Proposed regs. clarify research expenditure eligibility under sec. 174.

• Author: Hudson, David S.

The IRS in September issued proposec regulations (REG-124148-0.5) clarifying the application of Sec. 174 to the costs to create "pilot models" or prototypes. The proposed rules state that the reason a taxpayer creates a prototype or other product, and not its subsequent sale or use, determines whether it qualifies under Sec. 174. In addition, the IRS provides a definition of a pilot model and proposes to apply an approach consistent with the Sec. 41 research credit "shrinking back" rule to prototype costs.

Background

Under Sec. 174(a), taxpayers may treat research or experimental expenditures paid or incurred in a tax year in connection with a trade or business as expenses that are not chargeable to a capital account. They may deduct such expenditures in the year paid or incurred. Regs. Sec. 1.174-2(a)(1) defines "research or experimental expenditures" as "expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product."

Sec. 174(c) and Regs. Sec. 1.174-2(b) (1) specify that Sec. 174 does not apply to any expenditure for the acquisition or improvement of land, or for the acquisition or improvement of property to be used in connection with the research or experimentation that is of a character that is subject to the allowance for depreciation. Regs. Secs. 1.174-2(b)(2) and (4) expand upon this limitation when research or experimental expenditures occur on a project that results, as an end product of the overall effort, in depreciable property to be used in the taxpayer's trade or business. Under this provision, the costs to design the end product may be treated as Sec. 174 costs and deducted in the year incurred, but the cost of the component materials of the asset constructed are not deductible and must be charged to an asset account.

The IRS has argued in the past that Sec. 174(c) precludes Sec. 174 treatment in the case of a subsequent sale of a resulting product to a customer because the sale gives rise to depreciable property in the hands of the customer. However, in T. G. Missouri, 133 T.C. 278 (2009), the Tax Court rejected this argument.

Proposed Regs.

In particular, adopting the Tax Court's holding in T.G. Missouri, the proposed regulations provide that a deduction under Sec. 174(a) is not inconsistent with a taxpayer's subsequent sale or...