With enhanced definitions and numerous additional examples, final regulations issued in July (T.D. 9680) clarify research and experimentation (R&E) expenditures under Sec. 174 that may be deducted currently or capitalized and amortized.
Under the final regulations, the ultimate success, failure, sale, or use of a product is not relevant to a determination of eligibility under Sec. 174 (Regs. Sec. 1.174-2(a)(1)). Even if production has begun, as long as uncertainty concerning the development or improvement of the product has not been eliminated, costs can still be R&E expenditures.
The final regulations refine the definition of a pilot model as any representation or model of a product produced to evaluate and resolve its uncertainty about the product during the product’s development or improvement. The pilot model may be a fully functional representation or model of the product or component of the product (Regs. Sec. 1.174-2(a)(4)).
The final regulations add a new subsection addressing components of a product, explaining that uncertainty concerning the development or improvement of one or more of its components does not necessarily indicate uncertainty as to other components or the product as a whole (Regs. Sec. 1.174-2(a)(5)). Therefore, even if uncertainty of an overall product’s general design has been resolved, a taxpayer can consider uncertainty surrounding one or more of its components to determine whether those components' costs qualify as R&E expenditures.
To illustrate these changes, the final regulations add 11 examples illustrating the definition of R&E expenditures and the treatment of pilot models, components, and revisions to existing products and processes. Notable points include:
- Material and labor costs incurred to build a pilot model, as well as costs incurred to use the pilot model for R&E purposes, qualify as R&E expenditures.
- A pilot model can be constructed for a component of a product.
- Any number of pilot models may be constructed.
- If a pilot model is later sold or put to an unrelated use, this does not preclude treating the initial cost of constructing the model as an R&E expenditure.
- Costs of creating a variation to an existing product can be R&E expenditures if available information regarding the existing product does not resolve the uncertainty related to creating the variation.
- Costs of testing a new process may qualify as R&E expenditures.
- When a subcontractor performs both R&E and production activities, the costs incurred by the taxpayer for the R&E portion of the work can qualify as R&E expenditures under Sec. 174. The costs related to production cannot.
- If an asset is created for which no R&E expenditures were incurred but is then used for R&E relating to a different product, then the depreciation expense arising from that asset is a deductible R&E expenditure.
For more, see “Revisions Clarify R&E Expenditures Regs. for Taxpayers,” by Sarah Lovinger, CPA, in the November 2014 issue of The Tax Adviser.
Alistair M. Nevius, editor-in-chief,
The Tax Adviser
Also look for articles on the following topics in the November 2014 issue of The Tax Adviser:
- How qualified longevity annuity contracts fit into clients’ financial plans.
- What trust and estate fiduciaries need to know about the net investment income tax.
- The most important factors the IRS now considers for granting innocent spouse equitable relief.