How Does Section 174 Impact the Taxes Owed by Your Startup to the IRS?

Section 174 Capitalization and Amortization | R&E

What is Section 174 in R&D Tax?

Section 174 marks a recent addition to the tax code, applicable from the tax year 2022 onward. It introduces changes to the calculation of profits for corporate taxes.

This regulation holds implications for all startups, mainly those already generating revenue, including global startups. Notably, it can lead to a scenario where startups with revenue but no tangible profits may face a substantial tax obligation.

The critical shift introduced by Section 174 is that R&D expenses are no longer immediately deducted; they are spread out over a specified period (5 years for the U.S. and 15 years for international operations).

As of tax years commencing in 2022 or later, taxpayers are obligated to capitalise and amortise research and experimental (R&E) expenses over either five or 15 years. This alteration carries significant implications for a diverse array of companies, influencing both financial statements and tax returns. Given the ongoing struggle to reverse this legislative change, businesses are advised to identify affected costs and evaluate the resulting impacts proactively.

What constitutes Section 174 research and experimental expenditures?

For federal income tax purposes, Section 174 encompasses a comprehensive range of costs incurred by companies in the course of developing or enhancing a product or process. These expenditures typically relate to activities aimed at resolving "uncertainty" and involve questions regarding capability, methodology, or the appropriateness of design. 

In practical terms, this definition is expansive and encompasses diverse expenses.

Direct costs under Section 174 may encompass:

  • Wages
  • Supplies
  • Computer rental (including cloud computing)
  • Third-party contractor costs directly linked to the R&E activity

Indirect costs under Section 174 may encompass the following:

  • Rent
  • Utilities
  • Overhead
  • Allowance for the depreciation of property used in research-related activities
  • Attorney fees associated with the creation and perfection of patents
Also, check out Inkle’s Free Online Section 174 Tax Calculator:

Which businesses will feel the impact?

A diverse array of companies is poised to be affected by the requirement to capitalise and amortise Section 174 expenditures. This includes businesses that:

  • Claim R&D credits
  • Report book R&D on ASC 740
  • Internally develop software
  • Engage in the development of new or improved products or processes
  • Have inventory subject to UNICAP rules

How will recent revisions affect my financials and tax obligations?

The Tax Cuts and Jobs Act (TCJA) amended Section 174 concerning the federal income tax treatment of research & experimental (R&E) expenditures incurred for tax years starting post-December 31, 2021. Previously, companies could deduct such costs for federal income tax purposes or use alternative recovery methods. 

However, the new regulations necessitate capitalisation and dictate a recovery period of 5 years for domestic R&E/15 years for foreign R&E. Notably, the updated rules explicitly categorise software development costs as R&E expenditures, subjecting them to the same capitalisation and recovery guidelines.

Despite anticipating a legislative change to reinstate R&E expensing, Congress still needed to enact a deferred capitalisation provision. While negotiations may resume, companies must evaluate the repercussions of these rules on their financial statements. 

The rules introduce new and substantial book-tax differences and associated deferred tax assets. Effective tax rates may be affected, particularly concerning other tax calculations. 

Given legislative challenges, companies should be prepared to account for this change in tax compliance, planning, and payment considerations.

What are the challenges in implementing and maintaining these changes?

Companies will be tasked with establishing a method to identify and track all research and experimental (R&E) expenditures falling under Section 174. This undertaking is likely significant due to these provisions' broad and subjective nature. 

As mentioned earlier, many costs traditionally not classified as "R&E" may now be subject to Section 174 capitalisation. Even companies that initially believe they have a roadmap for cost identification through historical Research Tax Credit (RTC) computations or financial statement reporting methods (such as ASC 740 or tracking software development expenses) may discover that these starting points do not offer a comprehensive approach to account for all R&E costs subject to capitalisation. 

Additionally, with limited near-term guidance expected from the Treasury and the IRS, companies will need to navigate several technical considerations.

However, identifying these costs is only the beginning, as the mandated capitalisation and amortisation under Section 174 can influence various other tax computations. 

  • Interest expense limitation computations under Section 163(j)
  • State/local tax reporting, particularly in states that have yet to conform with the Tax Cuts and Jobs Act.
  • Treatment of Research and experimental payments between related parties (e.g., a U.S. parent paying for Research and experimental conducted on its behalf by a Controlled Foreign Corporation).
  • Computations under the foreign-derived intangible income (FDII) & global intangible low-taxed income (GILTI) regimes.
  • Determination of excludable Section 174 costs for Section 263A computational purposes.


Which entities fall under Section 174 capitalisation?

In brief, Section 174 applies to any taxpaying entity that incurs qualifying research and development (R&D) costs, irrespective of industry or business size. Specifically, various types of businesses are affected, including:

  1. Corporations: Regardless of size, corporations that have incurred qualifying R&D costs are subject to Section 174 capitalisation.
  1. Small businesses, including startups: Regardless of their current profitability status, small businesses and startups heavily invested in R&D have the option to capitalise or amortise their research expenses.
  1. Sole proprietorships, partnerships, and LLCs: These entities can also benefit from Section 174 if they have qualifying R&D expenses.
  1. Pass-through entities, including S-corporations: These entities can utilise Section 174 for eligible costs associated with R&D. Moreover, R&D credits can be passed through to partners, individual shareholders, or members.

What types of costs are subject to Section 174 capitalisation?

Various categories of expenses can fall under Section 174 capitalisation:

  1. Salaries and wages: The salaries/wages of employees engaged in or directly supervising or supporting research activities can be subject to capitalisation.
  1. Supplies and materials: The costs associated with supplies used in the research process, ranging from lab equipment to necessary software, can be subject to capitalisation.
  1. Patent costs: Expenses related to obtaining patents for a product/process developed through research activities can be capitalised.
  1. Overhead expenses: Certain indirect expenses, such as utilities for a research lab or depreciation on research equipment, can be allocated to research activities and thus subject to capitalisation.
  1. Contract research expenses: If a third party is enlisted to conduct research on behalf of a company, the associated costs can be subject to capitalisation.

What types of items are not eligible for Section 174 deductions?

Section 174 does not allow deductions for all research and development (R&D) expenses. For instance, costs related to land or depreciable properties are not deductible. 

Furthermore, costs associated with research conducted post the commencement of commercial production, marketing research, quality control, and funded research (including research supported by grants, contracts, or any external funding) are generally excluded from Section 174 deductions.

What is considered Research and Development (R&D) as defined by Section 174?

For tax purposes, meeting the following four-part test outlined by the Internal Revenue Service is necessary to qualify for the R&D credit:

  1. Business purpose: The research must aim to benefit a business component, encompassing products, processes, computer software, techniques, formulas, or inventions intended for sale, lease, license, or use in the company's trade or business.
  1. Technological in nature: The development of the business component must be rooted in a hard science discipline, such as engineering, physics, chemistry, life or biological sciences, or computer sciences.
  1. Elimination of uncertainty: The activity must seek to discover information that would reduce uncertainty about developing or improving a product or process.
  1. Process of experimentation: The business must assess multiple design alternatives or employ a systematic trial-and-error approach to overcome technological uncertainty.

Which states align with Section 174?

To determine conformity to Section 174, companies need to consult the specific state in which they are filing. States adhere to either a rolling or static basis of conformity to the Internal Revenue Code (IRC). In states with rolling conformity, any changes to the federal tax code are automatically adopted as they occur. 

Examples of states following this approach include Illinois, New Jersey, New York, and Pennsylvania.

Conversely, states with static conformity adopt the federal tax code as of a specific date.

Static conformity states include Florida, Georgia, Virginia, and North Carolina. Some states practice selective conformity, adopting specific sections of the IRC. Notable examples include Arkansas, Colorado, and Oregon.

It's important to note that the degree of conformity can vary among states and may be subject to specific additions/exceptions based on each state's individual tax laws.

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