The IRS issues guidance on Specified Research or Experimental (SRE) Expenditures for Software Development under Section 174

Software SRE Expenditures under new IRS rules Demystified: Navigating Section 174 with Expert Advice

Only weeks before the October extended deadline, the IRS finally issued interim guidance on “Amortization of Specified Research or Experimental Expenditures (SRE) under Section 174” and intends to issue proposed regulations addressing:

1. capitalization and amortization of specified research or experimental (SRE) expenditures under Section 174 of the IRS as part of the Tax Cuts and Jobs Act (TCJA), and
2. the treatment of SRE expenditures under Section 460 for special rules for long-term contracts requires the percentage-of-completion method (PCM) of accounting is required for large contractors with contracts meeting the definition of “long-term”. LTC are defined as contracts that are not completed within the same taxable year in which it is entered into.
3. the application of Section 482 to cost sharing arrangements involving SRE expenditures.

The interim guidance addresses the definitions of SRE and software development, the capitalization and amortization of SRE expenditures, the identification of SRE expenditures, and contract research. It also provided a non-exhaustive list of the types of costs that are considered incident to SRE activities or software development activities, as well as the types of costs that are not permitted to be treated as SRE expenditures.

How are SRE expenses treated under Section 174 (as amended by the Tax Cuts and Jobs Act)?

The amended Section 174 rules requires corporations to capitalize SRE expenditures, including software development costs, and amortize US-based SRE over a period of 5 years, and non-US based SRE over 15 years, beginning with the midpoint of the taxable year in which such expenditures are paid or incurred starting tax year 2022.  This means they are no longer an expense to be deducted against income each tax year.  Thai is especially burdensome for US entities who do most of their software development overseas to save money, as those expenses need to be amortized over 15 years.

What exactly are SRE expenditures? 

SRE expenditures refer to research or experimental expenditures which are paid or incurred during such taxable year in connection with the taxpayer’s trade or business that–

1. satisfy the requirements under Section 1.174-2 to be R&E expenditures or
2. are paid or incurred in connection with the development of any computer software, regardless of whether such expenditures qualify as research or experimental under Section 1.174-2.

To clarify, Section 1,174-2(a)(1) defines R&E (Research and Experimentation) expenditures as costs linked to a business’s R&D efforts. Simply put, SRE (Sustainable Research Expenditure) covers all expenses related to enhancing or creating a product. It further clarifies that expenses qualify as R&D costs when they’re spent on activities aimed at reducing uncertainty about a product’s design, a component, or a subcomponent.

The main issue with Section 174 for many of our SaaS or software clients was in the language that seemed to cover ALL expenditures “paid or incurred in connection with the development of any computer software, regardless of whether such expenditures qualify as research or experimental.”

Tax professionals like ourselves were left to interpret whether it only covered initial development, whether it covered bugs, fixes and upgrades; and whether software development for another company’s IP, or “work for hire” would be covered.  No one knew, as Cleer could not let the April 2023 tax deadline go by, when tax is DUE, and let our Clients suffer the penalty of not paying or underpaying

What expenditures DO NOT qualify as SRE?

According to the latest IRS Notice, the following costs are not allowed as SRE expenditures, regardless of whether they may be incident to SRE activities described in Section 4.02(4)(b) or incurred in connection with software development activities described in Sections 4.02(4)(a) and 5.03:

1. Costs incurred or paid by general and administrative departments that indirectly support or benefit SRE activities, such as accounting personnel services used to account for research expenditures.
2. Interest on debt used to fund SRE activities;
3. Cost paid or incurred for activities related to software development projects (described in Section 5.05) that are not considered software development for purposes of Section 174;
4. Costs associated with website content input;
5. Costs for website hosting;
6. Costs associated with registering a domain name or trademark;
7. Costs specified in Section 1.174-2(a)(6)(i) through (vii);
8. Amounts representing SRE expenditure amortization; and
9. Amounts representing amortization of research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2022

What activities are considered software development, according to the IRS?

Software development includes, but is not limited to, the following activities for purposes of Section 174:

1. Planning the development of computer software or upgrades and enhancements to existing software, including the identification and documentation of software requirements;
2. Designing the computer software or any upgrades or enhancements to it;
3. Constructing a model of the computer software or its upgrades and enhancements;
4. Creating and transforming source code into machine-readable code;
5. Testing computer software or upgrades and enhancements to such software, as well as any modifications to address defects found during testing, until the following date only:

1. In the case of computer software developed for use by the taxpayer in its trade or business, the software is placed in service, and
2. In the case of computer software developed for sale or licensing to others, technological feasibility has been established, product masters have been created, and the computer software is ready for sale or licensing to others.

6. Production of the product masters in the case of computer software developed for sale or licensing to others or the upgrades and enhancements to such software

What are some examples of costs that are INCLUDED in SRE activities?

The notice provides a non-exhaustive list of examples of SRE expenditures, which include:

1. Labor costs. Labor costs include all elements of compensation other than severance pay paid to employees and independent contractors who perform, supervise, or directly support SRE activities.
2. Materials and supplies cost. Cost of material and supplies, including non-depreciable tools and equipment under Section 168, which are used or consumed in the performance of SRE activities or in the direct support of SRE activities, including property placed in service in a taxable year that begins on or before December 31, 2021
3. Cost recovery allowances. Depreciation, amortization, and depletion allowances for assets used in or directly supporting SRE-related activities
4. Patent costs. Costs related to obtaining a patent, such as attorneys’ fees incurred in making and perfecting a patent application.
5. Certain operation and management costs. Rent, utilities, insurance, taxes, repairs and maintenance costs, security costs, and similar overhead costs for facilities, equipment, and other assets used in the performance or direct support of SRE activities
6. Travel costs. Travel expenses of those performing SRE activities or providing direct support for SRE activities

What costs associated with software development projects are NOT considered software development for purposes of Section 174?

According to Section 5.05 of this notice, the following activities associated with software development projects are not considered software development for purposes of section 174:

1. For computer software developed for use in its trade or business. 

Expenditures incurred after installing the software, such as:

1. Training of employees and other stakeholders who will use the software
2. Maintenance activities after putting the software in service that do not give rise to upgrades or enhancements
3. Activities involving data conversion, excluding the development of software that facilitates access to existing data or data conversion; and
4. Installation of computer software and other tasks associated with putting the software into service

2. For computer software developed for sale or licensing to others. Costs incurred at the time the software is ready for sale or licensing, including:

1. Marketing and promotional activities;
2. Maintenance tasks that do not result in upgrades and enhancements;
3. Distribution activities; and
4. Customer support activities

How should software development activities associated with the purchase of computer software be treated?

According to Section 5.04 of this notice, upgrades and enhancements to purchased computer software are considered software development for purposes of Section 174. Therefore, they must be capitalized and amortized.

However, the following costs DO NOT qualify as SRE under Section 174, and are an expense that does not have to be amortized:

1. Purchase and installation of the computer software (including the configuration of pre-coded parameters to make such software compatible with the business and re-engineering the business to make it compatible with the purchased software);
2. Planning, designing, modeling, testing, and deployment activities associated with the acquisition and installation of such software

How are the costs incurred or paid by the research recipient to be accounted for in accordance with Section 174?

According to Treasury Regulation, treatment of research costs paid or incurred by the research recipient do not have to be amortized or capitalized. For research costs to be treated as SRE expenditures, the performance of the services must be at the research recipient’s order and risk.

How are costs paid or incurred by the research provider treated for purposes of Section 174?

A research provider is subject to Section 174, capitalization of costs paid or incurred associated with research activities performed on behalf of the research recipient, if (1) the research provider bears the financial risk under the terms of the contract entered into with the research recipient or (2) the research provider has the right to use the resulting SRE product in its trade or business or exploit any resulting SRE product through sale, lease, or license, regardless of whether the research recipient is required to treat its costs as SRE expenditures under Section 6.03 of this notice.

Notably, Section 6.04 states that “the research provider shall not be treated as having a right to use the SRE product in the research provider’s trade or business or to otherwise exploit the SRE product through sale, lease, or license if such right is available to the research provider only upon obtaining approval from another party to the research arrangement who is not related to the research provider within the meaning of Sections 267 or 707.”

Can Cleer help us determine how Section 174 applies to us and what the tax implications are? 

Absolutely! We have many SaaS and other clients involved in software development for whom we have navigated this change in accounting method. Cleer offers Federal Income tax preparation.  Either way, we can help you account for your software development, bug fixes and upgrades, and work-for-hire for another person’s IP to make sure we optimize your tax savings under this confusing new law and guidance.

We also offer all-in-one monthly accounting packages that include monthly statements plus your Federal and state tax returns.  If you have any other questions about forming your company or how to maximize your tax savings,book a consultation to discuss the best structure for your startup business no matter what state you register in.

If you have further questions or need assistance, feel free to contact us.