IRS Section 174 and SBIR/STTR Awards
With the September and October 15 tax (extension) deadlines looming, now is a critical time for SBIR/STTR awardees to determine if their contracts are subject to IRS sections 41 and 174 (if they have not already), and if so, how they can minimize the impact of amortization, while maximizing the R&D tax credit. The following post on this important topic is the second from one of our newest partners in 2024, Hull & Knarr LLP, written by Business Development Manager, John Berry.
While ReliAscent does not offer tax advice and does not officially endorse any approach or company, we do want to keep government contractors up to date on this important topic, and make you aware of the options you may have to minimize 174's impact, and the opinions of Tax Professionals and IRS Sec 41 and 174 consultants. We will also be posting a blog written by Sycamore Growth Group, another R&D Credit and 174 Consultant, shortly.
Earlier in the year, companies across the country expressed optimism that Section 174 amortization requirements that went into effect for Tax Year 2022 would go away. The House of Representatives passed a bill in January 2024, the American Innovation and Jobs Act (H.R. 2267), which would retroactively repeal the Section 174 requirements for R&D expenses, and the thought was the Senate would soon follow suit. Fast forward seven months and taxpayers are now in limbo as the bill still lies in the Senate with no resolution in sight. Taxpayers that filed extensions in hopes of change are now in a position where it looks like they must file without changes being made to Section 174.
With businesses at a crossroads, it’s important for businesses to understand whether the R&D they perform meets the criteria for qualified research under Section 41 (R&D Credit) or not. Qualified research expenditures under Section 41 should be included in Section 174 whether a business decides to pursue Section 41 Credits or not. Section 41 is an election – Section 174 is a requirement. With that said, we have encountered many businesses that were afraid they were going to have to shut their doors because they couldn’t afford to pay the tax that resulted from the Section 174 amortization requirements. After several consultations, these businesses came away with a sigh of relief because their research fell under “funded research." “Funded research” is an exclusion in Section 41 and as such, if a company can’t receive a R&D Credit for the research they perform, it should not be expected to claim it as a R&D expense under Section 174. The question becomes, what is “funded research” and what is “non-funded research?” In an effort to help businesses understand where they fall, we will break it down below.
Contract Types and what they mean for Section 174
For companies to be able to determine whether the R&D performed under a government or commercial contract can qualify as their R&D for the R&D Credit, the activities must pass the 4-Part Test, the contract must put the company at financial risk, and the company must have substantial rights into the Intellectual Property.
To simplify this, defense contractors with SBIR/STTRs that are structured as Firm Fixed Price (FFP) contracts have a high likelihood of their contracts qualifying as their R&D because as long as the activity passes the four-part test, FFP contracts are milestone-based where the company has to submit a deliverable (report, prototype, etc.) in order to be paid. That constitutes financial risk. Additionally, while the government has rights to use the technology developed by the company, the company also has rights to reuse the technology in a different application should it choose to. That is an example that would constitute substantial rights.
As such, FFP contracts that are structured in a similar fashion to what is outlined above can qualify as R&D, but those expenses also need to be accounted for in Section 174. To be clear, just because you are under the assumption that your contract is an FFP contract, it’s important that the clauses in your contract are analyzed to make that determination. For example, some contracts are FFP Level of Effort (LOE) contracts and while they may be labeled as a FFP, the LOE component makes it highly unlikely to qualify for Section 41 due to not meeting the Financial Risk criteria set forth by the IRS.
Time & Materials (T&M) contracts, and a large majority of Cost Plus Fixed Fee (CPFF) contracts, are much more straight forward. Predominately, these contracts are structured in a way where a company gets paid for the hours they perform regardless of whether the research is successful. Contracts structured this way do not put the companies performing the work at Financial Risk in the eyes of the IRS, and therefore the companies under these contracts cannot include this work in Section 41. If they can’t include it in Section 41, they are not subject to include it in Section 174.
Note that there typically is one portion of a CPFF contract, the final report, which is contingent upon success and therefore expenses tied to that part of the project actually are likely to be qualified research and included in Section 41 and Section 174. However, this is usually a small percentage of the overall expenses.
In Conclusion
Due to unclear regulations, there has been a lot of misinformation about what falls under Section 174 amortization requirements and what doesn’t. Companies with a lot of T&M and CPFF contracts still may have some Section 174 expenses, but it’s nowhere near what a lot of those companies are told. Companies with FFP contracts on the other hand are going to have more includable 174 expenses while also having more R&D Credit (which can help offset the effects of amortization).
How Hull & Knarr can help?
If you have questions about your contracts and want confirmation on whether they should or should not be included in Section 174 amortization, you can schedule a free consultation here. We can talk about your contracts and at the end of that meeting, you can decide if further assistance is needed or not.