The IRS recently published new proposed regulations for research & development (R&D) costs under Section 174 that amend some of the rules around what costs qualify under Section 174 for an R&D deduction. In general, these amendments attempt to quell arguments that section 174(c) and The Depreciable Property Rule disqualify section 174 treatment when tangible property resulting from those expenditures is subsequently sold. Such an interpretation is against the intent of the provision, encouraging businesses to invest in research activities, as businesses would be unable to determine whether their expenditures qualify for section 174 treatment. Thus, the new Section 174 rules allow 174 treatment even if the item is sold. This is in line with the recent case TG Missouri, 133 T.C. 278 (2009) where costs still qualified under 174 and as a supply expense even though the molds were sold to customers.
The new 174 provisions identify five major clarifications for taxpayers seeking to deduct research or experimental expenditures. First, if expenditures qualify as research or experimental the ultimate sale or use of the product is irrelevant. Second, the Depreciable Property Rule in section 1.741-2(b)(4), which has remained unchanged since 1957, is an application of the general definition of research activities provided in section 1.741-2(a)(1) and should not be used to disqualify expenditures that were otherwise eligible. Third, a ‘pilot model’ is, “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.” Fourth, any expenditures to produce a product after all uncertainties have been eliminated do not qualify as research or experimental. Finally, a ‘shrinking-back’ provision addresses situations wherein the requirements of section 1.741-2(a)(1) are met for only a component of a larger product, but the product as a whole does not. The shrink-back provision is similar to the existing provision in section 1.41-4(b)(2).
The amendments include ten new examples to help clarify the irrelevancy of depreciable property produced from qualifying activities, as well as emphasize that only expenditures representing research and development costs in the experimental or laboratory sense qualify for treatment under section 174. These examples will primarily benefit manufactures of both custom and mass produced products, from household tools to aircrafts, as the ultimate use or disposal of any pilot models produced is irrelevant.
The examples in section 1.174-2(a) illustrate that the costs of producing pilot models, as well as the costs of testing pilot models, qualify for section 174 deductions. Additionally, the cost to retest and reconfigure a failed component design of a produced machine, found during quality control testing, qualifies as well. However, these examples emphasize that the cost of producing the product, after the uncertainty has been eliminated, does not qualify for section 174 treatment. It is important to note that a component produced to test and eliminate uncertainties is also considered a pilot model, but the cost to produce the redesigned component does not qualify, as the uncertainty has already been eliminated. The costs to produce multiple pilot models also qualify for the deduction, as illustrated by an example wherein a manufacturer produces multiple models to test extreme heat and cold exposure, submersion, and vibration, and their subsequent sale or destruction has no bearing on the qualification of their production cost, so long as they were produced to eliminate uncertainty and therefore defined as pilot models. The examples further illustrate that the cost to produce and test improvements and new components of equipment used in the taxpayer’s trade or business, as well as the research and development of new production processes, qualify for section 174 treatment.
The examples in section 1.174-2(b) provide clarification of and illustrate contracted research and development cost, as well as the application of The Depreciable Property Rule. In the first example, a company is contracted with no guarantee of economic utility to provide a specially-built machine. The qualification of the contract cost is limited to the extent that the amounts expended were used by the contractor for research or experimentation; the production cost portion of the contract does not qualify. [However, without the price of research versus production explicitly stated in the contract, it will be difficult for a tax preparer to determine these values.] The final two examples illustrate the application of The Depreciable Property Rule. In the first example, $5,000,000 is spent by an aircraft manufacturer to construct a new test bed to develop and improve manufactured aircrafts. None of the $5,000,000 is deductible because it does not meet the definition of research and development costs, a fact the example seems to assume. Interestingly, the allowance for deprecation of the test bed does qualify for section 174 treatment, to the extent the test bed is used in the research or experimentation of other products. The final example builds on these facts but assumes that $50,000 of the $5,000,000 were costs related to the elimination of uncertainty regarding the new test bed’s design. Therefore, the $50,000 qualifies for section 174 treatment by way of section 1.174-2(b)(2). Again, this will likely be difficult for a tax preparer to determine if the taxpayer has not traced these expenditures upfront.