How to Use a Section 174 Statement Instead of Form 3115

For tax years beginning after December 31, 2021, the option to immediately deduct research and experimental costs in the year they are incurred has been eliminated. Internal Revenue Code Section 174 now mandates that these costs be capitalized and amortized over several years. This shift represents a formal change in a company’s method of accounting.

This accounting method change would normally require businesses to file a detailed Form 3115, Application for Change in Accounting Method. Recognizing the impact of this rule change, the Internal Revenue Service (IRS) has provided a simplified alternative. Businesses can attach a statement to their tax return to comply with the new law instead of the full form.

Defining Specified Research or Experimental Expenditures

To comply with the new rules, a business must first identify which of its costs fall under the category of “specified research or experimental” (SRE) expenditures. The Internal Revenue Code defines these as costs connected to activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. This uncertainty relates to the capability, method, or appropriateness of the product’s design.

This definition covers a range of direct and indirect expenses. Direct costs include the salaries of employees engaged in research, such as engineers and scientists, and the cost of materials used in their work. Indirect costs incident to research activities must also be capitalized, which can include overhead like rent, utilities, and depreciation for facilities used for research. For example, the costs of developing and testing a pilot model or a new manufacturing process are SRE expenditures.

Software development is a specifically addressed area within SRE expenditures. All costs associated with the planning, design, coding, installation, and testing of computer software are subject to capitalization under Section 174. This applies whether the software is developed for internal use, to be sold to customers, or integrated into a product with hardware components. The requirement covers the software development lifecycle up to the point it is placed in service.

Certain costs are explicitly excluded from the definition of SRE expenditures, including:

• Expenses for quality control testing of established products, efficiency surveys, and management or feasibility studies.
• Costs related to market research, sales, or advertising.
• The costs of acquiring another entity’s patent, model, or production process.
• Expenses related to literary, historical, or similar projects.

Required Information for the Section 174 Statement

To use the simplified procedure, a taxpayer must prepare a statement that includes specific information as outlined by the IRS. The statement must provide the following details:

• The taxpayer’s full legal name, complete address, and Employer Identification Number (EIN) or Social Security Number (SSN).
• The beginning and ending dates of the first taxable year in which the new Section 174 rules apply.
• The designated automatic accounting method change number, which is “265” for this change or “270” to rely on specific rules in recent IRS notices.
• A clear description of the types of SRE expenditures being capitalized.
• The total amount of SRE expenditures paid or incurred during the first year of the change.
• A declaration specifying the amortization period being used: a 5-year period for U.S. research and a 15-year period for foreign research.

The amortization must begin at the midpoint of the taxable year in which the costs were paid or incurred.

How to Prepare and File the Statement

Once all necessary information is gathered and SRE expenditures are calculated, prepare the physical statement. The information should be compiled into a single document and clearly labeled at the top as “Section 174 Statement.” This title ensures the document is recognized as a substitute for Form 3115 for this accounting method change.

The completed statement must be attached to the taxpayer’s timely filed original federal income tax return for the year of the change. This includes returns filed by the original due date or under a valid extension. The statement is considered part of the return itself.

A simplification of this process is the elimination of a separate mailing requirement. When filing Form 3115 for an automatic change, a duplicate copy must be mailed to the IRS National Office. For taxpayers using the statement for this Section 174 change, this duplicate filing is not required.

While the statement was initially for the first taxable year of the law change, the IRS has provided updated procedures for later years. This guidance offers continued administrative relief. For instance, a business making the change for its 2024 tax year can receive audit protection, even if it did not file to adopt the new method for its 2022 tax year.