Since it was first enacted in 1954, IRC Section 174 has allowed for a deduction and potential cash savings for research and experimental (R&E) expenditures for a wide range of industries, including construction contractors. Historically, companies have been able to deduct these R&E expenses fully in the year in which they were incurred allowing immediate taxable income offsets. In 2017, the Tax Cuts and Jobs Act (TCJA) radically changed IRC Section 174 from allowable eligible expenses to be deducted in the year incurred to requiring such expenses to be capitalized.
As a construction finance leader, if you’re struggling to navigate the complexity and uncertainty that surrounds IRC Section 174 and IRC Section 460, we’ve got you covered.
Section 174 Expenses and Activities
Generally, IRC Section 174 requires companies to capitalize R&E expenditures beginning with calendar year 2022 tax returns and amortize those expenditures over five years for domestic research and 15 years for foreign research.
What are R&E Expenditures?
- Generally incurred in connection with a taxpayer’s trade or business that represent research and development costs in the experimental sense, including activities intended to eliminate uncertainty concerning the development or improvement of a product.
- Generally include all costs incident to the development or improvement of a product. Product can include any tangible product, process, formula, invention, design, pilot model, software, technique, patent or similar property used in a taxpayer’s business or held for sale, lease or license.
- Should not be confused with expenditures for research and development (R&D). The definition of R&E expenditures under IRC Section 174 is broader than the definition of “qualified research expenditures” under IRC Section 41 Credit for Increasing Research Activities (R&D Credit). The biggest example of differences is incidental and overhead costs are considered R&E under IRC 174, but not R&D for the IRC 41 Credit. Expenses such as fringe benefits, depreciation, utilities, rent, and other overhead costs are R&E, but not R&D. A key point about the changes to IRC Section 174 is that even if a taxpayer is not eligible to take the R&D Credit under IRC Section 41, the requirement to capitalize IRC Section 174 costs still applies.
Expanding Design and Innovation Capabilities
If your company is among a growing number of construction contractors who are investing in engineering, designing, and architecture to maximize in-house design-build capabilities, IRC Section 174 may unlock opportunities for you to enjoy tax savings while innovating.
Technology has enabled construction contractors to continue to redefine their impact on design and delivery of new solutions and value for their clients. Some of the activities that may apply to IRC Section 174 include the following:
- Design and development of engineering systems and evaluating alternatives
- Feasibility and constructability analyses
- 3D modeling and computer-aided design
- Determining project requirements and design considerations
- Bid and proposal time for evaluating technical options
- Evaluation of technical alternatives
- Concept and value engineering
- Designing LEED/green initiatives
The capitalization of these costs has meant significant upfront costs to organizations engaging in research activities. In addition, the expense and documentation tracking adds another complicated and fragmented project that is often limited by communication silos between accounting and other groups in the construction company.
Yet another compounding issue is that the details of these expenses and analyses are often needed with a quick turnaround time to comply with internal and external filing obligations. One way to counteract these issues is by systemizing documentation, collection, and storage of any R&E expense-related information.
Applying Section 174 to Long-Term Contracts
In general, when a contract meets the definition of a long-term contract it is required to apply PCM under IRC Section 460. Under this method, revenue and expense on a long-term contract is recognized by a completion factor. The completion factor is the ratio of allocable contract costs incurred to date (numerator) and the estimated total allocable contract costs to be incurred on the contract (denominator).
Before the effective date of IRC Section 174 as amended by the TCJA, R&E expenditures were required to be included in both the numerator and the denominator of the completion factor to the extent they were allocable contract costs. Under Rev. Proc. 2024‐23, a taxpayer can change its method of accounting under IRC Section 460 so that the costs allocable to a long‐term contract accounted for using PCM include amortization deductions of R&E expenditures in the numerator, rather than the capitalized amount of such expenditures.
A taxpayer may determine estimated total allocable contract costs (the denominator) in one of the two ways:
- Include all R&E amortization that directly benefits or is incurred by reason of the performance of the long‐term contract.
- Include only the portion of such amortization expected to be incurred and deducted during the term of the contract.
These options have important trade-offs. The first option will generally maximize the revenue deferral but can cause an administrative burden of repetitive look-back interest computations. The latter option should be administratively simpler but at the cost of a more moderate revenue deferral. Even under the first option, all remaining unrecognized contract price must be included in gross income for the tax year following contract completion. Contractors should consider these alternatives carefully and work with their tax advisor.
Keep a R&D Credit Study in Mind
The R&D Credit was enacted to incentivize U.S. companies to continue to tackle complex and challenging projects and innovative designs. Frequently, R&E and R&D expenditures overlap. As a result, construction companies may qualify for significant cash savings by leveraging the R&D Credit if they are caught in the web of IRC Section 174.
Eligible companies interested in taking advantage of the R&D Tax Credit can claim a powerful dollar-for-dollar tax reduction but require significant documentation. For construction contractors, often eligible R&D expenses focus on eligible labor costs but can include outside subcontractors in certain cases.
Plan for Uncertainty
While attempts to delay or repeal Section 174 have not yet been successful, these efforts continue to benefit from strong bipartisan support. However, because of the cost to the government of implementing a more business-friendly R&D expense rule, it is questionable whether it would pass.
Due to the uncertainty in whether Section 174 is further modified and to what extent, it may be prudent to apply for a change in accounting method to realize short-term tax benefits. Please speak to your tax advisor on this issue.
Construction companies should also consider implementing digital transformations with a capture now and decide later mindset. A digital transformation will improve documentation and recordkeeping and prepare companies for any potential legislative changes. Finally, with data in hand, companies should consider the applicability of an R&D Credit study to offset the negative impacts of Section 174.
RKL’s Tax Services Group specializes in helping companies take advantage of these credits and developing the processes to continue doing so in the future. We identify expenditures that qualify for the tax credit under both federal and state regulations. Beyond helping you capture tax savings, we provide ongoing value by helping to develop internal procedures to properly track these expenses moving forward. To learn more, visit our R&D Tax Credits page or contact me at the email below.
