Election to defer research and experimental expenditures . For tax­able years ending after August 29, 1976, the claim on a tax return of a deduction for a portion of re­search and experimental expenses incurred, without a written election statement, will not be treated as an election to defer and amortize such expenses; Rev. Rul. 71-136 revoked.

Rev. Rul. 76-324

The Internal Revenue Service has been asked to reconsider the position set forth in Rev. Rul. 71-136, 1971-1 C.B. 97, relating to the proper method of electing to defer and amortize re­search and experimental expenditures under section 174 of the Internal Rev­enue Code of 1954.


The facts in Rev. Rul. 71-136 con­cern a taxpayer, a domestic corpora­tion, that expended 20x dollars for re­search and experimental expenditures in connection with product X during the taxable year ended December 31, 1964, its first year of operation. The taxpayer’s books and financial state­ments for 1964 reflected a deduction of one-fifth of the amount so expended as amortization for the year. A deduc­tion of one-fifth of the amount ex­pended was claimed as a deduction on the taxpayer’s Federal income tax re­turn for 1964 and each of the 4 suc­ceeding years. The return for 1964 did not contain a written statement in the form required by section 1.174-4(b)(1) of the Income Tax Regula­tions regarding an election to amortize the expenditures.

During the taxable year ended De­cember 31, 1968, the taxpayer ex­pended 30x dollars for research and experimental expenses in connection with new product Y. Such amount was deferred by the taxpayer on its books and one-fifth of that amount was amortized and claimed as a deduc­tion on the taxpayer’s Federal income tax return for 1968.

In 1969 the taxpayer expended an additional 10x dollars for research and experimental expenditures in connec­tion with product Y. Part of such ex­penditure was expensed and part was deferred by the taxpayer for Federal income tax purposes in 1969.

The taxpayer did not request per­mission to change its method of treat­ment of research and experimental ex­penditures for 1968 with respect to new product Y.

The questions presented in Rev. Rul. 71-136 were whether a valid elec­tion to defer research and experi­mental expenses was made by the tax­payer in 1964, pursuant to section 1.174-4 of the regulations, and wheth­er section 174 of the Code was prop­erly applied in 1968 and 1969 with respect to the research and experi­mental expenditures made in 1968 and 1969.

Section 174(a) of the Code pro­vides, in part, that a taxpayer may treat research or experimental ex­penditures that are paid or incurred by the taxpayer during the taxable year in connection with the taxpayer’s trade or business as expenses that are not chargeable to the taxpayer’s capi­tal account. The expenditures so treated shall be allowed as a deduc­tion. Section 174(b) provides, in gen­eral, that a taxpayer may, under cer­tain circumstances, elect to treat such expenditures as deferred expenses.

Section 1.174-1 of the regulations provides, in part, that research or ex­perimental expenditures paid or in­curred by the taxpayer in connection with the taxpayer’s trade or business may be treated as expenses not charge­able to capital account and deducted in the year in which they are paid or incurred (section 1.174-3), or they may be deferred and amortized (sec­tion 1.174-4). Research or experi­mental expenditures that are neither treated as expenses nor deferred and amortized under section 174 of the Code must be charged to capital ac­count.

Section 1.174-3(a) of the regula­tions provides, in part, that research or experimental expenditures paid or incurred by a taxpayer during the tax­able year in connection with the tax­payer’s trade or business are deductible as expenses, and are not chargeable to capital account, if the taxpayer adopts the method provided in section 174(a) of the Code. If adopted, the method shall apply to all research and experimental expenditures paid or incurred in the taxable year of adoption and all subsequent taxable years, un­less a different method is authorized by the Commissioner of Internal Reve­nue under section 174(a)(3) with re­spect to part or all of the expenditures.

Section 1.174-3(b)(1) of the regu­lations provides, in part, that the con­sent of the Commissioner is not re­quired to treat the research and ex­perimental expenditures as expenses if the taxpayer adopts such method for the first taxable year in which the tax­payer pays or incurs research or ex­perimental expenditures. The taxpayer may do so by claiming in the taxpay­er’s income tax return for such tax­able year a deduction for such research or experimental expenditures. If the taxpayer fails to adopt the method for the first taxable year in which the tax­payer incurs such expenditures, the taxpayer cannot do so in subsequent taxable years, unless the taxpayer ob­tains the consent of the Commissioner under section 174(a)(2)(B) of the Code and section 1.174-3(b)(2).

Section 1.174-4(a)(1) of the regu­lations provides, in part, that if a tax­payer has not adopted the method provided in section 174(a) of the Code of treating research or experimental expenditures paid or incurred by the taxpayer in connection with the tax­payer’s trade or business as currently deductible expenses, the taxpayer may elect to treat such expenditures as de­ferred expenses under section 174(b).

Section 1.174-4(a)(5) of the regu­lations provides, in part, that the elec­tion shall apply for the taxable year for which the election is made and for all subsequent taxable years, unless a change to a different treatment is au­thorized by the Commissioner under section 174(b)(2) of the Code. That regulation section further provides that in no event will the taxpayer be permitted to treat part of the expendi­tures with respect to a particular project as deferred expenses under sec­tion 174(b) and to adopt a different method of treating the balance of the expenditures relating to the same proj­ect for the same taxable year.

Section 1.174-4 (b)(1) of the regu­lations provides, in part, that the elec­tion under section 174(b) of the Code shall be made by attaching a statement to the taxpayer’s return for the first taxable year to which the election is applicable. That section further pro­vides that the statement shall be signed by the taxpayer and shall contain six enumerated items of information.

Section 1.174-4 (b)(2) of the regu­lations provides, in part, that applica­tion for permission to change to a dif­ferent method of treating research or experimental expenditures or to a dif­ferent period of amortization for de­ferred expenses shall be in writing and shall be addressed to the Commis­sioner.

Section 266 of the Code provides that no deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under regu­lations prescribed by the Secretary or the Secretary’s delegate, are charge­able to capital account with respect to property, if the taxpayer elects, in ac­cordance with such regulations, to treat such taxes or charges as so chargeable.

Section 1.266-1(c)(3) of the regu­lations provides, in part, that if the taxpayer elects to capitalize an item or items under section 1.266-1, such election shall be exercised by filing with the original return for the year for which the election is made a state­ment indicating the item or items that the taxpayer elects to treat as charge­able to a capital account.

In Kentucky Utilities Co. v. Glenn, 394 F.2d 631 (6th Cir. 1968), one of the issues involved was whether the taxpayers had elected to capitalize social security taxes paid on construc­tion work under section 24(a)(7) of the Internal Revenue Code of 1939 (the predecessor of section 266 of the 1954 Code). The taxpayers had treated the social security taxes in their Federal income tax returns for the years involved therein as if they had elected to capitalize such taxes. The taxpayers attached a detailed schedule to their returns that clearly indicated those items that the taxpay­ers were capitalizing. However, no formal statement electing to capitalize the taxes was filed by the taxpayers. The taxpayers subsequently amended their returns and filed statements claiming deductions for such taxes. The court held that the taxpayers had made a binding election with their original returns that could not be retroactively changed.

In the situation described in Rev. Rul. 71-136, the taxpayer did not file a written statement with its Federal income tax return for the year 1964, electing to treat the research and ex­perimental expenses as deferred ex­penses under section 174(b) of the Code, as required by section 1.174-4(b)(1) of the regulations. However, the taxpayer, in its 1964 return, did treat such expenditures as if it had elected to defer such expenses by de­ducting only one-fifth of the amount expended.

Rev. Rul. 71-136, relying upon Kentucky Utilities Co., held that, al­though the taxpayer did not file the formal statement required by section 1.174-4(b)(1) of the regulations with its Federal income tax return for 1964, the taxpayer made a sufficient election to defer its research and experimental expenditures under section 174(b) of the Code by treating such expendi­tures on its Federal income tax return as if it had elected to defer such ex­penditures by deducting only one-fifth of the amount expended.

However, the facts in Kentucky Utilities Co. are distinguishable from the facts in Rev. Rul. 71-136. In Ken­tucky Utilities Co., the taxpayers, although they did not file a formal statement electing to capitalize the taxes involved therein under section 266 of the Code, did attach a detailed schedule to their returns that clearly indicated those items that the taxpayers were capitalizing. Such treat­ment is consistent with section 1.266-1(c)(3) of the regulations, which re­quires “a statement indicating the item or items . . . which the taxpayer elects to treat as chargeable to capital account.” In Rev. Rul. 71-136, the taxpayer did not attach a schedule or other information that clearly indi­cated the items it was electing to defer and amortize. Thus, the taxpayer failed to clearly communicate its in­tention to defer and amortize the ex­penditures in question.

In addition, sections 1.266-1(c)(3) and 1.174-4(b)(1) of the regulations contain distinctly different require­ments for elections made under sec­tion 266 and section 174(b) of the Code, respectively. Section 1.174-4 (b)(1) requires greater formality and more specific information than section 1.266-1(c)(3). The taxpayer in Rev. Rul. 71-136 did not attach a statement that contained the six enumerated items of information required by section 1.174-4(b)(1).

Accordingly, in Rev. Rul. 71-136, the taxpayer’s treatment of its re­search and experimental expenditures on its 1964 Federal income tax return was not a valid election to defer and amortize such expenditures under sec­tion 174(b) of the Code and section 1.174-4(b)(1) of the regulations. In addition, since the taxpayer did not make a valid election in 1964 to defer and amortize its research and experi­mental expenditures, section 174 of the Code was not properly applied in 1968 and 1969 with respect to the re­search and experimental expenditures made in 1968 and 1969. Therefore, in­asmuch as the taxpayer did not make a valid election under section 174(b) and did not adopt a method provided in section 174(a), its research and ex­perimental expenditures incurred in the above years must be capitalized.

Rev. Rul. 71-136 is revoked.

Pursuant to the authority contained in section 7805(b) of the Code, this Revenue Ruling will not be applied to taxable years ending before August 30, 1976, the date of publication of this Revenue Ruling in the Internal Revenue Bulletin.

LET'S TALK

Do you have questions about the research tax credit? If so, we would like to hear from you.

Your Name (required)
Your Email (required)
Your Message