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Regs Confirm Subsequent Events Are Not Relevant to Deductibility of Research and Experimental Expenses. (Parker Tax Publishing August 12, 2014)

Final regulations on the deductibility of research and experimental expenses confirm that the ultimate success, failure, sale, or other use of the research or property resulting from the research or experimentation is not relevant in determining the deductibility of such expenses. T.D. 9680 (7/21/14).

In 1957, the IRS issued regulations under Code Sec. 174. Reg. Sec. 1.174-2(b)(1) provided that under Code Sec. 174, expenditures for the acquisition or improvement of property subject to an allowance for depreciation or depletion were not deductible under Code Sec. 174 in the year of the acquisition or improvement. However, the regulations treated depreciation deductions as Code Sec. 174 expenditures to the extent that the property to which the allowances related was used in connection with research and experimentation. The 1957 regulations further provided, in Reg. Sec. 1.174-2(b)(4), that expenditures resulting in depreciable property to be used in the taxpayer's trade or business were still deductible to the extent of amounts expended for research or experimentation. The rules in Reg. Sec. 1.174-2(b)(1) and Reg. Sec. 1.174-2(b)(4) are referred to as the "Depreciable Property Rule." Until a proposed change in 2013, the Depreciable Property Rule remained unchanged from the rule's adoption in the 1957 regulations.

In 2013, the IRS issued proposed regulations reflecting the following revisions to the research and experimental expense regulations. First, the proposed regulations amended Sec. 1.174-2(b)(4) to provide that the "Depreciable Property Rule" was an application of the general definition of research or experimental expenditures and should not be applied to exclude otherwise eligible expenditures from being deducted. Second, to counter an interpretation that Code Sec. 174 eligibility could be reversed by a subsequent event, the proposed regulations provided that the ultimate success, failure, sale, or other use of the research or property resulting from research or experimentation was not relevant to determining eligibility. Third, the proposed regulations defined the term "pilot model" as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term included a fully-functional representation or model of the product or a component of a product. Fourth, the proposed regulations clarified the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible under Code Sec. 174 because these costs are not for research or experimentation. Finally, the proposed regulations provided a shrinking-back rule, similar to the rule provided in Reg. Sec. 1.41-4(b)(2), to address situations in which the requirements of Reg. Sec. 1.174-2(a)(1) are met with respect to only a component part of a larger product and not with respect to the overall product itself.

On July 21, the IRS finalized these regulations with very few changes. With respect to pilot models, the final regulations modify Example 5 to clarify that it is not necessary for each pilot model to be tested for a discrete purpose for the costs of multiple pilot models to qualify as research and experimental expenditures. Another change dealt with the shrinking-back rule,because some practitioners requested that this rule be eliminated as it was peculiar to Code Sec. 41 and served no purpose in Code Sec. 174. In response, the IRS clarified that the shrinking-back rule is intended to ensure that Code Sec. 174 eligibility is preserved in instances in which a basic design specification of the product may be established, but there is uncertainty with respect to certain components of the product, even if uncertainty arises after production of the product has begun. While the substance of the shrinking-back rule was retained in the final regulations, in response to practitioner concerns and to avoid any unintended confusion with the shrinking-back rule of Reg. Sec. 1.41-4(b)(2), the term "shrinking-back rule" was deleted from Reg. Sec. 1.174-2(a)(5).

The final regulations apply to tax years ending on or after July 21, 2014. However, taxpayers have the option of applying the final regulations to tax years for which the statute of limitations has not expired.

For a discussion of the rules for deducting research and experimental expenditures, see Parker Tax ¶95,500. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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