Abstract: Section 174 Background

As a government credits and incentives practice with more than a decade of experience claiming federal R&D credits, Sycamore Growth Group LLC, in response to Notice 2023-63, has thoroughly researched the historical intent and application of Section 174.

The 1954 Congress established Section 174 of the Internal Revenue Code to promote new industries and national defense through innovation. It enabled startups to record R&D expenses on their tax returns without disrupting established businesses’ research activities or accounting practices.

Congressional records confirm that established businesses could already obtain deductions. Businesses performing contract research and industries such as engineering and custom tooling always had the flexibility to include research and experimentation in the cost of goods sold (Section 471) or as ordinary and necessary business expenses (Section 162).

When defining qualified research under Section 41, Congress intentionally used the word may when referencing Section 174, emphasizing that eligible R&D expenses weren’t required to be recorded as Section 174 costs. Any taxpayer could claim the credit, even when the research and experimentation expenses were recorded under Sections 471 or 162.

The removal of immediate deduction under Section 174 in the Tax Cuts and Jobs Act (TCJA) of 2017 didn’t signal a fundamental shift in congressional intent. There’s no evidence that Congress sought to deter new industry creation, weaken national defense, or undermine businesses such as engineering firms, custom manufacturers, and contract researchers. The preservation of the “may” clause in Section 41 in the TCJA affirmed the 2017 Congress’ intent for Section 174 to remain elective for taxpayers conducting research and experimentation in the course of carrying on their business.

The TCJA change primarily affects startups that haven’t yet commercialized their research and large research departments conducting activities unrelated to carrying on their business. Further, many multinational enterprises benefit from extended amortization.

These facts suggest that removing immediate deduction under Section 174 doesn’t significantly deviate from Congress’ original purpose for the law. Notice 2023-63, however, strays so far from the purpose and historical application of Section 174 that it disincentivizes research and experimentation.

The historical recharacterization of Section 174 by the IRS is evident in Snow v. Commissioner, where the commissioner’s restrictive interpretation was unanimously rejected by the Supreme Court in 1974. During oral arguments, the commissioner said he didn't know the motivation behind the enactment of Section 174, revealing that the commissioner went to court unaware of Congress’ purpose for writing the law. 

The Notice also rewrites Section 41 by nullifying the effect of “may” and challenging various tax code sections such as 195, 263(a), 263A, and 471 without substantiation. As a result, many taxpayers intend to abandon the credit due to its nonrefundable nature, combined with the negative effect of amortization. For most of those taxpayers, this is the only way to avoid bankruptcy.

The departure by the IRS from congressional intent, particularly in light of West Virginia v. EPA, is concerning. An agency should not reinterpret a statute for a purpose it wasn’t intended. Unfortunately, the Notice has taken this approach with Section 174.

Pursuing revenue through Notice 2023-63 has far-reaching economic consequences. It stifles innovation and harms businesses, including critical defense and infrastructure contractors. Our practice is aware of multiple Department of Defense contractors prepared to back out of government contracts if this change is finalized.

In summary, the Notice 2023-63 misinterprets the purpose and application of Section 174. To rectify this, the Notice must be withdrawn entirely and guidance must be provided that aligns with the law’s intended function, that a research and experimentation expense remains eligible for the ordinary and necessary business expense treatment.

Sycamore has attached a research paper covering Snow v. Commissioner and similar cases that challenge the restrictive interpretation of Section 174, along with suggestions for guidance informed by congressional intent.

Our legal analysis concludes the proposed regulations applying to 2023 returns do not conform to the law.