Interplay Between R&D Tax Rules and Long-Term Contract Accounting – Surprises and Opportunities

By Justin Herp

On September 8, 2023, the Internal Revenue Service (IRS) released Notice 2023-63, which provides interim guidance outlining forthcoming proposed regulations under section 174.  The release is welcome news to taxpayers and tax advisors experiencing significant uncertainty over the final tax treatment of section 174 costs for tax years 2022 and after.  While not all of the uncertainty has been resolved, Notice 2023-63 is particularly helpful for taxpayers in the construction and manufacturing industries that are required to account for their contracts under section 460.

Background

Section 174 expenditures are broadly related to research and experimental (R&E) costs for taxpayers performing research & development (R&D) activities.  Prior to 2022, taxpayers were typically permitted to deduct these costs in full in the year the costs were incurred.  However, the Tax Cuts and Jobs Act (TCJA) amended section 174 to require that expenditures incurred in tax years beginning on or after December 31, 2021 be capitalized and amortized over a five-year period for domestic research activities (or 15-year period for foreign research activities).  Our teams have discussed section 174 costs more broadly in past publications.

The changes to the treatment of section 174 expenditures have negatively impacted many taxpayers, some of which have found themselves facing steep tax bills on their 2022 tax returns.  Yet, the IRS has until recently been near silent with respect to clarifying how taxpayers should apply the new section 174 rules—including the interplay among section 174 and section 460, which governs the tax treatment of certain construction and manufacturing contracts.

Section 460 requires that many taxpayers in the construction industry and a limited subset of manufacturers recognize revenue for tax purposes using the percentage-of-completion method (PCM).  Under the PCM, taxpayers compute a completion factor for each contract.  The completion factor is the ratio of contract costs incurred to date as the numerator over total costs expected to be incurred in satisfying the contract as the denominator (a “cost-to-cost” calculation).  This completion factor is then multiplied by the contract price to yield the cumulative amount of revenue which is taxable.  Below is an illustration of the computation of the completion factor and how the completion factor subsequently impacts taxable revenue.

There are many nuances to the requirements under section 460 that are beyond the scope of this discussion, but the principle is that the PCM recognizes revenue for tax purposes as progress is made on a contract.  Progress, in turn, is measured by the amount of costs incurred to date in the performance of the contract.

The Collision of Sections 174 and 460

Prior to the release of Notice 2023-63, many taxpayers faced uncertainty in how or whether to adjust their section 460 PCM calculations for the changes in the treatment of section 174 costs in 2022.  For instance, some taxpayers feared that existing regulations and IRS guidance created a misalignment between the deduction for section 174 expenditures (via the amortization required starting in 2022) and the year the same expenditures should be factored into the PCM calculation.

One reading of the existing IRS authority concluded that for purposes of applying the PCM and computing taxable revenue, a taxpayer would deem a section 174 cost as having been incurred in the earlier of the year the associated services or property were provided to it or the year it paid for such services or property.[1]  Meanwhile, for purposes of computing taxable deductions, the deduction of the same costs would occur as the amortization was allowed under section 174.

Such an interaction would have heavily burdened taxpayers utilizing the PCM and may have been an unintended consequence unforeseen by Congress in the drafting of the TCJA.  Legislation introduced in Congress during the summer of 2023 by the House of Representatives appeared to recognize this issue.  The legislation proposed that—in conjunction with a delay of the section 174 capitalization and amortization requirements until 2026—the section 174 amortization expense be included in the numerator of the PCM completion factor for those years, rather than the full amount of section 174 costs incurred or paid.  However, this legislation ultimately gained no traction.

A Fix to the Problem?

The IRS clearly recognized the conflict existing between section 174 and section 460, as Notice 2023-63 provides a welcome relief for affected taxpayers.  Within the guidance, the IRS states that it intends to permit taxpayers who incur section 174 expenditures in connection with a long-term contract to include only the section 174 amortization expense in the numerator of the PCM completion factor.

The request for comments from the IRS in Notice 2023-63 proposes two alternatives for how the denominator of a section 460 completion factor is computed – either by using total estimated section 174 expenditures associated with the contract or only the total expected amortization of such section 174 expenditures over the life of the contract, with the former treatment requiring an adjustment for any unrecognized section 460 revenue to be includible in taxable income in the year following a contract’s completion – even if associated section 174 costs previously capitalized have some years left to be amortized. 

These two alternatives would yield different results in cases where a contract will have a shorter life than the amortization period of the section 174 costs within the contract’s costs, since the standard five or 15-year amortization periods for domestic and foreign section 174 costs, respectively, continue even if the associated contract which generated the costs has already been completed.

Generally, the former treatment of the two alternatives contemplated by the IRS for determining the PCM completion factor denominator would yield a more favorable result.  Interestingly, for affected taxpayers, the result may be more beneficial than if Congress had not enacted the changes to section 174 at all.  See Exhibits A through C below for an illustration of the interactions as discussed above. Note, however, that the proposed regulations issued after the IRS reviews comments submitted on Notice 2023-63 may establish only one of the alternatives.

Fact Pattern:

Assume a taxpayer has a long-term contract required to be accounted for with the PCM pursuant to section 460.  The contract price is $2,000,000.  The taxpayer has incurred $900,000 of costs to date through 2022 and anticipates incurring another $600,000.  Based on the $1,500,000 of total estimated contract costs, the taxpayer anticipates a gross profit of $500,000.

Of the $900,000 of allocable contract costs incurred to date through 2022, $200,000 are domestic section 174 expenditures and $700,000 are not section 174 expenditures.

Exhibit A – Hypothetical Repeal of Section 174:

Before 2022 and the changes to the deductibility of section 174 costs, the taxpayer would compute a PCM completion factor of 60% ($900,000 of costs incurred over $1,500,000 of total estimated costs).  Applied to the $2,000,000 contract price, this PCM completion factor would yield taxable revenue of $1,200,000.  When reported with the $900,000 of deductions for costs incurred, the net taxable income associated with the contract would be $300,000.

Exhibit B – Application of Section 174 Before Notice 2023-63:

We’ll assume the same fact pattern for the contract, but we’ll now consider the application of section 174 with the required capitalization and amortization but before the guidance released in Notice 2023-63.

There is no change to the calculation of the completion factor, as the $900,000 is includible in the numerator as incurred.  However, only $720,000 of costs are deductible - $700,000 of costs which are not section 174 costs, plus $20,000 of the $200,000 of section 174 costs as amortization (based on a half-year convention and a five-year amortization period).

This scenario results in taxable income of $480,000—a substantial increase from Exhibit A, and demonstrative of the cause for concern that faced many contractors subject to the PCM before Notice 2023-63 was released.

Exhibit C – Application of Section 174 After Notice 2023-63:

We’ll again assume the same fact pattern for the contract, but now we’ll consider the application of Notice 2023-63 while employing the method described in the IRS’ request for comments—measuring the denominator of the PCM completion factor as inclusive of the total section 174 costs estimated to be incurred over the life of the contract.

In this scenario, the taxpayer computes its PCM completion factor numerator to be $720,000, which is $700,000 of non-section 174 costs, plus $20,000 of the $200,000 of section 174 costs as amortization (based on a half-year convention and a five-year amortization period).  The denominator is the $1,500,000 of total estimated contract costs.  With this method, the PCM completion factor is 48% - yielding $960,000 of taxable revenue.

The amount of contract costs deductible is the same as Exhibit B:  $720,000.

This scenario results in taxable income of $240,000—a substantial reduction in taxable income from Exhibit B and, interestingly, even a reduction in taxable income compared to Exhibit A, which reflects the results had the TCJA not amended treatment of section 174 costs in the first place.

Note, however, that such results assume that the section 174 costs are properly includible in the PCM completion factor calculation as allocable contract costs.  Further, these calculations exclude any indirect section 174 costs that are not allocable to particular contracts but are still required to be capitalized and amortized over the applicable amortization period by taxpayers.  Practically, in many cases, taxpayers may hope to only mitigate some of the unfavorable impacts of the changes to section 174, rather than come out in a net beneficial position after applying the IRS’ recent guidance.

Application of Released Section 174 Guidance

The IRS intends to release proposed regulations comprising the above guidance in early 2024 based on recent indications from IRS officials. While the proposed regulations are planned to be effective for tax years ending after September 8, 2023, the IRS will permit taxpayers to rely on the rules described in Notice 2023-63 for tax year 2022 if all aspects of the guidance are applied consistently.  The treatment of section 174 costs within section 460 contracts discussed above is just a single topic within the broader guidance within Notice 2023-63, so any contractors subject to the PCM would not be able to avail themselves of the favorable guidance applicable to section 460 PCM calculations without ensuring full compliance with other, potentially less favorable aspects of the guidance.

If a taxpayer has already filed a 2022 tax return, then an amended tax return to conform with the guidance issued in Notice 2023-63 is not permitted.  The IRS anticipates releasing procedural guidance in the future describing how taxpayers should address the handling of section 174 costs on 2023 tax returns, which were not treated in accordance with the guidance in Notice 2023-63.  This would include any contractors subject to the PCM that treated section 174 expenditures that were allocable contract costs in accordance with the prior Exhibit B example.

In the meantime, any contractor subject to section 460 that has incurred section 174 costs allocable to its PCM contracts should consult with a tax advisor to review its circumstances and be prepared to take action when the IRS issues further proposed regulations and procedural guidance, likely taking the form of additional accounting method changes.  Our tax professionals are equipped with the expertise to help you evaluate any potential opportunities provided by further guidance on the interaction of section 174 and the PCM. Contact us today.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.

[1] Reg. sections 1.460-1(b)(8) and 1.461-4(d)(2)(ii)