IRS Obsoletes Decades-Old Guidance on Accounting for Research and Experimental Costs

(Parker Tax Publishing May 2023)

The IRS obsoleted Rev. Rul. 58-74, which provides that if a taxpayer adopted the expense method under pre-TCJA Code Sec. 174(a) to currently deduct research or experimental expenditures paid or incurred during the tax year in connection with its trade or business, but failed to deduct such expenses in a year to which the expense method is applicable, the taxpayer should file a claim for refund or amended return to deduct the expenses. According to the IRS, there are insufficient facts in Rev. Rul. 58-74 to properly analyze whether the taxpayer's failure to deduct certain research or experimental expenditures, such as the cost of obtaining a patent, when it deducted other research or experimental expenditures, constituted a method of accounting or an error. Rev. Rul. 2023-8.

Background

The Tax Cuts and Jobs Act (TCJA) amended Code Sec. 174, effective for amounts paid or incurred in tax years beginning after December 31, 2021. For amounts paid or incurred in tax years beginning on or before December 31, 2021, former Code Sec. 174(a) permitted a taxpayer to currently deduct research or experimental expenditures that were paid or incurred during the tax year in connection with its trade or business (expense method). Alternatively, a taxpayer could elect to defer and amortize these expenditures under former Code Sec. 174(b). If expenditures were neither currently deducted nor deferred and amortized, they had to be charged to capital account.

If the expense method was adopted for amounts paid or incurred in tax years beginning on or before December 31, 2021, it had to be used for all qualifying expenditures in the tax year adopted and for all subsequent years, unless the IRS consented to a different method for all or part of the expenditures under former Code Sec. 174(a)(3). A taxpayer on a different method could apply for permission to change to the expense method for all or part of the expenditures by submitting a written application to the IRS.

Rev. Rul. 58-74 provides that if a taxpayer adopted the expense method but failed to deduct expenses relating to the cost of obtaining a patent or other items of research or experimental expenditures for prior tax years to which the expense method is applicable, the taxpayer should file a claim for refund or amended return to deduct additional research or experimental expenditures in the year or years when the expenditures were paid or accrued. Rev. Rul. 58-74 further provides that the additional research or experimental expenditures cannot be treated as deferred and amortized under former Code Sec. 174(b) or chargeable to capital account and subsequently amortized or written off upon abandonment of the project or projects because consent to change a method of accounting was not obtained. Accordingly, the deduction for the additional research or experimental expenditures could be lost if the period of limitations on claims for credit or refund under Code Sec. 6511 has expired and amended returns could not be timely filed.

Observation: The TCJA amended former Code Sec. 174 to require research or experimental expenditures (for amounts paid or incurred in tax years beginning after December 31, 2021) to be charged to capital account and amortized ratably over the five-year period (or the 15-year period in the case of any specified research or experimental expenditures which are attributable to foreign research) beginning with the midpoint of the tax year in which the specified research or experimental expenditures were paid or incurred. According to the IRS, the rationale for obsoleting Rev. Rul. 58-74 is independent of the removal of the expense method by the TCJA amendments to former Code Sec. 174.

Rev. Rul. 2023-8

The IRS periodically obsoletes rulings that are no longer determinative because: (1) the applicable statutory provisions or regulations have been changed or repealed; (2) the ruling position is specifically covered by a statute, regulation, or subsequent published position; or (3) the facts set forth no longer exist or are not sufficiently described to permit clear application of the current statute and regulations.

The IRS stated that it is obsoleting Rev. Rul. 58-74 because there are insufficient facts in the ruling to properly analyze whether the taxpayer's failure to deduct certain research or experimental expenditures, such as the cost of obtaining a patent, when it deducted other research or experimental expenditures, constituted a method of accounting or an error. For example, Rev. Rul. 58-74 does not explain whether the taxpayer consistently treated the costs of obtaining a patent in determining its taxable income. Rev. Rul. 58-74 also fails to describe the cause and extent of the deviation in the treatment of certain research or experimental expenditures that were not deducted.

According to the IRS, whether a change in accounting treatment of amounts paid or incurred for research or experimentation expenditures constitutes a change in method of accounting or the correction of an error depends on the specific facts of a particular situation. If the facts demonstrate that a taxpayer has a change in method of accounting, then filing an amended return, refund claim, or administrative adjustment request (AAR) under Code Sec. 6227, as applicable, in reliance upon Rev. Rul. 58-74 would conflict with the statutory requirement that a taxpayer must secure the IRS's consent to change a method of accounting. In addition, filing an amended return, refund claim, or AAR, as applicable, in reliance upon Rev. Rul. 58-74 in such a case would be inconsistent with the IRS's position that a taxpayer may not, without prior consent, retroactively change from an erroneous to a permissible method of accounting by filing amended returns. Lastly, filing an amended return, refund claim, or AAR, as applicable, in reliance upon Rev. Rul. 58-74 in such a case would be inconsistent with the automatic change procedure for a taxpayer changing from treating research or experimental expenditures under any provision of the Code other than Code Sec. 174 to treating such expenditures under former Code Sec. 174 and the regulations thereunder.

Prospective Application

Rev. Rul. 58-74 is obsoleted as of July 31, 2023. The obsoletion of Rev. Rul. 58-74 does not affect the characterization of the costs of obtaining a patent in Reg. Sec. 1.174-2(a)(1). Furthermore, the obsoletion of Rev. Rul. 58-74 does not affect the specific rules for changing a method of accounting under former Code Sec. 174 and the regulations under former Code Sec. 174, including the requirement that such change be implemented on a cut-off basis.

A taxpayer may file a claim for refund, amended return, or AAR, as applicable, in reliance on Rev. Rul. 58-74 if the taxpayer is: (1) claiming a deduction for additional research or experimental expenditures to which the expense method under former Code Sec. 174(a) is applicable for the tax year or years in which they were improperly deferred or capitalized; (2) otherwise using the expense method for such tax year or years; and (3) timely filing the claim for refund, amended return, or AAR not later than July 31, 2023.

The eligibility to file a claim for refund, an amended return, or an AAR in reliance on Rev. Rul. 58-74 does not imply that the IRS will grant such claim for refund, amended return, or AAR. The IRS will continue to challenge the applicability of Rev. Rul. 58-74 to a particular claim for refund, amended return, or AAR when appropriate. For example, the IRS may challenge the applicability of Rev. Rul. 58-74 when the taxpayer's facts in the amended return, refund claim, or AAR are distinguishable from Rev. Rul. 58-74, including where the taxpayer failed to adopt the expense method under former Code Sec. 174(a).

For a discussion of the current deduction method for research and experimental expenditures, see Parker Tax ¶95,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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