Federal Income Taxation of Intellectual Property Development and Cost Recovery | Gray Reed
Intellectual property (“IP”) development can cost millions of dollars so cost recovery timing can be financially material. General tax principles typically require that expenses associated with creating assets having useful lives lasting longer than the current tax year are capitalized. However, IP as an asset class has several statutory cost recovery possibilities (§§ 162, 167, 174, 197, etc.)[1] Like many areas of federal income tax, the rules are full of exceptions and exceptions to exceptions. Naturally federal courts have also supplied a host of tests and factors that can impact the federal income tax cost of IP development. This post is therefore not exhaustive and covers only select topics. As such, specialized areas, like film and television production expenses under § 181 are beyond the scope of this discussion.
The General Deduction Rule: § 162
To use § 162, an IP development cost must be (1) an ordinary and necessary expense (as opposed to a capital expenditure) and (2) paid or incurred “in carrying on a trade or business”. With respect to the expense requirement, the Treasury Regulations include a robust regulatory regime under §§ 263 and 263A that specifically discusses the capitalization of IP costs.[2] However, it is important to remember that the foregoing regulations only affect amounts otherwise deductible under §§ 162(a) and 212.[3] The § 263 regulations are mainly exceptions to the “expense” test of § 162[4] and those regulations identify multiple intangibles treated as capital expenditures. A non-exclusive list including some of the more important IP related capitalized costs (and certain exceptions) in commercial and corporate transactions today follows:
- Creation Costs. Amounts paid to create certain intangibles such as (i) amounts paid to create, originate, or renew financial interests like entity equity, letters of credit, options, and futures contracts; (ii) prepaid expenses; (iii) certain contract rights, (iv) memberships and privileges; (v) rights obtained from a governmental agency for things like trademarks, licenses, permits, or franchises; and (vi) certain contract rights.[5]
- Separate and Distinct Intangible Assets and Carveouts. Amounts paid to create or enhance a separate and distinct intangible asset, meaning an IP interest with ascertainable and measurable value in moneys worth that is subject to protection under applicable state, federal or foreign law and the possession and control of which is intrinsically capable of being sold, transferred or pledged (ignoring any restrictions imposed on assignability) separate and apart from a trade or business are capitalized.[6] The capitalization requirement is broad, but notably includes deduction carveouts for (x) software development[7] and (y) package design.[8] The “package design” deduction is a concession by the IRS in guidance such as Rev. Proc. 2002-9; Rev. Proc. 97-35, and cases like RJR Nabisco, Inc. v. Commissioner, 76 T.C.M. (CCH) 71, T.C. Memo. 1998-252. Well advised taxpayers should be careful with taking packaging deduction costs too far though. For instance, the costs of obtaining trademarks and copyrights on packaging are amounts paid to a government agency for a right guaranteed by that agency and are therefore capitalized creation costs.[9] The § 263 software carveout was substantially affected by the TCJA. After December 31, 2021, software development costs must be capitalized as “specified research or experimental (SRE) expenditures” and amortized over 5 years (15 years for foreign research costs) under § 174(c)(3). The IRS supplied guidance to this effect in Notice 2023-63 stating “SRE expenditures include expenditures… paid or incurred in connection with the development of any computer software” and “[s]uch expenditures may not be treated as ordinary and necessary expenses under § 162 or capitalized under § 195, § 263(a) , § 263A, or § 471.”[10] Rev. Proc. 2000-50 (which formerly supplied substantial guidance in this area) is thus now obsolete.[11] Software development is more fully discussed below.
- Facilitation Costs. Amounts paid to investigate or pursue the acquisition or creation of an intangible are typically capitalized.[12]
There are some important exceptions to capitalization. For example, short-lived self-created IP (the 12-month rule) costs do not require capitalization in many cases.[13] This post will also not discuss the UNICAP rules of § 263A, except to say that even though UNICAP mainly focuses on tangible personal property, IP reduced to or sold in a tangible medium is affected by those rules. Taxpayers should consider direct and indirect production costs and have its tax advisors thoroughly review the capitalization regulations to both maximize deductions and comply with capitalization rules.
Finally, § 162 includes a “carrying on” and “trade or business” component. The Code does not include a global definition of “trade or business” that applies in all circumstances. Taxpayers should know that typically a trade or business involves an activity carried on with continuity and regularity, the primary purpose of which is to generate profit or income.[14] What constitutes “carrying on” is also amorphous. Whether a business is in fact operational (carrying on) or merely a start-up is a question of fact.[15]
Research and Experimental Expenditures: § 174
For tax years before 2022,[16] § 174 allowed taxpayers to either deduct research and experimental expenditures (“SRE”)[17] or elect to capitalize and amortize such costs over a 60-month period. The term “SRE” expenditures means research or experimental expenditures that are paid or incurred by the taxpayer during a tax year in connection with the taxpayer’s trade or business.[18]
The TCJA removed the SRE expense election and instead required SREs to be charged “to capital account” and amortized over either 5 years (for domestic research) or 15 years (for foreign research).[19] Taxpayers should therefore carefully review (x) whether they have an SRE expenditure using the statutory and Notice definitions and (y) the source (domestic or foreign) of those expenditures. As a specific example, software development costs are treated as SREs and must consider § 174.[20] Notice 2023-63 expansively defines computer software so developers should consider reviewing whether their projects fit in that definition.[21]
Notice 2023-63 also recognized that long-term contracts under § 460 are impacted by the post-TCJA § 174. Code Section 460(a) essentially requires use of the percentage of completion method (“PCM”) to account for taxable income related to a long-term contract. The § 460 regulations provide that under the PCM, the portion of a contract price reported in a tax year relates to the ratio of incurred allocable contract costs to total estimated allocable contract costs. That tracking ratio represents the portion of the contract considered completed. Under the PCM, a taxpayer generally deducts allocable contract costs as they are incurred with the principle being an increase in reported contract price is matched by deduction of the costs that drove the ratio increase.[22] But, the TCJA’s changes to § 174 meant that SREs are charged to capital account (not immediately deducted), thereby causing an increase to the percentage of contract price reported while preventing a corresponding deduction. Notice 2023-63 states that proposed regulations may be issued to address the amortization of SREs under § 174 and the treatment of SRE expenditures in § 460 “to provide that the costs allocable to a long-term contract accounted for using the PCM include amortization of SRE expenditures under § 174(a)(2)(B), rather than the capitalized amount of such expenditures, and that such amortization is treated as incurred for purposes of determining the percentage of contract completion and deduction.”[23] Rev. Proc. 2024-9 offers additional guidance for SREs and the PCM method when considering interim guidance under Notice 2023-63. Finally, Notice 2024-12 clarified and modified Notice 2023-63. Taxpayers with SRE expenditures should carefully consult both aforementioned IRS Notices and the Revenue Procedure as the law in this area continues to evolve.
Capitalized Costs and Certain Credits
When §§ 162 and 174 do not prescribe a deduction or capitalization decision, §§ 197 and 167 might provide cost recovery options. Code Section 197 allows ratable 15-year amortization for any “amortizable section 197 intangible”.[24] Purchased intangible assets are typically considered “section 197 intangibles” (and therefore mainly “amortizable section 197 intangibles”) while self-created (developed) IP is often – though not exclusively – ineligible for § 197 amortization.[25] Both (i) self-created intangibles described in § 197(d)(1)(D), (E), and (F) (perhaps the most identifiable of which are self-created trademarks and trade names) and (ii) intangibles created in connection with the acquisition of a trade or business (or substantial portion of the assets of a trade or business) are not subject to the § 197(c)(2) “self-created intangible” exclusion from the definition of “amortizable section 197 intangible”. Stated simply, self-created trademarks, tradenames, or intangibles created to facilitate the acquisition of a trade or business can often be amortized over 15 years under § 197(a).[26] Note that § 197 is quite complex with lengthy regulations. This post covers only a small fraction of transactions that fit within § 197.[27]
In the event §§ 162, 174, and 197 do not apply to IP cost recovery with an ascertainable useful life, taxpayers can consider § 167 (though safe harbors exist for some self-created IP that are not § 197 intangibles)[28] The Code also allows research and development credits (“R&D Credit”) through § 41. This post does not discuss the R&D Credit, though we note the IRS has proposed changes to Form 6765 (for R&D Credit reporting) which may cause new reporting challenges.
Why Does IP Cost Recovery Matter?
The costs of developing IP are substantial as the races to create the (i) best artificial intelligence systems and (ii) most efficient pharmaceuticals suggest. Additionally, the IRS is increasing its headcount to amplify its enforcement efforts.[29] The combination of rising enforcement and IP spending illustrates the need to address front-end tax planning and back-end litigation defense, because in substance, IP development’s “deduct versus capitalize” nature is relatively low hanging enforcement fruit. It is simple enough to argue improper deductions were taken even if it is not in practice easy to determine what costs are more reasonably expensed versus capitalized. There is a host of case law illustrating the granularity of these determinations.[30] Companies with heavy IP budgets should take stock of their development costs and prepare for future enforcement.
[1] All “§” references are to specific sections of the Internal Revenue Code (the “Code”) unless otherwise noted.
[2] See §§ 263, 263A; and Treas. Reg. § 1.263(a)-4(b).
[3] This means that other provisions of the Code may supply a deduction for IP costs even though they would otherwise be capitalized under the § 263 regulations.
[4] This post will not consider § 212.
[5] Treas. Reg. § 1.263(a)-4(b); Treas. Reg. § 1.263(a)-4(d).
[6] Treas. Reg. § 1.263(a)-4(b)(3).
[7] Treas. Reg. § 1.263(a)-4(b)(3)(iv). But see post TCJA § 174(c)(3).
[8] Treas. Reg. § 1.263(a)-4(b)(3)(v).
[9] See Treas. Reg. § 1.263(a)-4(l), Example 9.
[10] Notice 2023-63, Section 4.03 and Section 4.04.
[11] See Notice 2024-12 Section 2.06.
[12] Treas. Reg. § 1.263(a)-4(b)(1)(v); Treas. Reg. § 1.263(a)-4(e)(1)(i).
[13] Treas. Reg. § 1.263(a)-4(f)(1).
[14] Commissioner v. Groetzinger, 480 U.S. 23 (1987).
[15] See e.g., Lamont v. United States, 97-2 USTC ¶50,861 (Fed. Cl. 1997) and Frank v. Commissioner, 20 T.C. 511 (1953).
[16] The Tax Cuts and Jobs Act (“TCJA”) substantially revised § 174.
[17] See Notice 2023-63
[18] § 174(b); Notice 2023-63, Section 4.02.
[19] § 174(a).
[20] § 174(c)(3).
[21] Notice 2023-63, Section 5.02(1).
[22] See generally Treas. Reg. § 1.460-5(b).
[23] Notice 2023-63, Section 8.03. This Notice also discusses cost sharing agreement regulations under § 482 that are affected by the TCJA’s revisions to § 174. Code Section 482 is beyond the scope of this post.
[24] § 197(a).
[25] § 197. See also Treas. Reg. § 1.197-2(d)(2)(i) (“[E]xcept as provided in paragraph (d)(2)(iii) of this section, amortizable section 197 intangibles do not include any section 197 intangible created by the taxpayer (a self-created intangible”).
[26] See, e.g., Treas. Reg. § 1.197-2(d)(2)(iii)(A) (“Thus, for example, capitalized costs incurred in the development, registration, or defense of a trademark or trade name do not qualify for the exception and are amortized over 15 years under section 197.”)
[27] Nor is consideration given herein to § 1253 and contingent payments for franchises, trademarks, or trade names.
[28] See Treas. Reg. § 1.167-3(b).
[29] See, e.g.,
[30] See, e.g., Mylan, Inc. v. Commissioner, 76 F.4th 230 (3d Cir. 2023), aff’g 156 T.C. 137 (2021) (legal expenses incurred by a generic drug manufacturer to prepare letters to brand name drug manufacturers as part of an ANDA application process involves creation of an intangible and must be capitalized, but legal expenses incurred to defend against patent infringement were deductible since the patent litigation was distinct from the ANDA process).
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