IRC Section 174: Domestic and Foreign R&E, Software, and Credits

For tax years beginning after December 31, 2024, the rules under IRC Section 174 for deducting research expenditures split in two: domestic research and experimental costs are again immediately deductible under new Section 174A, while foreign research costs must still be capitalized and amortized over 15 years under the amended Section 174. The One Big Beautiful Bill Act, signed July 4, 2025, created this split and largely undid the mandatory capitalization that the Tax Cuts and Jobs Act imposed starting in 2022.¹ Where you spend the money now matters more than when you spend it.

What Counts as a Research or Experimental Expenditure

Both Section 174 and Section 174A use the same definition. The core test is whether the taxpayer faces genuine technical uncertainty at the time the money is spent. Uncertainty exists when available information does not establish whether a product can be developed, what method will work, or what design is appropriate.² The work must be technical in nature and aimed at resolving a specific challenge that standard engineering practices cannot already solve.

Qualifying costs typically include running laboratory facilities, paying salaries for engineers and technicians conducting experiments, buying supplies consumed during testing, and developing pilot models or inventive processes. Attorney fees for preparing and filing patent applications also qualify.³ The project does not have to succeed for the spending to qualify.

Several categories are specifically excluded:²

Land and depreciable equipment used in research follow standard depreciation rules. The depreciation deductions themselves on research equipment can be treated as research expenditures.
Quality control testing of materials or finished products for shipping purposes.
Efficiency surveys, management studies, and consumer surveys.
Advertising and promotional costs, however innovative.
Purchasing another party’s patent, model, or production process. You cannot claim R&E treatment for work someone else already completed.
Costs to locate or evaluate deposits of ore, oil, gas, or other minerals, which are governed by separate depletion rules.⁴

Domestic Research Under Section 174A

For tax years beginning after December 31, 2024, any domestic research or experimental expenditure can be deducted in full in the year it is paid or incurred. This is the default treatment, and no election is required.⁴ “Domestic” means any research expenditure not attributable to foreign research within the meaning of Section 41(d)(4)(F). Research performed in the United States, the District of Columbia, or U.S. possessions qualifies.

A taxpayer who prefers to spread the deduction can elect instead to capitalize domestic R&E costs and amortize them over a period of at least 60 months, starting in the month the taxpayer first realizes benefits from the research. The election must be made by the filing deadline (including extensions) for the year it applies to. Once made, the chosen method and amortization period apply for that year and all following years unless the IRS approves a change. Most businesses will prefer the immediate deduction, but the election can be useful in years when taxable income is already low.

Foreign Research Under Section 174

Foreign research expenditures get much less favorable treatment. Section 174, as amended, now applies solely to research attributable to work conducted outside the United States and its possessions. Those costs must be capitalized and amortized over 15 years.⁵

A mid-year convention applies. Regardless of when during the year the money is spent, amortization begins at the midpoint of the taxable year. For a calendar-year taxpayer, that means July 1.³ Because of the convention, the deduction actually spans 16 tax years, with a half-year allowance in the first and last years and full-year deductions in between. The annual rate works out to roughly 6.67%, with approximately 3.33% in the first and sixteenth years.

Abandoning the project does not accelerate the remaining deduction. If property connected to foreign R&E spending is disposed of, retired, or abandoned before the 15-year period ends, the unamortized balance must continue to be written off over the original schedule.³ The taxpayer also cannot reduce the amount realized on a sale by the unamortized R&E costs.¹

One narrow exception exists. A corporation that ceases to exist in a transaction not covered by Section 381(a), essentially a liquidation rather than a merger, can deduct its remaining unamortized foreign R&E costs in its final tax year. This does not apply if the transaction was structured primarily to claim that deduction.³

Software Development

Both Section 174 and Section 174A explicitly treat software development costs as research expenditures. Any amount paid or incurred to develop software is classified as R&E regardless of whether the project involves genuine technical uncertainty.⁴ Domestic software development is immediately deductible starting in 2025. Software development performed overseas gets the 15-year treatment.

The R&E classification covers coding, testing, architecture work, and upgrades that add new functionality or materially improve speed or efficiency. It includes salaries for the engineers doing the work, cloud computing resources used during development, and related facility costs.³ Routine maintenance does not. Bug fixes, diagnostic work, and error corrections performed after software is placed in service are ordinary business expenses. The dividing line is whether the work creates something the software could not previously do or merely keeps existing features running.

Website costs like web hosting, domain registration, and content entry are not software development and should not be capitalized as research expenditures.³

Contract Research and Offshore Arrangements

When a business hires an outside firm to perform research, the hiring party (the “research recipient”) typically treats the payments as its own R&E costs. The contractor performing the work can also have R&E expenditures of its own, but only if one of two conditions is met: the contractor bears financial risk of the research failing, or the contractor retains a right to use, sell, or license the resulting technology.³

A contractor performing work for a flat fee with no ownership stake and no risk of loss generally has no R&E expenditures to capitalize or deduct. Know-how picked up along the way does not count as an R&E product unless it qualifies for patent, copyright, or similar legal protection. For offshore development, the contractor’s geographic location controls whether the hiring party faces a 15-year amortization schedule or an immediate deduction.

Coordination With the Section 41 Research Tax Credit

The Section 41 credit and the Section 174/174A deduction overlap but are not identical. Section 41 is more restrictive: not every expense that qualifies for the R&E deduction qualifies for the credit. Patent procurement costs, for example, are deductible under Section 174A but do not count as qualified research expenses under Section 41.²

A taxpayer who claims the Section 41 credit must reduce the R&E deduction by the amount of the credit. You cannot get a full deduction and a full credit on the same dollar of spending.⁶ Alternatively, a taxpayer can elect a reduced credit, calculated as if the credit were reduced by the maximum corporate tax rate, and keep the full deduction. The election must be made by the filing deadline for the year, including extensions, and once made it cannot be revoked for that year.

Costs Capitalized During 2022 Through 2024

Businesses that capitalized domestic R&E costs during 2022, 2023, and 2024 under the old TCJA rules still have unamortized balances on their books. The One Big Beautiful Bill Act provides three paths.⁷

Do nothing and keep amortizing the 2022–2024 capitalized costs over the remaining months of the original five-year schedules. No election or filing change is required.
Elect a catch-up deduction. Any taxpayer can deduct the entire unamortized balance of 2022–2024 domestic R&E in the 2025 tax year, or split that amount equally between 2025 and 2026.
Small businesses can elect to apply Section 174A retroactively to all tax years beginning after December 31, 2021. This is available to taxpayers with average annual gross receipts of $31 million or less over the three tax years before 2025, and it requires amended returns or administrative adjustment requests. The deadline is July 6, 2026, or the applicable refund claim deadline under Section 6511, whichever comes first.¹

Small businesses electing the retroactive path must also retroactively apply the amended Section 280C(c) rules for every applicable year. They may make a late reduced-credit election under Section 280C(c)(2) for some or all of those years, useful when the full deduction reduction would have exceeded the benefit of the credit.⁷

Reporting and Method Changes

Businesses report R&E amortization on Part VI of Form 4562, Depreciation and Amortization, attached to the income tax return: Form 1120 for corporations, Form 1065 for partnerships, or Form 1040 for sole proprietors. A taxpayer changing accounting methods to comply with the current rules generally must file Form 3115, Application for Change in Accounting Method.⁷

The original Form 3115 gets attached to the timely filed return for the year of change. A signed duplicate must also be mailed to the IRS National Office in Ogden, Utah, no earlier than the first day of the year of change and no later than the date the original return is filed.⁸ Skipping the duplicate mailing can delay processing of the method change.

State Conformity

State conformity with the federal R&E rules varies. Some states automatically adopt the current federal treatment through rolling conformity, so the Section 174A immediate deduction flows through without adjustment. Others decoupled from the TCJA capitalization requirement years ago and already allowed immediate expensing at the state level. Still others use a static conformity date and may not incorporate the 2025 federal changes until their legislatures act. The same research expenditure could be immediately deductible on the federal return and in one state while still subject to capitalization in another, so multi-state filers should verify each state’s status before assuming the federal answer carries over.

1
United States Code. Public Law 119-21 – One Big Beautiful Bill Act, Section 70302
2
Internal Revenue Service. Audit Techniques Guide – Credit for Increasing Research Activities (IRC 41) – Qualified Research Activities
3
Internal Revenue Service. Notice 2023-63 – Guidance on Amortization of Specified Research or Experimental Expenditures Under Section 174
4
Office of the Law Revision Counsel. 26 USC 174A – Domestic Research or Experimental Expenditures
5
Office of the Law Revision Counsel. 26 USC 174 – Amortization of Research and Experimental Expenditures
6
Office of the Law Revision Counsel. 26 US Code 280C – Certain Expenses for Which Credits Are Allowable
7
Internal Revenue Service. Rev. Proc. 2025-28
8
Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method