Section 174 Expenses: Deduction Rules, Amortization, and R&D Credit

Section 174 expenses are the research and experimental costs a business pays to develop or improve a product, process, formula, invention, or piece of software. Starting with tax years beginning after December 31, 2024, new Section 174A permanently restores full expensing for domestic research costs, ending the stretch from 2022 through 2024 when businesses had to capitalize those costs and amortize them over five years.¹ Foreign research expenses still must be capitalized and amortized over 15 years, and software development costs of any kind remain Section 174 expenses regardless of where or how the software is built.²

What Qualifies Under Section 174

A cost qualifies if it relates to research and development in the experimental or laboratory sense and is connected to the taxpayer’s trade or business. The core test is uncertainty. The work must be aimed at discovering information that eliminates doubt about whether a product can be developed, what method to use, or what design is appropriate.³ If your team already knows the answer and is simply executing a proven method, the activity does not meet the threshold.

“Product” is broad. It covers any pilot model, process, formula, invention, technique, patent, or similar property, whether the business plans to use it internally or sell it to customers. Qualification turns on the nature of the activity, not the sophistication of the result. A modest improvement to an existing manufacturing process can qualify just as well as a groundbreaking invention, provided there was genuine technical uncertainty at the outset.

The specific cost categories that fall under Section 174 include:

Wages and salaries paid to employees who perform the research or directly supervise it.
Materials and supplies consumed during experimentation, including prototype materials.
Overhead, meaning the share of rent, utilities, and similar facility costs attributable to research activities.
Contract research paid to outside contractors, consultants, or research organizations that perform work on the taxpayer’s behalf and at the taxpayer’s risk. The full amount paid is treated as a Section 174 expense.⁴
Patent costs, including attorneys’ fees and other expenses of making and perfecting a patent application.

Costs That Don’t Qualify

Several categories look like R&D but lack the required technical uncertainty and are excluded by the Treasury regulations:³

Quality control testing that confirms products meet existing specifications.
Efficiency surveys and management studies focused on business operations.
Consumer surveys and market research.
Advertising and promotions.
Acquiring someone else’s patent, model, or production process. That is an acquisition cost, not research.
Literary or historical research.

These excluded costs are generally deductible as ordinary business expenses under Section 162, reducing taxable income in the year paid.⁵ When amortization rules would otherwise apply on the Section 174 side, having a cost classified under Section 162 can be more favorable for cash flow, which is why the classification matters.

Software Development Is Always Section 174

Any amount paid or incurred in connection with developing software is treated as a Section 174 research expense. No exceptions, no opt-out. This applies whether the software is built for sale, for licensing, or for the company’s own internal use. The classification captures the full development lifecycle: planning functional specifications, high-level systems design, writing source code, building models, and testing, up until the software is placed in service (for internal tools) or technological feasibility is established (for software intended for sale).⁴

Cloud-based software receives the same treatment. The IRS has clarified that “computer software” includes programs and routines accessed remotely through a private network or the internet, including via cloud computing. If your company is building a SaaS platform, the development costs are Section 174 expenses just as they would be for a traditional desktop application. Some software-adjacent costs sit outside this classification: paying a hosting provider a periodic fee to run your website on its servers, and inputting content into a website, are not treated as software development.

How Domestic Research Costs Are Deducted in 2025

For tax years beginning after December 31, 2024, Section 174A permanently restores full expensing for domestic research spending. A business can deduct the full amount in the year it is paid or incurred, the same treatment that was available before 2022.¹

Section 174A also offers an optional alternative. A business can elect to capitalize domestic research costs and amortize them over a period of at least 60 months, beginning with the month the taxpayer first realizes benefits from the research. This election makes sense only in narrow situations, such as when a business wants to defer deductions to offset expected higher income in later years. Most businesses will simply take the immediate deduction.

Legacy Amortization From 2022 Through 2024

The Tax Cuts and Jobs Act required businesses to capitalize domestic research costs incurred in tax years 2022 through 2024 and amortize them over five years. Those existing schedules do not disappear now that Section 174A allows full expensing again. A company that spent $100,000 on domestic research in 2023, for example, deducted 10% in 2023, 20% in 2024, and continues deducting 20% annually through 2027, with a final 10% in 2028.⁴ Returns will need to track both the legacy amortization and any current-year full expensing.

How Foreign Research Expenses Are Amortized

Section 174A’s full-expensing rule does not reach foreign research. Any research conducted outside the United States, Puerto Rico, or U.S. territories still must be capitalized and amortized over 15 years.² What controls is where the research activities are physically performed, not where the company is headquartered or incorporated.

The amortization uses a mid-year convention. Regardless of when during the year the spending occurs, it is treated as if it happened at the midpoint of the taxable year. For a standard 12-month tax year, that midpoint is the first day of the seventh month. The first year produces a deduction equal to roughly 3.33% of the total (6 months out of 180). Subsequent full years allow about 6.67% (12 months out of 180), with the final partial amount claimed in the sixteenth year.⁴

Amortization deductions are reported on IRS Form 4562.⁶

Abandoned or Disposed Projects

If you dispose of, retire, or abandon property tied to research expenses still being amortized, you cannot accelerate the remaining deductions. The unamortized balance keeps running on its original schedule as if nothing had happened, and the unamortized costs also cannot factor into any gain or loss calculation on a sale.⁴ This rule bites most on foreign research (still on the 15-year schedule) and legacy domestic costs from 2022 through 2024. The one exception is when the corporation itself ceases to exist. In a complete liquidation or similar transaction, the remaining unamortized balance can be deducted in the final tax year.

How Section 174 Connects to the R&D Tax Credit

Section 174 classification is a prerequisite for the Section 41 R&D tax credit. A cost cannot generate a Section 41 credit unless it first qualifies under Section 174.⁷ Section 41 then layers on stricter requirements. The research must relate to a specific qualified purpose, and the uncertainty must be resolved through experimentation grounded in engineering, computer science, or the hard sciences. Patent procurement costs, for instance, qualify under Section 174 but not for the Section 41 credit.

When a business claims both, Section 280C prevents a double benefit. The default rule reduces the Section 174 deduction by the credit amount, so a $50,000 R&D credit reduces the research deduction by $50,000. A business can instead make an irrevocable election to take a reduced credit, in which case the credit is reduced by the product of the credit amount and the maximum corporate tax rate (currently 21%). That election preserves the full deduction at the cost of a smaller credit and simplifies the math for most businesses.⁸

Changing Your Accounting Method

Adjusting the treatment of Section 174 expenses, whether adopting Section 174A full expensing or correcting a prior approach, is a change in accounting method and requires IRS consent. That consent is usually obtained by filing Form 3115 during the tax year the change takes effect.⁹

For changes bringing prior years into compliance with the old TCJA version of Section 174, the Form 3115 must include a statement describing the type of expenditures, the years involved, and whether the change is being made on a cut-off basis or with an adjustment for the cumulative difference. For changes adopting the new Section 174A treatment in tax years beginning after December 31, 2024, the Form 3115 requirement is waived. Taxpayers instead attach a statement to their return using designated automatic accounting method change number 273.

1
Office of the Law Revision Counsel. 26 USC 174A: Domestic Research or Experimental Expenditures
2
Office of the Law Revision Counsel. 26 USC 174: Amortization of Research and Experimental Expenditures
3
GovInfo. 26 CFR 1.174-2 – Definition of Research and Experimental Expenditures
4
IRS. Notice 2023-63 Guidance on Amortization of Specified Research or Experimental Expenditures under Section 174
5
eCFR. 26 CFR 1.162-1 – Business Expenses
6
Internal Revenue Service. About Form 4562, Depreciation and Amortization
7
Internal Revenue Service. Audit Techniques Guide: Credit for Increasing Research Activities IRC 41 – Qualified Research Activities
8
Office of the Law Revision Counsel. 26 U.S. Code 280C – Certain Expenses for Which Credits Are Allowable
9
IRS. Revenue Procedure 2025-28