What Are Section 174 Expenses Under the New Tax Law?

Section 174 of the Internal Revenue Code addresses the tax treatment of research and experimental (R&E) expenditures. This provision guides how companies account for costs associated with developing new products or processes for tax purposes. These rules are important for businesses engaged in research and development activities, as they directly influence a company’s taxable income and overall tax liability.

Historically, Section 174 offered taxpayers flexibility in deducting or amortizing these costs. However, recent changes implemented through the Tax Cuts and Jobs Act (TCJA) of 2017 have significantly altered this landscape. These modifications mandate a different approach to how businesses handle their R&E expenses, impacting a wide array of industries. Understanding these updated rules is important for any business involved in innovative endeavors.

Defining Qualified Research and Experimental Expenditures

Research and experimental expenditures, as defined under Section 174, generally refer to costs incurred in connection with a taxpayer’s trade or business that represent research and development in an experimental or laboratory sense. This broad definition typically includes all costs incident to the development or improvement of a product or process. Such activities aim to discover information that would eliminate uncertainty concerning the development or improvement of a product or its appropriate design.

Specific examples of qualifying costs include wages for personnel directly involved in research activities, the cost of materials and supplies used in experiments, and certain attorney fees related to securing patents. Software development costs are explicitly included within the scope of Section 174 expenditures, meaning businesses developing software must now treat these expenses under these rules.

However, certain expenditures are expressly excluded from Section 174 treatment. These typically involve activities that do not carry the same level of experimental uncertainty. Excluded costs include ordinary testing or inspection for quality control, efficiency surveys, management studies, consumer surveys, market research, or advertising. Additionally, costs for acquiring land or depreciable property, or research conducted after commercial production has begun, are generally not considered Section 174 expenses. The definition for Section 174 purposes is distinct from the definition used for the research and development (R&D) tax credit under Section 41.

Current Tax Treatment and Amortization Rules

A significant change to Section 174, enacted by the Tax Cuts and Jobs Act of 2017, mandates that research and experimental expenditures must be capitalized and amortized. This mandatory capitalization applies to tax years beginning after December 31, 2021. Previously, businesses had the option to immediately deduct these expenses in the year they were incurred, or to amortize them over a period of at least 60 months.

Under the new rules, these expenses can no longer be immediately deducted. Instead, they must be spread out over a specific amortization period. Domestic research and experimental expenditures are amortized over five years, while foreign research and experimental expenditures must be amortized over 15 years. This change can significantly increase a business’s taxable income in the short term, as deductions are deferred.

The amortization period begins at the mid-point of the tax year in which the expenses are paid or incurred. This mid-point convention means that for expenses incurred throughout a tax year, only half of the first year’s annual amortization amount is deductible in that initial year. For example, if a business incurs $100,000 in domestic Section 174 expenses during 2024, the total annual amortization over five years would be $20,000. Due to the mid-point convention, the deductible amount for 2024 would be $10,000.

Even if property related to the R&E expenditures is disposed of, retired, or abandoned, the amortization of these expenses must continue over the original period. This means a business cannot accelerate the deduction of remaining unamortized costs upon the cessation of a project or sale of an asset. The requirement to amortize these expenses applies regardless of whether a business claims the R&D tax credit.

Identifying and Classifying Section 174 Expenses

Properly identifying and classifying Section 174 expenses is an important internal process for businesses. This involves a thorough review of various cost categories to determine which expenditures qualify as research and experimental activities. Businesses need robust record-keeping systems to accurately track these costs throughout the year.

Direct costs directly attributable to R&E activities are often the most straightforward to identify. These include employee wages for individuals directly engaged in research, lab materials, and supplies consumed during experiments. Contract research expenses, which are payments made to third parties for R&D services, also fall under this category.

In addition to direct costs, Section 174 can also encompass certain indirect costs. These might include a portion of overhead expenses such as rent, utilities, and depreciation of equipment used in R&E activities, provided they are directly attributable to the research function. Companies must meticulously break down these costs to ensure accurate classification.

A crucial aspect of classification is differentiating between domestic and foreign R&E costs. This distinction is important because domestic expenses are amortized over five years, while foreign expenses are amortized over 15 years. Businesses with international operations must maintain separate records to track the geographic origin of their research activities. Establishing clear internal accounting policies and procedures is therefore necessary to ensure compliance with these differing amortization periods.

Reporting Section 174 Expenses on Tax Returns

Once Section 174 expenses have been identified, classified, and their amortization calculated, they must be properly reported on federal income tax returns. The primary form used for this purpose is Form 4562, Depreciation and Amortization. This form is designed to report various types of depreciation and amortization deductions, including those related to research and experimental expenditures.

Specifically, Section 174 amortization is typically reported in Part VI of Form 4562, titled “Amortization.” Here, businesses will list the description of the costs, the date amortization began, the total amortizable amount, and the current year’s amortization deduction.

After completing Form 4562, the total amortization amount is then carried over to the appropriate line on the business’s main tax return. For corporations, this would generally be Form 1120, U.S. Corporation Income Tax Return. Sole proprietorships report these amounts on Schedule C (Form 1040), Profit or Loss From Business, while partnerships and S corporations report them as separately stated items on their respective Schedules K and K-1. The IRS has provided procedural guidance for taxpayers to properly apply these new rules and make the necessary accounting method changes.