What You Need to Know About Section 174 R&D Expense Amortization
- Laurie Chen, CPA, MBA
- Jun 4, 2023
- 2 min read
Updated: Jun 4, 2023
Section 174 and Section 41 of the Internal Revenue Code (IRC) in the United States provide tax benefits to businesses that engage in research and development (R&D) activities.
These provisions encourage companies to invest in R&D by allowing them to claim deductions or credits on their taxes.
A few examples of expenses are:
Salaries
Heat, light, and power
Drawings
Models
Laboratory materials
Attorneys’ fees, and
Depreciation on build attributable to the R&E project
Etc
Section 174 allows businesses to deduct expenses related to research and experimentation from their taxable income.
Examples of qualifying expenses include:
Salaries and wages: Paying employees who are directly involved in conducting R&D activities.
Supplies and materials: Purchasing materials, chemicals, or other supplies required for R&D projects.
Contract research: Outsourcing R&D work to third-party organizations, like universities or specialized research firms.
Depreciation: Allocating the costs of property, plant, and equipment used in R&D projects over their useful lives.
Software development: Creating or modifying software for R&D purposes, including designing, coding, and testing
Section 41, also known as the Research and Development (R&D) Tax Credit, allows businesses to claim a tax credit for a portion of their qualified research expenses.
Examples of qualifying expenses include:
Wages: Salaries and wages paid to employees who are directly engaged in qualified research activities or who are directly supervising or supporting such activities.
Supplies: Costs of materials, supplies, and other items used in conducting qualified research activities.
Contract research: Payments made to third parties for conducting qualified research activities on behalf of the taxpayer, subject to certain limitations.
Basic research payments: Payments made to qualified educational institutions, scientific research organizations, or grants to qualified organizations for basic research
Both Section 174 and Section 41 provide incentives for businesses to invest in research and development activities, fostering innovation and technological advancements.
However, prior to 2022, companies used to be able to deduct Section 174 expenses in the year they incurred fully.
Now, with the expiration of the tax law change, you are required to amortize those expenses.
Let’s dig into the details of this change...
Suppose a business spends $100,000 on domestic research activities….
In 2021, the business could deduct the full $100,000 of Sec. 174 expenses in 2021.
However, starting in 2022, the business will have to deduct the $100,000 incrementally over a five-year period.
This change can cause an unexpected increase in taxable income, especially in the first few years that the new rules apply, due to the reduction of currently allowable deductions.
Most businesses, and even tax firms are unaware of this year due to the assumption that this law change would be extended past 2021. This did not happen and therefore businesses have not been accounting for “deductible expenses” to reclassify into “amortized expenses”.
Therefore, estimated payments made in 2022 may be understated
In addition, amortization may not have occurred and will be up to the business to recognize this and clean up the books to reflect these changes.
This may mean more work for businesses and owing more in taxes than originally thought.
