Expenses & Deductions.

• Author: Anderson, Kevin

M&A pitfalls for deferred research expenditures

Before the enactment of the 2017 law known as the Tax Cuts and Jobs Act (TCJA), PL. 115-97, taxpayers could deduct expenditures related to research or experimental (R&E) activities immediately. Although a taxpayer could choose to amortize the expenditures under Sec. 174(b) or 59(e), that was not the default rule.

Effective for amounts paid or incurred in tax years beginning after Dec. 31, 2021, the TCJA replaced the text of Sec. 174 and, among other changes, requires taxpayers to amortize R&E expenditures over five or 15 years (depending on whether the expenditures relate to foreign research activities). Although the change may appear to be purely a timing difference, taxpayers that engage in common merger-and-acquisition (M&A) transactions may find that the deductions are passed to the buyer or lost altogether. Taxpayers with significant deferred R&E expenditures should take care to avoid losing these deductions if possible.

As of this writing, Treasury and the IRS have issued minimal guidance on current Sec. 174, and future guidance may provide more clarity or different results than what is detailed in this item.

Former Sec. 174

Prior to the TCJA, former Sec. 174(a) allowed the immediate deduction of R&E expenditures paid or incurred during a tax year. Taxpayers had the option of amortizing R&E expenditures for 60 months or more. To qualify for this elective deferral treatment, the expenditures had to meet several criteria, including that they be "chargeable to capital account but not chargeable to property of a character which is subject to the allowance under section 167...or section 611" (former Sec. 174(b)(1)(C)).

To the extent R&E expenditures were deferred in this manner, the deferral increased the taxpayer's basis in the related property, and to the extent they were subsequently deducted, the basis in property was correspondingly reduced (Sec. 1016(a)(14)). If a taxpayer deferred R&E deductions under former Sec. 174(b) and subsequently abandoned the related project, it could potentially claim a loss under Sec. 165.

Taxpayers also had a second option to amortize R&E expenditures that would otherwise be deductible over a 10-year period (Sec. 59(e)). A similar adjustment to the taxpayer's basis in its property was made for R&E expenditures deferred and subsequently deducted under Sec. 59(e). Although the TCJA did not modify Sec. 59(e), the effects of the interaction between the requirements of Sec. 59(e) and current Sec. 174 are not entirely clear, and the election under Sec. 59(e) may not be available for some or all R&E expenditures paid or incurred in tax years beginning after Dec. 31, 2021.

Post-TCJA Sec. 174

The current text of Sec. 174(a)(2) now requires taxpayers to "charge [R&E] expenditures to capital account" and...