Editorial · October 11, 2023
Section 174 research expenses: the 5 year amortization rule
Section 174 research expenses can no longer be deducted all at once for most businesses. Starting with tax years that begin after December 31, 2021, you must spread those costs over five years if the work was done in the United States. If the work was done abroad, the period is 15 years. This guide explains what counts, how the math works, and what to track.
What changed in the law
For decades, a business could deduct research and experimental costs in the year it paid them. Congress changed that in the Tax Cuts and Jobs Act, signed in December 2017. Section 13206 of that law rewrote section 174 of the tax code. It took effect for tax years that begin after December 31, 2021.
Under the new rule, you may not deduct these costs right away. You must record them as a capital cost. Then you deduct them in equal parts over time. Domestic research uses a 5 year period. Research done outside the United States uses a 15 year period. The tax code calls these costs "specified research or experimental" expenses, often shortened to SRE.
Software development is included
Many owners miss this part. The same law says that money spent to develop software is treated as a research cost. That is true even if the work has nothing to do with a lab. A company that builds its own app, tool or website feature may be affected.
IRS Notice 2023-63 gives examples. Planning, designing, and building a model of the software count. So does writing source code and testing it. For software you build for your own use, these costs count until the software is placed in service. For software you plan to sell or license, they count until it is ready for sale.
Some work does not count. The notice says that training staff, fixing bugs after launch, converting data, and installing the software are not software development. Buying software off the shelf and setting it up is also outside the rule.
What the IRS said on September 8, 2023
The rule was clear in the law, but many questions were not. On September 8, 2023, the IRS and the Treasury Department released Notice 2023-63. It is interim guidance. It also says that the agencies plan to issue proposed rules later. Until then, taxpayers may rely on the notice.
The notice does not change the research credit under section 41. That credit has its own rules and its own definitions. A cost can be a section 174 cost and still not earn the credit.
The notice also covers cost types. It lists labor costs, such as pay, payroll taxes, benefits, and stock pay for people who do or directly support the work. It lists supplies and tools that are used up in the work. It lists depreciation on equipment used for the work, patent costs, and a share of rent, utilities and similar overhead. It says costs that only indirectly help the work, such as payroll staff who cut checks for researchers, are not included.
How the five year math works
You do not get a full year of deductions in year one. The law starts the clock at the midpoint of the tax year. For a full 12 month year, the midpoint is the first day of the seventh month. A business on the calendar year gets six months of deductions in the first year.
Here is a simple example. Say a calendar year business spends $100,000 on domestic software development in 2023. The five year period is 60 months. Each month is worth about $1,667. Six months in the first year gives a deduction of $10,000. The business then deducts $20,000 in each of the next four years. The last $10,000 comes in the sixth year.
The notice also adds a harsh point. If you stop using the property or give up on the project, you cannot deduct the rest at that time. The law says the deduction continues over the original period.
What to track now
Good records matter more under this rule. Start with a few simple habits.
- List each project that involves research, testing or software development.
- Record the hours that staff and contractors spend on each project.
- Keep invoices for supplies, tools and outside developers.
- Note where the work was done, since the United States and foreign work follow different periods.
- Separate costs that the notice says are not included, such as staff training and routine bug fixes.
If you already filed a return for a tax year that began in 2022 and did not apply the rule, speak with a tax professional. The notice points to the existing IRS procedure for changing an accounting method, found in Revenue Procedure 2023-24. This article is general information and is not tax advice.
Sources
- Internal Revenue Service, Notice 2023-63, Guidance on Amortization of Specified Research or Experimental Expenditures under Section 174, released September 8, 2023.
- Public Law 115-97, the Tax Cuts and Jobs Act, section 13206, December 22, 2017.