By Peter J. Scalise
As a synopsis, I.R.C. § 174 allows taxpayers to elect to take a current deduction for research and experimentation expenditures in the tax year they are paid or incurred or to defer certain research and experimentation expenditures and amortize them. Since its enactment in 1954, I.R.C. § 174(c) has provided that I.R.C. § 174 does not apply to any expenditure for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation and of a character that is subject to depreciation or depletion. In 1957, the IRS (hereinafter the “Service”) issued Treas. Reg. § 174-2(b)(1) and (b)(4) to implement this rule. This is referred to as the “Depreciable Property Rule”.
Tax professionals have long debated on whether the sale of a product resulting from otherwise qualifying research or experimentation expenditures should subsequently disqualify those expenditures from I.R.C. § 174 treatment. The Service had previously taken the position that I.R.C. § 174(c) precluded I.R.C. § 174 treatment in the case of a subsequent sale of a resulting product to a customer, because the sale gives rise to depreciable property in the hands of the customer. However, in the pivotal case of T.G. Missouri Company v. Comm’r, 133 T.C. 278 (2009), the Tax Court rejected the Service’s argument that research or experimentation expenditures were disqualified under I.R.C. § 174 because the product resulting from research was sold to customers and was subject to depreciation in the customers’ hands.
The Service has now issued Proposed Treasury Regulations in which it proposes several substantive revisions to the current regulations and provides additional examples to further elucidate the scope and application of the statute as follows:
➢ First, to counter an interpretation that I.R.C. § 174 eligibility can be reversed by a subsequent event, the Proposed Treasury Regulations provide that the ultimate success, failure, sale, or other use of the research or property resulting from research or experimentation is not relevant to a determination of eligibility under I.R.C. § 174;
➢ Second, the Proposed Treasury Regulations amend Treas. Reg. § 1.174-2(b)(4) to provide that the “Depreciable Property Rule” is an application of the general definition of research or experimentation expenditures provided for in Treas. Reg. Sec. § 1.174-2(a)(1) and should not be applied to exclude otherwise eligible expenditures;
➢ Third, the Proposed Treasury Regulations define the term “pilot model” 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 (i.e., to the extent the shrinking-back provision described below applies); and
➢ Fourth, the Proposed Treasury Regulations clarify the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible under I.R.C. § 174 because these costs are not for research or experimentation. Finally, the Proposed Treasury Regulations provide a shrinking-back provision to address situations in which the requirements of Treas. Reg. § 1.174-2(a)(1) are met with respect to only a component part of a larger product and are not met with respect to the overall product itself. The Proposed Treasury Regulations provide new examples applying these provisions.
Please contact Peter J. Scalise, National Partner-in-Charge of Engineered Tax Services, for a complimentary consultation on the scope and application of these Proposed Treasury Regulations at (917) 822 0275.
About the Author
Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is a highly distinguished BIG 4 Alumni Tax Practice Leader and has approximately twenty years of progressive public accounting experience developing, managing and leading multi-million dollar tax advisory practices on both a regional and national level.
Peter is also a renowned keynote speaker and author on specialty tax incentives, tax controversy matters, and legislative updates from Capitol Hill for NAREIT, USGBC, AICPA, ASTP, NATP, ABA, AIA, TEI and serves as a volunteer member of the iShade Tax Faculty. Peter serves on both the Board of Directors and Board of Editors for The American Society of Tax Professionals (“ASTP”) and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an operating division of ASTP