What Is the Difference Between Section 174 and Section 41?

The U.S. tax code has specific provisions for handling costs associated with research and innovation, primarily Section 174 and Section 41. While both relate to research expenses, they serve distinct purposes and have different applications. Understanding the difference is important for proper tax planning and compliance. This article will clarify the functions of these two tax code sections and explain how they interact.

The Mandate for Amortizing Research Expenditures

Section 174 of the Internal Revenue Code governs the tax treatment of “research and experimental” (R&E) expenditures. These are costs incurred for research and development in an experimental or laboratory sense. Examples include the salaries of researchers, materials and supplies used in research, utility costs for a laboratory, and costs associated with developing software.

A change from the Tax Cuts and Jobs Act of 2017 (TCJA) altered how these costs are treated for tax years beginning after December 31, 2021. Before this change, businesses had the option to immediately deduct their R&E expenses in the year they were incurred.

Current law mandates that businesses capitalize all specified R&E expenditures and amortize them over a set period. For research conducted within the United States, the amortization period is five years. For research conducted outside the U.S., the period is 15 years.

This is a required accounting method. The amortization begins at the midpoint of the taxable year in which the expense is incurred. Even if the project is abandoned, the taxpayer must continue to amortize the remaining costs over the rest of the period.

The Incentive of the Research Tax Credit

Section 41 provides for the Credit for Increasing Research Activities, known as the R&D tax credit. Unlike Section 174, Section 41 offers a tax credit, which is a dollar-for-dollar reduction of a company’s tax liability. This credit is an incentive to encourage businesses to increase their investment in domestic research.

The expenses that qualify for this credit are “Qualified Research Expenses” (QREs), a narrower subset of the R&E expenditures under Section 174. QREs include in-house research expenses like wages and supplies. They also include 65% of the amounts paid to third-party contractors for qualified research.

To be considered a QRE, the underlying activity must satisfy a four-part test.

• The research must be for the purpose of creating a new or improved business component, such as a product, process, or software.
• The process of experimentation must rely on principles of the physical or biological sciences, engineering, or computer science.
• The taxpayer must demonstrate that the research was intended to eliminate uncertainty regarding the capability, method, or design of the business component.
• A process of experimentation must be used to evaluate one or more alternatives, such as modeling, simulation, or a systematic trial and error methodology.

Key Differences in Purpose and Application

The distinction between Section 174 and Section 41 is their purpose and application. Section 174 establishes a mandatory accounting rule for the timing of cost recovery. It dictates that all specified R&E expenditures must be capitalized and amortized.

Section 41, conversely, provides an optional tax incentive. It allows businesses to claim a tax credit to reduce their tax liability for conducting specific research activities. The purpose is to encourage companies to increase their spending on innovation within the United States.

This difference in purpose affects the scope of expenses each section covers. Section 174 applies to a broad category of R&E expenditures. Section 41 applies to a narrower set of QREs that must meet the four-part test, meaning a company will have more Section 174 expenses than QREs.

Calculating the Combined Tax Impact

When a business claims the research tax credit under Section 41, rules prevent a “double benefit” on the same expenses. A company is required to reduce its amortizable R&E expense base only if the research credit claimed in a year is greater than the amortization deduction for that same year.

Given the multi-year amortization schedules, it is uncommon for the annual credit to be larger than the annual amortization deduction. As a result, most businesses that claim the full research credit are no longer required to reduce their R&E expense base.

Tax law also includes an election to take a reduced research credit in exchange for avoiding any reduction to the R&E expense base. However, because the requirement to reduce the expense base is now rare, the strategic value of making this election has diminished for most businesses.