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Transactions with Unamortized Sec. 174 Assets Could be Trap for the Unwary

Published
Feb 3, 2025
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For decades, IRC Sec. 174 has allowed businesses to fully deduct their qualified research and experimental (R&E) expenditures in the year in which they were incurred. The Tax Cuts and Jobs Act dramatically altered this treatment, requiring businesses to instead capitalize and amortize their R&E expenditures over 5 years (15 years for foreign research expenditures). This change took effect for tax years beginning after December 31, 2021. 

IRC Sec. 174(d) Explained

In addition to the requirement that these R&E expenditures be amortized over a 5 or 15-year period, Sec. 174(d) now generally disallows any deduction for R&E expenditures related to property upon the disposition, retirement, or abandonment of such property during the amortization period. Instead, these expenditures must continue to be amortized over the remaining period even though they have been disposed, abandoned, or retired.

Notice of Proposed Rulemaking

While there are no regulations yet to assist taxpayers in the application of IRC Sec. 174(d), the IRS has provided some guidance through Notice 2023-63. Of note, Sec. 4.02 of the Notice clearly states taxpayers must continue to amortize any expenditures related to property upon the disposition, retirement, or abandonment of property with respect to which those expenditures were paid or incurred, except as otherwise provided in the Notice. Sec. 4.04 of the Notice.

Section 4.04 of the Notice contemplates the application of IRC Sec. 174(d) in situations where a corporation completely ceases to exist. If a corporation ceases to exist for federal income tax purposes through an IRC Sec. 381(a) transaction (such as a tax-free liquidation under IRC Sec. 332, or certain tax-free mergers under IRC Sec. 368), the Notice says the acquiring corporation essentially steps into the previous corporation’s place and amortizes the expenditures over the remaining amortization period. In cases where the corporation ceases to exist, but IRC Sec. 381(a) does not apply, the Notice states the corporation is allowed to deduct the unamortized R&E expenditures for its final taxable year.

Risks with Mergers and Acquisitions

In the absence of regulations, the plain language of IRC Sec. 174(d) and the Notice seem to indicate that unless the corporation liquidates, it must continue to amortize its expenditures (however impractical or contrary to other provisions that may seem). This opens companies that dispose of their assets, particularly targets in the private equity space, to some surprising and unexpected results.

Consider the following situation: Target company A is an S corporation. In connection with an F-reorganization (contemplated by Rev. Rul. 2008-18), A’s shareholders form a new S corporation for the purpose of owning and then selling target company A, which – prior to the sale -- made a qualified subchapter S subsidiary election and converted to a single member LLC. When the new S corporation then sells the SMLLC to corporation B, the new S corporation is essentially selling the company without fully liquidating or ceasing operations.  

There are any number of reasons why A’s shareholders may not wish to liquidate A after the sale.  For example, A’s shareholders may not want it to liquidate if A owns rollover equity, because that would trigger the gain on the rollover equity.  Alternatively, A might hold an earnout, and A’s shareholders may not wish to own their respective interests in the earnout separately. In all of these cases, A would need to be aware of the likely obligation to continue to amortize any R&E expenditures it still had at the time of the sale. 

Purchasers and targets should both be aware of this additional consideration in M&A situations.

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