What Is Rev Proc 2023-08 for R&E Accounting Changes?

The Internal Revenue Service (IRS) has released administrative procedures to provide guidance for taxpayers. This guidance outlines a simplified process for changing an accounting method to comply with new federal tax law. Specifically, these procedures address mandatory changes for how businesses must account for their research and experimental (R&E) expenditures. The primary function of this guidance is to grant taxpayers automatic consent from the IRS to make this required change, eliminating a more burdensome application process.

Understanding the New R&E Expenditure Rules

The necessity for this procedural guidance stems from changes to Internal Revenue Code (IRC) Section 174, enacted as part of the Tax Cuts and Jobs Act (TCJA). For any tax year beginning after December 31, 2021, businesses lost the ability to immediately deduct all of their R&E costs in the year they were incurred. This practice was replaced with a requirement to capitalize these costs and amortize them over several years.

The new rules mandate a specific amortization schedule. For research activities conducted within the United States, the associated costs must be deducted over a five-year period. If the research activities are performed in a foreign country, the amortization period is 15 years. This change impacts a company’s taxable income by deferring large deductions, potentially increasing tax liability in the short term.

The law also specifies that amortization must begin at the mid-point of the taxable year in which the expenditure is paid or incurred. This means that for the first year, a taxpayer can only deduct half of the annual amortization amount. These amortization rules require that costs continue to be amortized over the prescribed period even if the underlying research project is abandoned or the associated property is disposed of.

Under the revised Section 174, the definition of “specified research or experimental expenditures” is broad. It includes not only direct costs like wages for researchers and supplies in a lab, but also indirect costs associated with the research activities. An expansion under the TCJA is the explicit inclusion of all software development costs within this category.

Scope and Applicability of IRS Guidance

The IRS has issued specific procedural guidance for taxpayers who need to change their method of accounting to align with the updated rules. This guidance initially focused on the first taxable year the new law was effective but has since been updated to provide a similar automatic process for changes made in subsequent years. The guidance provides a simplified pathway to adopt the new capitalization and amortization method.

By following the steps outlined in the IRS procedures, a taxpayer is granted automatic consent for the accounting method change. Normally, a taxpayer must file Form 3115 and pay a user fee to request advance consent from the IRS National Office to change an accounting method. This procedural guidance waives that requirement for this specific change.

The procedures are intended for taxpayers to transition from a former method, such as immediately expensing all R&E costs, to the new mandatory amortization regime. The guidance is narrowly focused on this transition and does not apply to accounting method changes for R&E expenditures made in tax years beginning before January 1, 2022.

Required Documentation for the Accounting Method Change

For the first year of the change, the IRS provided simplified options, which in some cases allowed for a statement to be filed in place of the full Form 3115, Application for Change in Accounting Method. For changes in later years, a complete Form 3115 is generally required.

The taxpayer must identify their present method of accounting (e.g., deducting R&E costs as incurred) and the proposed method (e.g., capitalizing and amortizing costs over five or 15 years). The filing must include the taxpayer’s name and identification number, the tax year of the change, and a description of the types of expenditures being capitalized.

A declaration is also required, stating that the change is to capitalize specified R&E expenditures and amortize them over the appropriate 5-year or 15-year period, beginning at the midpoint of the tax year. For changes made in the first effective tax year, the change is made on a “cut-off” basis. This means there is no adjustment used to prevent the duplication or omission of income or deductions when changing accounting methods. The new method simply applies to all specified R&E costs paid or incurred in tax years beginning after December 31, 2021.

If a taxpayer did not make the change in the first required year and is filing in a subsequent year, a full Form 3115 is required. The change is then made with a modified adjustment that takes into account only the R&E expenditures that were paid or incurred after the effective date of the new law, ensuring that any costs improperly deducted in a prior year are brought back into alignment.

The Filing Process

The original statement or form must be attached to the taxpayer’s timely filed federal income tax return for the year of the accounting method change. This step incorporates the change into the official tax filing for the year.

A simplification provided by the IRS guidance is the waiver of the duplicate filing requirement. Under standard procedures, a taxpayer often must file a second copy of Form 3115 with the IRS National Office. The automatic consent procedures for this R&E change have eliminated this step.

Upon correctly filing the documentation with the tax return, the change is considered approved by the IRS automatically. The procedure also grants a form of audit protection. This means that if the taxpayer properly implements the change, the IRS will not challenge the taxpayer’s treatment of R&E expenditures for years prior to the new law’s effective date. This audit protection is limited and does not extend to other, unrelated accounting issues.