IRC Section 174 Amortization of Research Expenses

A significant shift in tax law, driven by the Tax Cuts and Jobs Act of 2017 (TCJA), has altered how businesses account for innovation-related costs. For tax years beginning after December 31, 2021, Internal Revenue Code (IRC) Section 174 requires companies to capitalize and deduct their research and experimental (R&E) expenditures over several years. This change marks a departure from the option that allowed businesses to immediately deduct these costs in the year they were incurred.

Previously, an immediate write-off was allowed to encourage investment in research. The new mandate to capitalize and amortize these costs was introduced as a revenue-raising provision to help offset other tax reductions within the TCJA. This change affects a wide range of businesses, altering their taxable income and cash flow calculations.

Defining Research and Experimental Expenditures

The scope of IRC Section 174 is broad, encompassing costs for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty relates to the capability, method, or appropriateness of the product’s design. A “product” is not limited to tangible goods and can include a process, formula, invention, technique, or software.

Expenditures under this definition include direct and indirect costs of the research process, such as wages for researchers and their supervisors, materials and supplies, and utility costs for the research facility. Costs for obtaining a patent, like attorneys’ fees, also qualify as R&E expenditures. The rules apply whether the research is performed by the business or by a third-party contractor on its behalf.

An update under the TCJA is the explicit inclusion of software development costs as R&E expenditures. This means all costs associated with planning, designing, coding, and testing computer software must be capitalized and amortized. This applies whether the software is developed for sale, lease, license, or for internal use. The IRS clarifies that activities like training employees on new software or routine data conversion do not qualify.

Conversely, certain expenses are excluded from the definition of R&E expenditures. These include expenditures for acquiring land or another’s patent, model, or process. While depreciation allowances for property used in research may be included, the acquisition cost of the property itself is not. Other excluded costs include:

• Quality control testing
• Efficiency surveys
• Management studies
• Market research or advertising

Required Amortization of Section 174 Costs

The TCJA mandates a strict amortization schedule for R&E expenditures. The recovery period depends on where the research activities take place. For research conducted within the United States, the capitalized costs must be amortized over a five-year period.

A longer period applies to research conducted outside the United States, where expenditures must be amortized over 15 years. This provision creates a tax incentive for businesses to locate their research operations domestically. The determination is based on where the activities are physically performed, not the location of the company’s headquarters.

An element of the amortization calculation is the mid-year convention. The deduction begins from the midpoint of the taxable year in which the expenditures are incurred. This means that in the first year, the business can only deduct half of a full year’s amortization, regardless of when the costs were paid during the year.

For example, a business that incurs $100,000 in domestic R&E costs has an annual amortization amount of $20,000 ($100,000 / 5 years). Due to the mid-year convention, the deduction in Year 1 would be only $10,000. The remaining $90,000 is deducted over the next four and a half years, with a full deduction in years 2 through 5 and a final half-year deduction in Year 6.

Treatment of Disposed, Retired, or Abandoned Projects

Section 174 rules have a restrictive treatment for research projects that are unsuccessful or discontinued. If a business disposes of, retires, or abandons a project before the end of its amortization period, the law prohibits an immediate deduction for the remaining unamortized costs.

Instead of allowing a loss, the taxpayer must continue amortizing the remaining capitalized balance over the original 5-year or 15-year period. This rule applies regardless of whether the project resulted in a viable asset or was a complete failure. The unrecovered costs cannot be accelerated and written off.

For example, imagine a company capitalized $500,000 of domestic R&E costs for a project. After taking deductions for Year 1 ($50,000) and Year 2 ($100,000), the company abandons the project in Year 3. At that point, the remaining unamortized basis is $350,000, which cannot be deducted as a loss in Year 3.

The business must continue its scheduled amortization deductions of $100,000 in Years 3, 4, and 5, with a final deduction of $50,000 in Year 6. This continuation impacts the financial modeling for research projects, as the risk of failure does not come with an immediate tax benefit for the unrecovered investment.

Accounting Method and Reporting

Properly reporting Section 174 amortization is done on Form 4562, Depreciation and Amortization. Taxpayers must report the total amortizable R&E costs and the calculated deduction for the year in Part VI of this form. The form requires a description of the costs, the date the amortization period begins, the total amount, the period, and the current year’s deduction.

The mandatory capitalization of R&E costs is considered a change in accounting method. To comply with the new law, taxpayers were required to change from the expensing method to the new capitalization and amortization method.

For the first tax year the rules were effective, taxpayers generally filed Form 3115, Application for Change in Accounting Method. This change is made on a “cut-off” basis, meaning it only applies to R&E costs paid or incurred in tax years beginning after December 31, 2021; costs from prior years are not affected.

Failure to correctly adopt this accounting method change can lead to compliance issues. The IRS has provided procedures for businesses that did not properly make the change in their first taxable year after 2021. It is important for businesses to maintain detailed records identifying all costs subject to Section 174, documenting whether they are for domestic or foreign research, and tracking the amortization schedule.