Definitions of R&E expenditures are amended under final rules

The IRS issued final regulations on which amounts paid or incurred in connection with the development of tangible property, including pilot models, qualify for the Sec. 174 deduction (or amortization) for research and experimental expenditures (T.D. 9680). The regulations finalize proposed rules issued last September (REG-124148-05), with a few changes in response to comments.

The regulations settle the question of whether the sale of a product resulting from otherwise qualifying research or experimental expenditures disqualifies those expenditures from Sec. 174 treatment. If expenditures qualify as research or experimental expenditures, it no longer matters, for purposes of the deduction, whether the resulting product is ultimately sold or used in the taxpayer’s trade or business.

Pilot models

The regulations define “pilot model” as any representation or model or a product that is produced to evaluate and resolve uncertainty during the development or improvement of the product. However, a commentator suggested that, under Example 5 of Prop. Regs. Sec. 1.174-2(a)(11), the deductibility of Sec. 174 expenses for multiple pilot models would be permitted only if each pilot model is tested for a purpose that is different from any other pilot model. Therefore, the final regulations modify Example 5 to clarify that it is not necessary for each pilot model to be tested for a discrete purpose for the costs of multiple pilot models to qualify as research and experimental expenditures under Sec.174.
 
Shrinking-back rule renamed

Some commentators suggested that the proposed regulations’ “shrinking back” rule should be eliminated because it was not necessary for purposes of Sec. 174 and might cause confusion with the shrinking back rules in Sec. 41. The proposed shrinking back rule addressed situations in which a component part of a larger product meets the requirements of Regs. Sec. 1.174-2(a)(1) (defining “research or experimental expenditures”), but the overall product itself does not.

The IRS retained the shrinking-back rule in the final regulations but, in response to the comments, changed the heading of Regs. Sec. 1.174-2(a)(5) from “Shrinking-back rule” to “Application of section 174 to components of a product,” to distinguish it from the Sec. 41 shrinking back rules. This rule preserves Sec. 174 eligibility for component parts where the overall product does not meet the Sec 174’s requirements.

Effective date

The rules are effective for tax years ending on or after July 21, 2014, but taxpayers can apply the rules to tax years for which the statute of limitation has not expired.

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.