Complete Guide to What Section 174 Now Requires

Section 174 of the Internal Revenue Code outlines how businesses in the United States must treat their research and development (R&D) expenses for federal tax purposes. These are the costs companies incur when developing or improving products, software, or business processes.

Until recently, businesses could immediately deduct qualified R&D expenses in the same year they were incurred. This provided a valuable tax benefit, particularly for startups and innovation-focused companies investing heavily in product development.

However, Section 174 doesn’t just affect companies that identify as R&D-intensive. It applies broadly to any business engaging in activities intended to create or improve functionality, performance, reliability, or quality. This includes software development, biotech experiments, prototyping in manufacturing, or even iterative improvements to existing tools or processes.

What Changed Under Section 174 and Why It Matters in 2025

For decades, U.S. businesses could deduct qualified R&D expenses immediately under Section 174. That changed with the Tax Cuts and Jobs Act (TCJA) passed in 2017, which introduced a delayed provision requiring all R&D costs to be capitalized and amortized starting with tax years beginning in 2022.

This meant that instead of deducting the full amount of R&D expenses in the year incurred, businesses had to spread those deductions out:

• 5 years for domestic R&D activities
• 15 years for foreign R&D activities

For startups and high-growth companies investing heavily in R&D, this created serious cash flow issues and higher near-term tax bills often during critical growth phases.

In 2025, Congress passed new legislation rolling back this rule. Businesses can once again immediately deduct domestic R&D expenses starting with the 2025 tax year. In addition, many businesses will be eligible to retroactively amend their 2022, 2023, and 2024 returns to claim deductions they previously had to amortize.

Why this matters:

• Cash flow improves: Businesses get larger deductions upfront again.
• Simpler compliance: No need to track complex amortization schedules.
• Retroactive refunds: If eligible, you may be able to reduce past tax liabilities by filing amended returns.

The new law has shifted the ground again, and businesses that kept up with the changes stand to benefit the most.

Is Amortization Still Mandatory?

For tax years 2022 through 2024, amortization under Section 174 was mandatory. Businesses had no choice but to capitalize and spread their R&D deductions over five years (or fifteen for foreign costs), regardless of their size or industry.

That rule has now changed, at least for domestic R&D expenses. Starting with tax year 2025, businesses can once again immediately deduct qualified domestic R&D costs in the year they are incurred.

Here’s the breakdown:

• 2022–2024: Amortization was required. However, with the 2025 law in place, many businesses may now be able to amend prior returns and apply the new rule retroactively.
• 2025 onward: Immediate deduction is restored for domestic R&D expenses.
• Foreign R&D: These expenses may still be subject to amortization. Final IRS guidance is pending on how the new law applies in cross-border scenarios.

What Expenses Qualify Under Section 174?

Section 174 applies to more than just traditional laboratory R&D. If your business is building, improving, or testing any product, software, or manufacturing process, there’s a strong chance you’re incurring Section 174 expenses, whether you realize it or not.

That’s because Section 174 covers both direct and indirect costs related to research and experimental activities aimed at eliminating uncertainty around a product's development or improvement.

Here’s how that breaks down:

1. Direct R&D Costs

These are expenses clearly tied to hands-on development work:

• Employee wages for developers, engineers, designers, scientists, and technical leads involved in R&D
• Materials and supplies used during testing, prototyping, or development
• Contract research costs, including payments to outside firms or freelancers for R&D activities
• Patent-related legal fees, including costs to file, prosecute, and protect intellectual property related to innovation

2. Indirect R&D Costs

These are supporting costs that enable the research process but aren’t directly creating the product:

• Rent or lease costs for facilities used in development
• Utilities like electricity, internet, and water powering the R&D operations
• Depreciation on R&D equipment and software tools
• Administrative support, insurance, and general overhead allocated to research efforts

Many businesses mistakenly think R&D rules only apply to high-tech industries. In reality, the definition under Section 174 is broader than what most expect. It applies to any activity intended to:

• Eliminate uncertainty in how something will be developed or improved
• Result in a functional product, process, or software
• Involve a process of experimentation (trial and error, testing, prototyping, modeling, etc.)

So even if you’re a manufacturer building custom parts, a startup iterating on app features, or a food tech company experimenting with new recipes, these costs could qualify under Section 174 and must be treated accordingly.

Does Section 174 Apply to My Business?

If your business is developing or improving a product, process, or software, even in small iterations there’s a strong chance Section 174 applies to you.

Many founders mistakenly assume these rules only apply to large corporations or companies doing formal R&D. But Section 174 is written broadly, and it applies based on the activity, not your industry or company size.

Here are the industries commonly affected:

• Software and SaaS: Writing new code, improving existing features, integrating new technologies
• Manufacturing: Prototyping, testing, and optimizing physical products or production methods
• Biotech and Pharma: Drug formulation, clinical trials, and lab research
• Engineering and Robotics: Building, designing, or refining mechanical or digital systems
• Agri-tech and Food Science: Developing new growing methods, recipes, or packaging solutions

But it’s not limited to these. Even a digital marketing agency building proprietary analytics tools, or a hardware startup experimenting with sensor calibration, could be subject to Section 174.

If you're:

• Employing technical staff like developers or engineers
• Spending on testing, prototypes, or new product features
• Using external contractors for development work
• Filing for patents

...you likely have qualifying Section 174 expenses, and you’re expected to treat them correctly under the tax code.

Ignoring this because you think you’re “not doing R&D” is risky. These rules apply regardless of whether you’re claiming the R&D tax credit or not.

Section 174 vs. Section 41: What’s the Difference?

Section 174 and Section 41 are often mentioned together, but they serve very different purposes.

What Section 174 covers?

Section 174 governs how you treat your R&D expenses for tax purposes. It applies broadly to any costs associated with developing or improving a product, process, or software. Whether or not you claim a tax credit, you're required to account for these costs under Section 174, either by expensing them (now allowed again starting in 2025) or amortizing them (required in prior years).

What Section 41 provides?

Section 41 offers the R&D tax credit, a direct credit that reduces your tax bill if you meet specific qualifications. But only a subset of your R&D expenses under Section 174 will qualify for the Section 41 credit.

Here are key differences between Section 174 and Section 41:-

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Just because you’re claiming the R&D tax credit under Section 41 doesn’t mean you’ve fully complied with Section 174. In fact, you must first identify and treat your expenses correctly under Section 174 before you can calculate your Section 41 credit.

For businesses claiming the credit, the two sections are deeply connected. For those not claiming it, Section 174 still applies, and failure to comply can still lead to penalties.

What If I Didn’t Amortize My R&D Expenses in 2022–2024?

Between 2022 and 2024, businesses were required to capitalize and amortize their R&D expenses under Section 174, even if they had previously deducted them in full. This shift created confusion, especially for small businesses and startups unfamiliar with the change.

If your business didn’t follow the amortization rules during those years, you’re not alone. Many companies either:

• Continued expensing R&D costs as they had before 2022, or
  
  
• Didn’t realize they needed to file a Form 3115 (Application for Change in Accounting Method)

Here’s what changed in 2025:

Congress passed a legislative fix restoring the option to immediately deduct domestic R&D expenses, starting with the 2025 tax year. Even more importantly, the law provides retroactive relief, which means eligible businesses can revisit 2022–2024 and reclaim missed deductions.

What this means for you:

• If you incorrectly expensed R&D during 2022–2024: you may now be in compliance thanks to the new law.
• If you followed the amortization rules: you may be able to amend prior returns and recover tax paid unnecessarily.
• If you ignored Section 174 entirely: now is the time to get current before the IRS starts reviewing filings under the updated guidance.

Startups and small businesses with average annual gross receipts under $31 million stand to benefit the most from this relief, especially if they are cash-constrained or have already paid taxes under the old rule.

Inkle can help you determine whether you qualify, whether an amended return or Form 3115 is required, and how to approach any necessary corrections.

What Are the Risks of Non-Compliance with Section 174?

Even if you’re not claiming an R&D tax credit, you're still required to treat research and development expenses correctly under Section 174. Failing to do so can lead to serious consequences, especially now that the IRS is paying closer attention to R&D reporting after the 2022 rule changes.

Here’s what’s at stake:

i) Underpayment penalties

If you fail to capitalize or properly expense R&D costs based on the rules for a given tax year, you may end up underreporting your taxable income. That opens the door to accuracy-related penalties and late payment interest.

ii) Return preparer liability

The IRS has made it clear: tax preparers must ensure that Section 174 treatment is handled correctly. If they don’t, and the return is audited, they can face separate penalties for due diligence failures.

iii) Audit exposure

R&D-related deductions and credits are among the most closely scrutinized areas during IRS audits. Inconsistent reporting, weak documentation, or incorrect treatment of expenses can all raise red flags.

iv) Amended return risk

If you don’t adjust filings for 2022–2024 based on the 2025 legislative changes, you may miss out on deductions you’re entitled to, or worse, stay out of compliance without realizing it.

What Documentation Is Required for Section 174?

Proper documentation isn’t just helpful under Section 174, it’s essential. Whether you’re deducting R&D costs or amortizing them, the IRS expects you to maintain clear, consistent, and contemporaneous records to justify your treatment.

At a minimum, your documentation should include:

i) Purpose of the research

You need to demonstrate that the activity aimed to develop or improve a product, process, formula, software, or invention. General business improvements or troubleshooting don’t qualify.

ii) Elimination of uncertainty

The project must involve uncertainty around capability, method, or product design, and a process to resolve that uncertainty (e.g., prototyping, testing, or simulations).

iii) Process of experimentation

Records should reflect how alternatives were evaluated. This could include development logs, iteration notes, test results, or code version history.

iv) Direct and indirect cost tracking

Maintain detailed records of:

• Employee time and roles (especially for technical staff)
• Supplies and materials used in R&D
• Contract research invoices
• Overhead allocated to R&D projects (e.g., rent, software tools, utilities)
  
  

v) Consistent cost treatment

Once you classify an expense as Section 174-eligible, it must be treated that way consistently across all tax years and filings.

In an audit, your ability to defend your R&D expense treatment depends entirely on documentation. Without it, deductions may be denied even if the work itself qualifies. For companies amending prior returns based on the 2025 law change, having historical documentation will also be key to justifying retroactive deductions.

How Inkle Helps You Stay Compliant with Section 174

Section 174 compliance isn’t optional, and getting it wrong can cost your business time, money, and peace of mind. Inkle helps you stay ahead by simplifying how you track, treat, and report R&D expenses across tax years.

Here’s how Inkle supports your team:

i) Automatically identifies R&D-related costs

Inkle helps you tag both direct and indirect R&D expenses, so you don’t miss deductions or misclassify eligible activity.

ii) Tracks changes in tax law across years

Whether you need to amortize prior years or take advantage of the 2025 expensing rule, Inkle applies the right treatment based on the tax year and current legislation.

iii) Streamlines amended return filings

If you're eligible for retroactive relief for 2022–2024, Inkle makes it easy to prepare and submit amended filings with the correct expense treatment.

iv) Supports audit-ready documentation

Inkle keeps records of qualifying activities, cost allocations, and justifications, so you’re ready if the IRS ever comes asking.

v) Integrates Section 174 with your broader tax strategy

Inkle also tracks which expenses may qualify under Section 41 (R&D credit) and helps ensure your filings are consistent across both rules.

Inkle gives you the tools to stay accurate, confident, and compliant. Book a demo to see how it works.

Frequently Asked Questions

Can I deduct R&D expenses in 2025 or do I still need to amortize them?

Yes, if your R&D expenses are related to domestic activities, you can deduct them in full for tax years beginning in 2025. Amortization is no longer required for domestic R&D. However, foreign R&D expenses may still need to be amortized over 15 years.

I didn’t amortize R&D expenses for 2022–2024. Can I fix this?

Yes. If your business is eligible under the new 2025 legislation, you may be able to file amended returns for prior years and retroactively deduct those expenses. You may also need to file IRS Form 3115 if a method change is involved. Consult your tax advisor or use Inkle to guide the process.

What types of R&D expenses are covered under Section 174?

Section 174 covers both direct expenses (like employee wages, contract research, supplies, patent costs) and indirect expenses (rent, utilities, depreciation) related to the development or improvement of a product, process, or software.

Is claiming the R&D tax credit under Section 41 enough to comply with Section 174?

No. Section 41 is a credit provision, while Section 174 governs how R&D costs are treated for deduction purposes. Even if you're claiming the credit, you must still classify and report expenses correctly under Section 174.

What documentation should I maintain for Section 174 compliance?

You’ll need to document the purpose of the research, the uncertainty being addressed, the experimental process used, and a breakdown of related costs. Records should support both your deductions and any credits claimed.

How can Inkle help me navigate Section 174 rules?

Inkle helps identify eligible expenses, apply the correct treatment based on current tax law, manage documentation, and file compliant returns including amended filings for past years. It’s built to simplify compliance for growing and innovative businesses.

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