and research facilities costs
- Travel expenditures that have been incurred for R&E purposes
- Heat, light, telephone bills, and similar overhead utility costs
- Depreciation
- Dues and publication expenses that have been incurred for R&E purposes
- Attorney fees or filing fees related to patents
Recent Changes to Section 174 Amortization for Software Development
As mentioned, there are several recent changes to Section 174 that directly affect software development in relation to the new guidance released by the IRS under Rev. Proc. 2023-11.
It includes the following:
- Taxpayers that have software development costs must now amortize the costs over 5 years for domestic research costs and 15 years for foreign research costs.
- The costs can no longer be fully deducted in the year paid or incurred.
While historically Section 174 Research & Experimental (R&E) expenditures allowed for the deduction or amortization of direct and indirect costs for R&E activities, the Tax Cuts and Jobs Act (TCJA) of 2017 changed the treatment of R&E expenditures. This change now requires the amortization.
How Does This Affect Taxpayers Claiming the R&D Tax Credit for Software Development?
Whether or not taxpayers claim the R&D tax credit, they are still required to amortize costs in compliance with Section 174.
Section 174 and Section 41 (R&D tax credit) are separate tax sections and have separate rules. However, both sections have similar definitions of R&D. This means that while the software development costs that are amortized under Section 174 may also be qualified for R&D tax credits under Section 41, which helps offset the tax liability from the Section 174 amortization.
How Does This Affect Taxpayers Claiming the R&D Tax Credit for Software Development?
R&D tax credits are claimed for direct research expenses (wages, contractor expenses, supplies, etc.). Section 174 also includes these amounts but is expanded to include certain indirect research costs (including facility costs) which are excluded from the R&D credit calculation.
So while most R&D tax credit expenses will qualify as a Section 174 expenditure, not all Section 174 expenditures will attain the level of qualification needed to claim the R&D tax credit. Many companies will therefore have Section 174 expenditures even if they do not claim the R&D tax credit.
Claiming R&D Tax Credits for Software Development
The following are examples of qualified research activities for software development companies to claim under the R&D tax credit:
- Design and development of new software components
- Design and development of new or improved software applications
- Internal Use Software development
- Virtual reality or game development
- Developing data mining techniques including big data analysis and processing
- Development of firmware
- Development of POS systems
- Integrating hardware and software components
- Development of document management systems
- Development of education-based software
- Design and development of CRMs
- Design and development of compliance systems
- Healthcare system and application development
- Development of financial and accounting software
- Developing simulators
- Development of data center tools
- Development of monitoring systems
- Development and integration of databases
- Designing and experimenting with computer hardware
- Reducing system latency
- Developing messaging technologies
- Network development and optimization
- Building QA or testing environments
- Integrating disparate or legacy systems with new software
By claiming any of the above-qualified activities towards the research credit, taxpayers will be able to offset some of the Section 174 amortization.
Get Help from Industry Leaders
One of the best ways to offset additional taxes because of these new, mandatory changes to Section 174 is to take advantage of the R&D credits. If you have any Section 174 costs and are developing a product, process, or software, it is likely you can also claim R&D credits. Our team at Source Advisors can help you navigate these changes through webinar offerings and direct meetings with our R&D tax professionals.
