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Proposed Regulations on Research and Experimental Procedures

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The IRS has proposed regulations to amend the definition of “research and experimental procedures” in order to clarify the treatment of amounts paid or incurred in connection with the development of tangible property, including pilot models.

Research and experimental expenditures are those that are paid or incurred in connection with your trade or business that represent research and experimental (development) costs in the “experimental or laboratory sense.” Expenditures are research and development costs in the “experimental or laboratory sense” if they are for activities undertaken to eliminate uncertainty concerning the development or improvement of the product. Generally, all costs incident to the development or improvement of a product (pilot model, process, formula, invention, technique, patent, or similar property) are considered research and experimental procedures.

Qualified research and experimental expenditures may be handled in one of four ways:

  • Currently deducted
  • Deferred and amortized over a period of at least 60 months beginning when benefits are first realized
  • Amortized over a ten-year period beginning when the expenses are incurred
  • Capitalized and depreciated by adding to the basis of any property resulting from the expenditures

There are several factors to consider when choosing between the four alternatives. Currently expensing the costs is easiest, because you avoid detailed recordkeeping and recapture provisions when the technology or assets are sold at a later date. Your current and anticipated income that the deduction offsets may figure into the equation, although the loss carryover provisions may diminish the significance of this factor. Expensing these costs also results in a tax preference item, with the potential to expose you to the alternative minimum tax (AMT). Yet another factor to consider is the potential reduction of the deduction for research expenses if the research credit is claimed, because qualifying expenses are reduced by the amount of the allowable credit.

If you have current income to offset, amortizing the costs over ten years may be an attractive compromise. This option can be preferable to the minimum 60-month amortization option because you can take a deduction currently rather than postponing it until benefits from the research and experimental expenditures are realized. In addition, you reserve a portion of the deduction for future years when increased income from the expenditures is anticipated. If your income is lower, amortizing these costs over ten years can be an advantage over currently expensing them. The disadvantages are that the ten-year amortization period is twice as long as the 60-month amortization period that is otherwise available, and detailed records are required.

The proposed regulations recommend the following revisions and clarifications:

  • In order to dispel the notion that eligibility for research and experimental expenditures can be reversed by a subsequent event, it is irrelevant whether the resulting product is successful, a failure, sold, or used in your trade or business.
  • The “depreciable property rule” is an application of the general definition of “research and experimental expenditures” and should not be applied to exclude otherwise eligible expenditures.
  • The term “pilot model” is defined as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term includes a fully-functional representation or model of the product or a component of a product (to the extent the “shrinking-back” provision applies).
  • The costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible because these costs are not for research or experimentation.
  • A “shrinking-back” provision addresses situations in which the requirements are met with respect to only a component part of a larger product, but are not met with respect to the overall product itself.
  • These regulations are proposed to apply to any tax year on or after these rules are published as final regulations in the Federal Register. However, the IRS will not challenge returns that are consistent with these rules and you may rely on them in the interim.

As a business owner engaged in research activities, you may be interested in learning more about the proper treatment of research and experimental expenses. We would like to discuss the requirements with you in greater detail. Please contact us at your earliest convenience to arrange an appointment.