What Is IRS Notice 2023-63? Rules for Section 174 Costs

The Tax Cuts and Jobs Act (TCJA) of 2017 changed the tax treatment of research and experimental costs. While businesses could previously deduct these expenses immediately, the TCJA mandated that for taxable years beginning after December 31, 2021, these costs must be capitalized and amortized. In response, the Internal Revenue Service (IRS) issued Notice 2023-63 as interim guidance, which was later modified by Notice 2024-12 and Revenue Procedure 2024-9.

Adding to the complexity, proposed legislation known as the Tax Relief for American Families and Workers Act of 2024 could, if enacted, postpone the capitalization and amortization requirement for domestic research costs until taxable years beginning after December 31, 2025.

Defining Specified Research or Experimental Expenditures

Specified research or experimental (SRE) expenditures include direct research activities and the costs incident to their development. This includes labor for employees and contractors who perform, supervise, or directly support research, as well as materials and supplies used in the process. Overhead costs, such as rent, utilities, and depreciation for facilities and equipment used in research, are also considered SRE expenditures.

Under Section 174, costs associated with the development of any software are treated as SRE expenditures. This includes planning, designing, coding, testing, and installing the software. The rule applies whether the software is developed for internal use, for sale, or for lease to others, resolving previous ambiguities about the treatment of these costs.

The guidance also carves out specific costs that are not considered SRE expenditures. These excluded costs include:

• General and administrative service department costs that only indirectly support research, such as payroll, human resources, and accounting.
• Interest paid on debt used to finance research activities.
• Costs related to securing a patent, such as attorneys’ fees incurred during the application process.
• Efficiency surveys, management studies, and consumer surveys.
• Costs for advertising and promotions.
• The acquisition of another’s patent, model, production, or process.

Research conducted outside the United States is subject to different treatment. For research performed outside the U.S., the amortization period is 15 years, compared to the 5-year period for domestic research.

Clarifications for Special Circumstances

Short Taxable Years

For businesses with a taxable year shorter than 12 months, the amortization deduction for SRE expenditures must be calculated on a pro-rata basis. A taxpayer determines the deduction by taking the amount that would have been allowed for a full 12-month year and multiplying it by a fraction. The numerator of this fraction is the number of months in the short taxable year, and the denominator is 12.

Disposition or Cessation of Property

If a research project is abandoned or the resulting property is disposed of, any unamortized SRE expenditures cannot be written off. Contrary to previous practices, taxpayers must continue to amortize the remaining unrecovered SRE expenditures over the rest of the original 5-year or 15-year statutory period. This rule applies regardless of whether the associated property is sold, exchanged, or abandoned.

Interaction with Long-Term Contracts

The guidance provides specific rules for how SRE expenditures interact with long-term contracts. Taxpayers are required to allocate SRE expenditures to their long-term contracts, and these allocated costs are then capitalized. Instead of being amortized under the standard Section 174 rules, these costs are recovered through the taxpayer’s long-term contract accounting method, such as the percentage-of-completion method.

Compliance and Procedural Guidance

The IRS has established procedures for taxpayers to gain automatic consent to change their accounting methods to comply with the new SRE rules. Revenue Procedure 2024-9 provides the procedures for obtaining this consent, allowing taxpayers to adopt the new capitalization and amortization method without needing to file a formal request for a private letter ruling.

The guidance is considered interim, which means taxpayers can rely on it until the Treasury Department and the IRS issue more formal proposed regulations. While earlier guidance suggested taxpayers had to apply all its rules consistently, Notice 2024-12 removed this requirement. This provides taxpayers with more flexibility, allowing them to adopt individual provisions from the notices.

This guidance applies to SRE expenditures paid or incurred in taxable years beginning after December 31, 2021. The notice does not apply to expenditures from taxable years before this date, which remain subject to the former Section 174 rules.