IRS Issues Modified Guidance on the Application of Section 174

On December 22, 2023, the IRS released Notice 2024-12. This notice clarifies and modifies previous guidance released in September 2023 via Notice 2023-63. As a brief background, Notice 2023-63 was issued to announce the Treasury Department and IRS’s intention to issue proposed regulations addressing:

1. The capitalization and amortization of specified research or experimental (“SRE”) expenditures under Section 174 of the Internal Revenue Code
2. The treatment of SRE expenditures under Section 460, and
3. The application of Section 482 to cost sharing arrangements involving SRE expenditures.

In addition to this announcement, the notice also served to issue interim guidance provided in several sections of the notice that taxpayers may rely on in their treatment of SRE expenditures in the interim until the formal publication of the aforementioned proposed regulations.

Notice 2024-12 was issued to specifically provide clarification and/or modification of three components of the guidance provided in Notice 2023-63:

1. The treatment of costs paid or incurred by a research provider for research performed under contract,
2. The requirement that a taxpayer who chooses to rely on any of the rules described in Notice 2023-63 must rely on all the rules described in Sections 3-9 of the notice, and
3. The obsoletion of Section 5 of Revenue Procedure 2000-50.

Contract Research Clarified – Excluded Product Right Exception

With regards to costs paid or incurred in research for contract scenarios, the IRS clarifies in Section 3 of Notice 2024-12 that if the contract researcher does not bear financial risk and obtains a so-called “excluded product right,” that the SRE incurred will not be deemed as Section 174 R+E expenditures. For purposes of this clarifying guidance, an excluded product right is defined as a product right that (1) is separately bargained for (that is, an SRE product right that arose from consideration other than the cost paid or incurred by the research provider to perform SRE activities under that contract), or (2) was acquired for the limited purpose of performing SRE activities under that contract or another contract with the research recipient.

As a result of this modifying guidance, it is recommended that taxpayers providing contract research services review their customer contracts and other related legal documents to determine if there is an opportunity to fall under the excluded product right exception, thereby allowing for the immediate expensing of R+E costs as ordinary trade or business expenses.

Waiver of the requirement to follow Notice 2023-63 Section 3-9 rules

Section 4 of Notice 2024-12 states that the previous requirement that a taxpayer rely on all the rules in Sections 3 through 9 of Notice 2023-63 if they choose to rely on any of the rules described in Sections 3 through 9 is waived.  

Clarification on Obsoletion of Rev. Proc. 2000-50

Section 5 of Notice 2024-12 clarifies that Section 5 of Rev. Proc. 2000-50 is obsolete only in relation to amounts paid or incurred in taxable years beginning after December 31, 2021, and therefore continues to apply to amounts paid or incurred in taxable years beginning on or before December 31, 2021.

Smith + Howard is closely monitoring all administrative guidance released to stay abreast of the latest developments surrounding the tax treatment of research and experimental expenses and is available to support with a range of research + development tax credit services.

To learn more, contact Brad Pittman at [email protected]