Accounting for Section 174 Expenditures

Internal Revenue Code Section 174 provides specific tax rules for handling the costs associated with a company’s research and development efforts. These expenditures, broadly defined as activities intended to eliminate uncertainty about a new or improved product or process, are a common part of business for companies in technology, manufacturing, and science.

Identifying Qualifying Expenditures

Included Costs

To qualify under Section 174, an expenditure must be incurred in connection with a taxpayer’s trade or business and relate to activities that are experimental in nature. This includes direct costs such as the salaries and wages of employees engaged in research activities, as well as the cost of materials and supplies consumed during the research process. Payments made to outside contractors for performing research and development on the business’s behalf also fall under this category.

Indirect costs that support the research function are also considered qualifying expenditures. This can include a portion of overhead expenses like rent, utilities, and depreciation for facilities and equipment used for R&D. For example, if a specific wing of a building is dedicated to a research department, a proportional share of the building’s utility and rent costs could be allocated as a Section 174 expenditure.

A significant category of included costs relates to software development. All costs for developing computer software are governed by these rules, including planning, designing, coding, and testing. This applies whether the software is for internal use, held for sale, or licensed to customers, and is separate from any research and development tax credit.

Excluded Costs

The costs of acquiring land or other depreciable property to be used in connection with research do not qualify. The costs to acquire another’s patent, model, or production process are not considered research expenditures. Activities that occur after the development and operational stage are not eligible, including costs for routine quality control testing, consumer surveys, and market research. Advertising and promotional expenses for a new product are also outside the scope of Section 174.

Amortization of Research and Experimental Costs

Effective for tax years beginning after December 31, 2021, all businesses must capitalize and amortize their research and experimental expenditures. The law establishes two distinct amortization periods based on where the research activities take place. For specified research or experimental (SRE) expenditures attributable to research conducted within the United States, the costs must be amortized over a five-year period. If the research is conducted outside of the United States, a 15-year amortization period applies.

A mid-year convention must be applied in the first year, which assumes all expenditures were incurred at the midpoint of that year. This means a business can only deduct half of a full year’s amortization in the first year. This effectively spreads the deductions over six tax years for domestic research and 16 for foreign research.

For example, a business that incurs $100,000 in domestic SRE costs during a tax year has an annual amortization amount of $20,000 ($100,000 / 5 years). Because of the mid-year convention, the deduction in the first year is limited to $10,000. For each of the next four years, the business would deduct the full $20,000, and the final remaining $10,000 would be deducted in the sixth year.

Tax Reporting and Compliance

The annual deduction amount is reported on Form 4562, Depreciation and Amortization. To adopt this mandatory accounting method, businesses were required to file Form 3115, Application for Change in Accounting Method, with the tax return for the first year the new rules apply. The IRS has provided procedures for an automatic change to simplify compliance.

Filing for this accounting method change under the automatic procedures can provide a measure of audit protection. This protection means that if a business correctly files for the change, the IRS will not require it to change its method for the same SRE costs for a tax year prior to the year of the change.

Treatment of Abandoned or Disposed Projects

The accounting treatment for research projects changes if the project is disposed of, retired, or abandoned before the end of its amortization period. Under the current rules, a business cannot immediately write off the remaining unamortized costs in the year of abandonment. Instead, the business must continue to amortize the remaining capitalized expenditures over the original amortization schedule.

For example, if a company spent $50,000 on a domestic research project and properly deducted $5,000 in the first year, it would have a remaining unamortized balance of $45,000. If the company completely abandons the project in year two, it cannot deduct the $45,000 at once. It must continue to take its annual $10,000 amortization deduction for the next four years and the final $5,000 in year six until the full cost has been recovered. An exception exists for certain corporate transactions, such as liquidations or reorganizations, where the acquiring company may continue the amortization.