Section 174: R&E Expenditures, Amortization, and Software Costs

Section 174 of the Internal Revenue Code, which governs research and experimental expenditures, now runs on a split system. For tax years beginning in 2025 and later, domestic research costs can once again be deducted in the year incurred under a new Section 174A, while foreign research still has to be capitalized and amortized over 15 years. Between 2022 and 2024, all research costs had to be amortized, and small businesses that filed under those rules may be able to amend those returns for retroactive relief.

What Counts as a Research or Experimental Expenditure

Treasury Regulation 1.174-2 sets the core test. A cost qualifies if it relates to activities meant to discover information that would eliminate uncertainty about developing or improving a product. Uncertainty exists when what you already know does not establish the method, capability, or appropriate design.¹ The focus is on the nature of the activity, not the sophistication of the technology or the type of product.

The scope is broad. IRS interim guidance identifies several categories of specified research or experimental expenditures:

Wages and benefits (including fringe benefits beyond W-2 Box 1) for employees directly performing research
Supplies and materials consumed during testing, prototyping, or experimentation
Amounts paid to outside contractors, research institutes, or engineering firms performing research on your behalf¹
Overhead such as rent, utilities, and depreciation on property used in research, allocated to the extent it supports the work
Patent costs, including attorney fees and filing costs²

Payments to third parties count the same as work done in-house. Hire an engineering firm to run experiments for you, and those invoices are research expenditures.¹

What Does Not Qualify

Several categories of spending look like R&D but sit outside Section 174:

Quality control testing on finished products
Efficiency surveys and management studies
Consumer surveys, advertising, and promotions
Purchasing another company’s product rather than developing your own
Literary or historical research
Mineral exploration for oil, gas, or ore deposits³

Costs to acquire or improve land, or to purchase equipment with its own depreciable life under Section 167, are also excluded. The annual depreciation on that research equipment, however, does get swept into your Section 174 calculation.³ A $200,000 testing machine is capital under normal rules, but the depreciation deductions running off of it are treated as research expenditures.

Costs incurred after uncertainty has been eliminated and production begins fall outside the provision. That line between development and manufacturing is where many businesses run into trouble during audits.²

Current Rules for 2025 and Later

The One Big Beautiful Bill Act, signed into law on July 4, 2025, restored immediate expensing for domestic research costs under a new Section 174A, effective for tax years beginning in 2025. You can deduct qualifying domestic costs in the year incurred, elect a 60-month amortization period, or choose a 10-year period if that fits your planning better.

Foreign research or experimental expenditures still have to be capitalized and amortized over 15 years using a mid-year convention.³ The mid-year convention treats all expenditures as incurred at the midpoint of the year, which for calendar-year taxpayers is the first day of the seventh month, so only a half-year of amortization is allowed in the first and last years of the schedule.²

The 2022 Through 2024 Amortization Period

For tax years beginning after December 31, 2021 and before 2025, the Tax Cuts and Jobs Act required every research and experimental expenditure to be capitalized. No immediate deduction was allowed. Domestic costs recovered over five years, foreign costs over 15, both with the mid-year convention. A calendar-year business recovered domestic costs at roughly 10% in year one, 20% in each of the next four years, and 10% in year six.²

Small businesses got a retroactive break in the 2025 law. If your average annual gross receipts across the 2022, 2023, and 2024 tax years were $31 million or less, you can amend your 2022 and 2023 returns to claim relief from the amortization requirement for those years. If that describes you, running the numbers on an amended return is likely worth the accounting cost.

Software Development Costs

The statute treats any amount paid or incurred for software development as a research or experimental expenditure, whether or not the work involves the traditional uncertainty test.³ Internal-use software, software built to sell or license, coding, testing, architecture design, and quality assurance labor all fall in.

The capitalization period runs from the start of development until uncertainty about the product has been eliminated. Costs after that point fall outside the provision.² For most software projects, that line falls around the completion of beta testing or the first commercially viable release. Ongoing maintenance and minor bug fixes are ordinary business expenses. Significant upgrades that add new functionality or require substantial design work restart the analysis and likely qualify as new research expenditures.

This line matters more for software companies than almost any other industry because labor is their dominant cost. Misclassifying six months of developer wages can create real exposure. Detailed time-tracking records and clear documentation of each project phase put you in a much stronger position if the IRS asks.

How This Interacts With the Section 41 R&D Credit

Section 174 and the Section 41 research credit overlap but do not match. Section 174 defines which costs must be capitalized or expensed. Section 41 provides a separate credit calculated from a narrower set of qualified research expenses, limited primarily to wages, supplies, and contract research performed in the United States. Section 174 casts a wider net, picking up overhead, benefits, patent costs, and foreign research that Section 41 ignores.

If you claim the credit, Section 280C(c) forces a coordination choice. By default, you have to reduce your deductible research expenditures by the amount of the credit. You can’t get both a full deduction and a full credit on the same dollar. The alternative is the reduced credit election: you take a smaller credit (regular credit minus the credit times the maximum corporate tax rate) and keep your full deduction.⁴ At a 21% corporate rate, that’s roughly 79% of the credit. The election must be made on the original, timely filed return (including extensions) and is irrevocable for that tax year.⁵ Which option saves more depends on your numbers, so run both before filing.

Abandoned or Retired Projects

For foreign research still subject to 15-year amortization, the statute prohibits any accelerated write-off if you abandon a project. You keep amortizing over the original schedule as though nothing happened.³ The same rule applied to domestic research during the 2022 through 2024 amortization period.² A narrow exception: if a corporation completely ceases to exist in a transaction where Section 381(a) doesn’t apply, it can deduct the remaining unamortized balance on its final return. If the corporation is acquired in a Section 381(a) transaction, the acquirer inherits the schedule.

For domestic research going forward, this trap is largely gone since costs are expensed immediately. For foreign R&D, plan around the possibility that a failed project’s costs will keep reducing taxable income only at the original pace.

Forms and Records

Several forms come into play depending on the situation:

Form 4562 reports depreciation and amortization, including any research expenditures still on a multi-year schedule (primarily foreign R&E costs for current filings).⁶
Form 6765 calculates the Section 41 credit, including the reduced credit election under Section 280C(c).⁵
Form 3115 is required for any change in accounting method, including the initial switch to capitalization under TCJA. The IRS treats that change as taxpayer-initiated with automatic consent, applied on a cut-off basis with no Section 481(a) adjustment.⁷⁸

These attach to Form 1120 for C corporations, Form 1065 for partnerships, or Form 1120-S for S corporations. Before filing, pull together W-2 wage records, contractor invoices, supply receipts, and overhead allocation workpapers to support the numbers on the return.

The general recordkeeping period is three years from the filing date. It extends to six years if more than 25% of gross income goes unreported, and to seven years if a loss from worthless securities or bad debt is involved.⁹ For expenditures still on a multi-year schedule, keep the underlying documentation for at least three years after the final amortization deduction, since the IRS can examine any year in which the deduction appears.

Penalties for Getting It Wrong

Improper handling carries the accuracy-related penalty under Section 6662, which adds 20% of any underpayment attributable to negligence or a substantial understatement. Deducting research costs that should have been capitalized, or capitalizing costs that belong somewhere else, exposes you to the penalty if the resulting shortfall is large enough. For individuals and pass-throughs, an understatement is substantial if it exceeds the greater of $5,000 or 10% of the tax that should have been on the return. For C corporations (other than S corporations), the threshold is the lesser of 10% of the required tax (or $10,000, whichever is greater) and $10 million.¹⁰ Reasonable cause and good faith, backed by contemporaneous documentation, can defeat the penalty.

1
eCFR. 26 CFR 1.174-2 – Definition of Research and Experimental Expenditures
2
Internal Revenue Service. Notice 2023-63 – Guidance on Amortization of Specified Research or Experimental Expenditures Under Section 174
3
Office of the Law Revision Counsel. 26 USC 174 – Amortization of Research and Experimental Expenditures
4
Office of the Law Revision Counsel. 26 USC 280C – Certain Expenses for Which Credits Are Allowable
5
Internal Revenue Service. Instructions for Form 6765 – Credit for Increasing Research Activities
6
Internal Revenue Service. About Form 4562, Depreciation and Amortization
7
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method
8
Internal Revenue Service. Revenue Procedure 2025-8
9
Internal Revenue Service. How Long Should I Keep Records?
10
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments