Tax Code 174: R&E Expenditure Amortization Rules

The tax treatment for research and experimental (R&E) expenditures, the costs of innovation and product development, has recently changed. Legislative actions have altered the long-standing rules, impacting financial planning and tax liability for a wide range of industries. These changes affect how businesses must handle these costs on their tax returns, moving from a flexible approach to a structured, long-term accounting method.

The Shift to Mandatory Amortization

Previously, businesses could elect to deduct 100% of their qualifying R&E costs in the year they were incurred. This immediate expensing provided a tax benefit that reduced taxable income and encouraged investment in innovation.

This practice was changed by the Tax Cuts and Jobs Act of 2017 (TCJA). For tax years beginning after December 31, 2021, the option to immediately deduct these expenses was eliminated. The law now mandates that all businesses must capitalize these costs and amortize them, which means spreading the deduction over multiple years.

For tax years 2022 through 2024, businesses must treat R&E costs as a capital expenditure. These capitalized costs are then deducted incrementally over a prescribed period. This change alters the timing of tax deductions, pushing the tax benefit out over several years instead of allowing it all in one year.

Proposed legislation for the 2025 tax year would, if passed, partially reverse these rules. For tax years beginning after December 31, 2024, the proposal would reintroduce the option for businesses to immediately deduct their domestic R&E expenses. This change would not be retroactive, meaning the amortization requirement remains in place for the 2022, 2023, and 2024 tax years. Under this proposal, the mandatory 15-year amortization for foreign R&E expenditures would remain.

Identifying Qualifying Research and Experimental Costs

R&E expenditures are costs a business incurs that represent research and development costs in the “experimental or laboratory sense.” This includes activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product, process, or formula.

Uncertainty exists if the information available to the taxpayer does not establish the capability, method, or appropriate design for developing or improving the product. Qualifying costs are those incident to resolving this uncertainty. Common examples include the salaries of technical staff engaged in R&E activities, the cost of materials consumed during research, and patent legal fees.

Certain expenditures are explicitly excluded from the Section 174 definition.

• Costs for quality control testing
• Efficiency surveys
• Management studies
• Consumer surveys

The cost of acquiring land or depreciable property for research is not an R&E expenditure; however, the depreciation allowances for that property can be treated as an R&E cost to the extent the property is used for research.

Software Development

The TCJA clarified that any costs paid or incurred for the development of computer software are to be treated as R&E expenditures. This means all such costs incurred in tax years beginning after December 31, 2021, must be capitalized and amortized. This rule applies to a wide range of activities, from initial planning and design to coding and testing of the software before it is placed in service or ready for sale.

This definition encompasses both software developed for internal use and software developed to be sold, leased, or licensed to customers. It includes direct costs like compensation for developers and indirect costs that support development. However, it does not apply to costs for software that is simply purchased or licensed from another party, as those costs are governed by different tax rules.

Calculating the Amortization Deduction

The annual amortization deduction depends on where the research activities took place. The law establishes two distinct amortization periods: five years for domestic R&E and fifteen years for foreign R&E. Domestic research is defined as research conducted within the United States, while foreign research is any research conducted outside of the United States.

A specific rule, known as the mid-year convention, must be applied in the first year. This convention dictates that amortization begins at the midpoint of the taxable year in which the costs are incurred, regardless of the specific date the expenses arose. This means that in the first year, the business can only deduct half of a full year’s amortization.

To illustrate, consider a business that incurs $100,000 in domestic R&E expenditures in a tax year where amortization is required. The full annual amortization amount is $20,000 ($100,000 divided by 5 years). Because of the mid-year convention, the deduction for Year 1 is only $10,000. In each of the following four years, the business would deduct the full annual amount of $20,000. The final $10,000 would be taken in Year 6.

If the same $100,000 in costs were for foreign research, the calculation would be similar but spread over a longer period. The full annual amortization would be approximately $6,667 ($100,000 divided by 15 years). The deduction in Year 1 would be about $3,333. The business would then deduct $6,667 for each of the next fourteen years, with the final portion being deducted in Year 16.

Treatment of Dispositions and Abandonments

Under the rules for the 2022-2024 tax years, if a property associated with R&E expenditures is disposed of, retired, or abandoned during the amortization period, the taxpayer cannot deduct the remaining unamortized costs. Instead, the business must continue to amortize those costs over the remainder of the original 5- or 15-year period.

For example, imagine a company spent $500,000 on a domestic research project in 2023 and began amortizing it over five years. If in 2024 the company abandons the project, it cannot write off the remaining unamortized balance. It must continue to take the scheduled annual amortization deductions through the end of the original period.

Proposed legislation would change this treatment for domestic projects for tax years beginning in 2025. If enacted, the proposal would allow a business to write off the remaining unamortized costs of a domestic R&E project in the year it is abandoned. The rule requiring continued amortization after abandonment would still apply to all foreign R&E expenditures.

Procedural Filing and Reporting Requirements

Businesses use Form 4562, “Depreciation and Amortization,” to calculate and claim their annual amortization deduction for R&E expenditures. The deduction is reported in Part VI of the form, and the total is then carried over to the appropriate line on the main business tax return, such as Form 1120 for corporations, Form 1065 for partnerships, or Schedule C for sole proprietors.

The IRS requires taxpayers to attach a statement to their return for the first year they adopt this accounting method. This statement must include the taxpayer’s name and identification number, the start and end dates of the tax year, and a declaration that the change is for specified R&E expenditures being capitalized and amortized. The statement should also specify that the change is being made on a cut-off basis, applying only to costs incurred in tax years beginning after December 31, 2021.