What Are Section 174 Expenses and Their Tax Treatment?

Section 174 expenses are costs incurred by businesses for developing new products, processes, or software. Understanding their definition and tax treatment is important for managing financial obligations. Their classification directly influences a business’s taxable income and tax strategy.

Defining Section 174 Expenses

Section 174 expenses are costs for research and development (R&D) activities. These activities involve efforts to discover information that would eliminate uncertainty regarding the development or improvement of a product, process, formula, invention, technique, patent, or similar property. Uncertainty exists if available information does not establish the capability or method for achieving the desired outcome or product design. The ultimate success or failure of the R&D activity does not determine whether costs qualify.

Qualifying activities include fundamental and applied research, and explicitly include costs for software development. The nature of the activity, not the product, determines eligibility. Costs can qualify even if incurred after production begins but before uncertainty about the product’s development or improvement is resolved.

Direct costs qualifying as Section 174 expenses include wages for employees engaged in R&D activities, and those who supervise or support this work. Materials and supplies consumed during R&D, such as those used in prototypes or testing, are also included. Payments to third parties for contract research services can qualify, provided the taxpayer retains substantial rights to the research.

Indirect costs for the research process, such as rent for facilities, utilities, and administrative expenses, may also be included. However, certain expenditures are excluded from Section 174 treatment. These include costs related to marketing, quality control testing, efficiency surveys, management studies, consumer surveys, advertising, and expenses incurred after a product enters commercial production. Research funded by another party where the taxpayer does not bear the economic risk is also excluded.

Current Tax Treatment of Section 174 Expenses

The tax treatment of Section 174 expenses changed for tax years beginning after December 31, 2021. Previously, businesses could immediately deduct these expenditures or amortize them over at least 60 months. The Tax Cuts and Jobs Act of 2017 removed this option, mandating a different approach.

Under current rules, all Section 174 expenditures, including software development costs, must be capitalized and amortized. For research conducted within the United States, costs are amortized over five years. Expenses for foreign research are amortized over 15 years. Foreign research is defined as any research conducted outside the United States, Puerto Rico, or any U.S. territory or possession.

Amortization begins with the midpoint of the taxable year when expenditures are paid or incurred, using a half-year convention. This means only half of the annual amortization is deducted in the first year. The remaining amortization is spread over subsequent full years, with the final portion deducted in the year following the end of the full amortization period. For example, a five-year amortization period effectively spans six tax years.

This mandatory capitalization and amortization is a significant shift for businesses with substantial R&D investments. It generally results in increased taxable income in early years compared to immediate expensing, leading to higher tax liabilities and impacting cash flow. Even if a research project is disposed of or abandoned, amortization of related Section 174 expenditures must continue; no immediate deduction for unamortized costs is allowed.

Distinguishing Section 174 Expenses from Other Business Costs

Section 174 expenses are distinct from other business costs, each governed by different tax rules. Understanding these differences is important for proper classification and tax compliance.

Section 174 expenses differ from Section 162 ordinary and necessary business expenses. Section 162 allows businesses to deduct routine operational costs like rent, utilities, marketing, and salaries for non-R&D personnel. While some R&D activities might involve ordinary costs, Section 174 specifically applies to costs for developing or improving new products or processes, which are considered capital for tax purposes under current rules, rather than routine operational expenses.

Section 174 expenses are also separate from Section 197 amortizable intangibles. Section 197 applies to the acquisition of intangible assets like patents, copyrights, trademarks, customer lists, and goodwill, amortized over 15 years. The key distinction is that Section 174 relates to the costs of creating research and experimentation, including intellectual property development. In contrast, Section 197 deals with purchased or acquired intangible assets. While Section 174 capitalized costs are treated as an intangible asset on a company’s balance sheet, they arise from internal development, not acquisition.

Section 174 expenses are not the same as depreciable property under Section 167 or Section 168. Section 167 allows for depreciation of property used in a trade or business or held for income production, while Section 168 provides accelerated depreciation methods (MACRS) for tangible property. Costs for tangible property, such as machinery, equipment, or buildings used in R&E activities, are generally depreciated under these sections, not directly amortized under Section 174. However, the depreciation expense of such property used in R&D can be an indirect cost included in Section 174 expenditures. Section 174 applies to experimental costs for developing a product or process, not the acquisition cost of tangible assets used for that development.