Rev. Rul. 85-186, 1985-2 C.B. 84

Research and experimental expendi­tures. Research or experimental costs previously deducted pursuant to sec­tion 174(a) of the Code are not sub­ject to recapture upon the subse­quent sale of the resulting technology. Rev. Rul. 72-528 revoked.

Rev. Rul. 85-186


Whether “tax benefit” recapture as ordinary income of research or experi­mental expenditures previously de­ducted pursuant to section 174(a) of the Internal Revenue Code is required upon subsequent sale of the resulting technology.


The principal business activity of the taxpayer is the manufacture and sale of consumer products. Since commencing trade or business activity in 1960, the taxpayer has engaged in extensive in-house research and experimental activi­ties directed at the development of patented and unpatented technology to be used in the manufacture of products sold in the ordinary course of taxpay­er’s trade or business. The taxpayer has consistently deducted all qualifying re­search or experimental expenditures pursuant to section 174(a) of the Code, and no portion of these deductions failed to effect a reduction of the tax­payer’s federal income tax liability. In 1985, the taxpayer decided to discon­tinue a product line to better conform its product offerings to its marketing strategy. As a result of the decision, the taxpayer sold certain patented and unpatented technology that had resulted from qualifying expenditures properly deducted in prior tax years pursuant to section 174(a) of the Code.


Section 174(a) of the Code and sec­tion 1.174-3(a) of the Income Tax Reg­ulations provide that a taxpayer may treat research or experimental expendi­tures that are paid or incurred during the tax year in connection with the tax­payer’s trade or business as expenses that are not chargeable to capital ac­count. Section 1.174-2(a)(1) of the reg­ulations provides that the term “re­search or experimental expenditures” as used in section 174 means expenditures incurred in connection with the taxpay­er’s trade or business that represent re­search and development costs in the ex­perimental or laboratory sense.

The tax benefit rule requires the in­clusion in income of certain amounts that were deducted in a prior tax year and that generated a tax benefit to the taxpayer through a reduction in the amount of tax liability in the prior tax year. See generally, Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff’d sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), cert. denied, 311 U.S. 658 (1940); Rev. Rul. 68-104, 1968-1 C.B. 361. In appropriate circumstances, if a deduc­tion reduces ordinary income in the year the amount is paid or incurred, and if an event in a subsequent taxable year triggers application of the tax ben­efit doctrine, the amount of the prior deduction will be included in gross in­come and characterized as ordinary in­come. See Merchant National Bank v. Commissioner, 199 F.2d 657 (5th Cir. 1952). In Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983), 1983-1 C.B. 50, the United States Su­preme Court stated that, in order for the tax benefit doctrine to be invoked, an event must occur in a subsequent year that is “fundamentally inconsist­ent” with the premise or premises on which the prior year deduction was based. The Hillsboro standard requires an analysis of whether the prior year deduction would have been allowed if the subsequent year event had occurred in the prior year, considering the pur­pose and the function of the provision allowing the prior year deduction.

To determine the applicability of the tax benefit doctrine to previously de­ducted research or experimental expenditures, Hillsboro requires a deter­mination of the purpose and the function of the provision permitting the prior year deduction. The legislative history of section 174 of the Code indi­cates two purposes for enacting section 174(a): (1) to encourage research and experimental activities and (2) to elimi­nate the uncertainty as to the tax treat­ment of research or experimental ex­penditures. H.R. Rep. Ho. 1337, 83rd Cong., 2d Sess. 28 (1954).

To encourage research or experimen­tal activities, section 174(a) permits the deduction of research or experimental expenditures during the tax year such expenditures are paid or incurred. This rule of section 174(a) represents a devi­ation from the general rules governing the deductibility of expenditures. Under the general rules, expenditures other­wise deductible under section 162 are not deductible to the extent attributable to the acquisition or creation of assets having a useful life extending substan­tially beyond the tax year. See sections 1.263(a)-2(a) and 1.461-1(a) of the reg­ulations. However, section 174(a) al­lows a current deduction for research or experimental expenditures even though such expenditures may lead to the crea­tion of assets having a useful life that extends substantially beyond the tax year.

To eliminate uncertainty as to the tax treatment of research or experimental expenditures, section 174(a) relieves taxpayers of the obligation, imposed by the rules that ordinarily govern the deductibility of expenditures, to allo­cate costs between amounts currently deductible and amounts required to be capitalized.

In the present situation, both pur­poses underlying section 174(a) were accomplished by allowing the taxpayer a current deduction for the research or experimental expenditures paid or incurred. The legislative purpose of en­couraging research or experimental ac­tivity was accomplished in the year of the deduction because that is the year the research or experimental expendi­tures were paid or incurred. The legis­lative purpose of relieving the taxpayer of the obligation to allocate costs be­tween amounts currently deductible and amounts required to be capitalized was accomplished in the year of the deduc­tion because the taxpayer was allowed a deduction in that year for all research or experimental expenditures paid or incurred. It would be inconsistent with this legislative purpose to relieve the taxpayer of the obligation to allocate costs in the year of the deduction only to impose the obligation in the year of disposition of the resulting technology.

Because the two legislative purposes for enacting section 174(a) were ac­complished in the year of the deduc­tions, the subsequent sale of the re­sulting technology had independent significance and was not fundamentally inconsistent with the prior section 174(a) deductions. Accordingly, the tax benefit doctrine as articulated in Hillsboro does not apply to the research or experimental expenditures previ­ously deducted by the taxpayer pursu­ant to section 174(a).


Under the facts set forth above, dis­position of the technology resulting from previously deducted section 174(a) expenditures is not fundamen­tally inconsistent with the prior year de­duction of such expenditures. Accord­ingly, under these facts, the tax benefit doctrine does not apply to the disposi­tion of the resulting technology.


Rev. Rul. 72-528, 1972-2 C.B. 481, involves a “pilot model” of a machine that had been constructed for use in the taxpayer’s product development pro­gram. The taxpayer claimed and was allowed a section 174(a) deduction for the entire amount of the costs incurred on the “pilot model.” The “pilot model” was totally destroyed in a suc­ceeding tax year by an explosion and fire, and the taxpayer subsequently was reimbursed by its insurance carrier for the loss suffered. Rev. Rul. 72-528 holds that the tax benefit doctrine applies to the receipt of insurance pro­ceeds. Because the holding of Rev. Rul. 72-528 is inconsistent with the holding of this Revenue Ruling, Rev. Rul. 72-528 is revoked.