IRS Releases Taxpayer-Favorable Proposed Regulations Affecting Research Credit

Sept. 12, 2013

On Sept. 6, the IRS issued taxpayer-favorable proposed regulations that clarify and expand the types of expenses that are within the scope of IRC Section 174, which provides many of the definitions of items that are eligible for the research credit under Section 41.

The proposed regulations include the following changes:

  • Any subsequent event or the ultimate success or failure of research and experimentation (R&E) activities (such as a sale of the property or use of the process for which the research is incurred) is irrelevant and cannot reverse the original treatment of the expenses related to these activities.
  • The depreciable property rule is expanded and allows the research credit for otherwise qualifying costs even though the result of the costs is an item of depreciable property.
  • A “pilot model” eligible as an R&E expense is any representation that is produced to evaluate and resolve uncertainty, including a fully functional representation or model.
  • Costs of producing a product after uncertainty has been eliminated are not eligible under Section 174.
  • Differences in the definition of the “shrink-back rule” between Sections 174 and 41 are eliminated.

Many of these changes are the result of the Tax Court’s 2009 decision in TG Missouri Corporation v. Commissioner. In that case, the court allowed the taxpayer to claim the research credit for expenses incurred in the development of prototype molds even though those molds were later sold to customers.

Although these revisions are proposed regulations, the IRS indicated it will not challenge return positions consistent with the proposed regulations and taxpayers may rely on these regulations until the date the final regulations are published. Taxpayers should evaluate the proposed regulations to determine whether the changes might result in opportunities to treat expenses as research expenses and what impact these changes might have on their base period computations under the research credit.

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