Since its enactment almost six decades ago, Section 174 of the IRC has enabled companies of all sizes to amortize their research and development expenditures.
The 2017 Tax Cuts and Jobs Act changes of Section 174 introduced mandatory capitalization and effectively increased the taxable income of businesses that invest in product research. The law went into effect on January 1, 2022.
Furthermore, the House bill H.R 3938 Build It In America that has yet to pass the House or Senate contains an upgrade of Section 174 that enables businesses to immediately deduct any R&D expenses they might have up to December 31, 2025.
Businesses of all sizes can rely on Section 174 of the IRC to reduce their tax liability by capitalizing or amortizing R&D costs. Let’s see which entities qualify for the IRC Section 174 capitalization.
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A Quick Glance at the IRC Section 174
Section 174 was added to the IRC in 1954 with the aim of encouraging businesses to experiment and research. Since then, the section has undergone several changes, including the changes introduced by the TCJA of 2017.
Starting from December 31, 2021, companies can only amortize R&D costs over five years or a 15-year period for R&D projects conducted abroad.
The TCJA removed the option to utilize a ten-year amortization period by electing to defer expenditure under Section 59 of the IRC.
Increased tax liability of businesses that invest in research, experimentation, and development and the resulting decrease in R&D investments are byproducts of the changes introduced by the TCJA.
The American Innovation and Jobs Act and several pending House bills address these issues by allowing businesses to claim R&D deductions against taxable income for the current tax year.
The purpose of this IRC section is to allow businesses from all industries to either amortize or deduct R&D costs. Under current legislation, amortization and capitalization election is mandatory, which increases the liabilities companies that invest in R&D have to cover.
Determining the IRC Section 174 Eligibility
All businesses, regardless of their size, are eligible for R&D amortization under IRC Section 174 if their expenses meet the research and experimentation criteria.
However, this IRC section primarily applies to the following types of business entities:
- S Corporations: All pass-through entities, including S Corporations, can use Section 174 to amortize R&D costs.
- Startups: The company’s profitability isn’t among the eligibility criteria. Consequently, startups and all other types of small businesses can amortize or capitalize R&D expenses with Section 174.
- LLCs, Sole Proprietorships, and Partnerships: Entities registered as LLCs, partnerships, or sole proprietorships can benefit from IRC Section 174.
- Corporations: All types of corporations with qualifying expenses can amortize domestic R&D expenditure over five years.
The Four-Part Test
The funds businesses invest in experimentation and research must meet specific criteria to become eligible for capitalization under Section 174. The expenditure must pass the so-called four-part test before it can be amortized under this IRC section.
Most importantly, only research funding related to a trade or business can qualify for Section 174.
- The research must be technological in nature: Section 174 treatment is permitted if the expenditure was utilized to fund research based on computer science, physics, etc.
Consequently, funds used for the research of product quality control, research conducted within literary projects, or advertising campaigns don’t qualify for Section 174 treatment.
- The Business Component Test: The information acquired through research and experimentation must be utilized to develop a product a company can sell, license, lease, or use in the business’s daily operations.
- R&D Cost in the Laboratory or Experimental Sense: The expenditure qualifies for Section 174 treatment if it is used to gather information that eliminates uncertainty regarding the product’s improvement or development.
- Experimentation test: A business entity must identify an uncertainty, find one or more alternatives and evaluate each alternative to satisfy the Process of Experimentation requirement.
According to the IRS: ‘Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.’
Qualifying Expenses for Section 174 Capitalization
Taxpayers cannot use Section 174 for the funds they spend on activities such as management studies, testing of materials, or routine data collection.
The IRS disallows Section 174 treatment for exploration expenditures, so businesses that invest in discovering or determining the quality of oil, ore, gas, or different minerals can’t use it to capitalize and amortize their expenses.
In addition, deducting costs of depreciable properties or land under Section 174 isn’t possible.
Businesses can rely on this IRC section to amortize their expenses before they start commercial production. Hence, costs of data acquisition regarding the production process, acquiring the necessary tools, or production planning aren’t deductible.
Here’s an overview of expenses that qualify for Section 174 treatment.
- The costs of research contracts: Businesses that hire external teams or use the services of third-party companies can amortize or capitalize their expenses under Section 174.
- Expenditure related to patent registration: Section 174 allows taxpayers to capitalize costs registering the patents of software and other products developed through experimentation and research.
- Compensation paid to researchers: Wages and salaries a company pays to the personnel that conducts, supports, or supervises the research are deductible under this section.
- Costs of materials: Businesses can use Section 174 to capitalize and amortize the costs of acquiring the materials and computer supplies necessary to conduct research.
- Indirect expenses: Equipment depreciation, laboratory utility bills, rent, attorney fees, and similar costs required to complete the research process qualify for Section 174 treatment.
State Conformity and IRC Section 174
The extent to which businesses can utilize Section 174 also depends on how a state where they’re registered and pay taxes conforms with the changes of the IRC.
Some states like New York or Illinois conform with the IRC on rolling bases as they adapt all changes of the IRC as soon as they occur. Consequently, the changes of Section 174 introduced under TCJA became effective at the start of 2022.
On the other hand, states like Florida or Virginia adapt to the changes of the IRC on a static basis, meaning that they enact new legislation annually to conform to the IRC.
Several states, including Arkansas and Oregon, conform to the IRC selectively and retain the right to adopt only specific parts of the IRC. Rolling and static conformity states can decouple from federal tax laws.
Consequently, California, a static conformity state, elected to decouple from the TCJA, so businesses registered in this state don’t have to comply with new Section 174 rules.
It’s also worthwhile adding that state conformity with Section 174 can also depend on the business entity’s structure due to differences in how corporations or pass-through organizations treat R&D expenditures.
Differences Between IRC Section 174 and Section 41
Both sections of the IRC define the rules and conditions under which companies can amortize R&D expenditure. However, the scope of costs Section 41 covers is much narrower than the scope of Qualified Research Expenses included in Section 174.
Most notably, taxpayers cannot deduct software development costs under Section 41, which isn’t the case with Section 174.
IRC Section 41 applies to wages a company pays to personnel conducting research, the materials required to complete a research, and contracts of third-party researchers. Moreover, the section only covers the costs of research conducted within the United States.
Section 174 allows companies that invest in research projects abroad to capitalize and amortize their foreign research expenditure over 15 years.
The R&D tax credit isn’t available to businesses that sustain tax losses during a tax year, so under Section 41, a company in the tax loss position cannot amortize qualified research expenses.
The TJCA changes of Section 174 make identifying, disclosing, and amortizing R&D expenses mandatory for all companies, regardless of their tax position or intent to claim this tax credit.
Section 174 changes don’t affect how Section 41 R&D credits are calculated because it refers to a much more comprehensive range of expenses.
Frequently Asked Questions
Companies must file Form 3115 to request a change in accounting method due to the recent Section 174 changes.
Taxpayers are also required to file a statement containing the list of R&D costs incurred during the tax year, technical documents, financial records, and IRS Form 4562 with their tax returns.
The most recent version of this IRC section allows businesses to expense costs of software developed for internal use. Consequently, companies can use Section 174 to amortize the expenses of coding, testing, and installing such software.
Under current regulations, accepting funded research, including research grants, makes companies ineligible for Section 174 amortization.
Businesses with overlapping Section 174 and Section 41 R&D expenditures must make the reduced credit election under Section 280C.
Deducting R&D Costs with IRC Section 174
The goal of IRC Section 174 is to facilitate technological advancement by encouraging businesses to invest in product research and development. Its future remains uncertain, and it’s currently impossible to tell how long it will remain in its present form.
The TCJA introduced changes to this section, increasing the tax burden on companies with significant R&D expenditure.
California and several other states decoupled from the TCJA, allowing businesses to continue deducting the full R&D expenditure in accordance with the section’s earlier version.
Depending on their location, businesses might struggle to navigate IRC Section 174 R&D deductions in the upcoming tax year because the proposed amendments of this section are unlikely to go into effect before the start of the 2023 filing season.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
