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IRS Issues Guidance On Deductible R & E Costs

by Mike Godfrey, Tax-News.com, New York

27 November 2001


In the latest issue of ecommercetax.com, Professor David Hardesty explores the subject of the tax treatment of research costs, based on guidance recently issued by the IRS to its field agents.

Although the guidance applies to activities related to the design of footwear, the concepts involved apply equally to all companies engaged in research, including companies developing new applications for the Internet. From what it has written, says the Professor, it seems clear the IRS is struggling with the definition of research costs. Guidance to its agents in some areas is vague, which does not bode well for companies that deal with these agents.

Costs that qualify as research and experimentation (R&E) under Section 174 are currently deductible, even by a company that is not actively engaged in business. This allows startup companies to deduct losses. Without Section 174, these costs would likely be capitalized or deferred.

According to the regulations, R&E costs under Section 174 are costs incurred in connection with the taxpayer's trade or business which are R&E costs in the experimental or laboratory sense. These include costs related to activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.

Uncertainty exists, says Professor Hardesty, if the information available to the taxpayer does not establish the capability or method for developing or improving the product, or the appropriate design of the product. Qualification depends on the nature of the activity, not the nature of the product or improvement, nor on the level of technological advancement the product or improvement represents.

The article goes on to examine this wording in more detail, and the recently-issued guidance, in which the IRS discusses the applicability of Section 174 to various costs involved in designing new footwear. It addresses design costs related to both nonfunctional elements of the footwear (color, logo placement, etc.), and functionality. Research into functionality, in this FSA, includes research into tread design, hook lace, and water resistance. The IRS concludes that costs related to both functional and nonfunctional aspects of the footwear can qualify under Section 174.

The manner in which the IRS addresses research related to functionality is not controversial, says Professor Hardesty. However, the way it addresses nonfunctional design costs is both puzzling and inconclusive. According to the IRS the term "uncertainty" must be limited to technological or scientific uncertainty in that a taxpayer must be uncertain as to whether it will be able to develop or improve its product in the scientific or laboratory sense. Put differently, the taxpayer must be uncertain as to whether it will be able to achieve its product development objective through its research activities. Conversely, uncertainty attributable to business or market concerns is not determinative of the existence of research and experimentation for purposes of section 174.

This definition is troubling, says the Professor, since it does not appear to exactly follow the regulations. Notice the phrase, “improve its product in the scientific or laboratory sense.” This seems to be a departure from the regulations, which define Section 174 expenditures as “costs in the experimental or laboratory sense.” By replacing the word “experimental” with the word “scientific” the FSA seems to distort the intent of the Section 174 regulations.

Despite the apparently restrictive definition, the IRS still concludes that it is possible for costs related to design of nonfunctional elements of a product to qualify as Section 174 costs. However, the IRS gives no guidance on how to reconcile this conclusion with its own definition of uncertainty. This leaves vague the issue of how costs of research into nonfunctional elements of a product can qualify under Section 174.

The guidance concludes that costs will not be disallowed under Section 174, merely because they relate to research into nonfunctional elements of a product. However, these costs will be disallowed if they are not R&E costs in the experimental or laboratory sense, and are not attributable to activities intended to eliminate uncertainty concerning the development of the product.

The problem with the IRS’s conclusion, says Professor Hardesty, is it does not leave us with concrete guidelines to judge when nonfunctional design costs will qualify under Section 174. It provides no examples, rules of thumb, or anything that would be helpful in this regard. Moreover, the IRS definition of uncertainty quoted above seems to eliminate what we would consider most design activities related to style, color, etc. What is needed is a way to look at design costs for nonfunctional elements of a product.

The way in which the FSA was written, concludes the article, illustrates the difficulty of the Section 174 rules. Taxpayers should be wary of IRS agents who are not necessarily well advised, and who may argue for overly aggressive restrictions on costs that qualify under Section 174. Taxpayers can protect themselves with thorough knowledge of the Section 174 rules, and records that document the uncertainties involved in their development projects.

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