Section 174 expenses

What Are Section 174 Expenses?

Section 174 expenses refer to the costs incurred by businesses for research and experimental (R&E) activities, including software development. These expenses are a crucial element of corporate taxation within the broader category of tax accounting. Historically, Section 174 allowed businesses significant flexibility in how they treated these expenditures for tax purposes. However, recent legislative changes have significantly altered their treatment, moving from immediate tax deductions to mandatory capitalization and amortization.

History and Origin

The initial framework for Section 174 was established in 1954 to eliminate ambiguity in the tax treatment of research and development (R&D) costs and to incentivize innovation. For decades, businesses had the option to either deduct these expenses in the year they were incurred, or to capitalize and amortize them over a period of not less than 60 months. This flexibility provided a powerful incentive for companies to invest in R&D, contributing to economic growth and technological advancement.²⁵

A significant shift occurred with the enactment of the Tax Cuts and Jobs Act (TCJA) in December 2017. While many provisions of the TCJA took immediate effect, the amendment to Section 174 was delayed. For tax years beginning after December 31, 2021, the TCJA mandated that all specified research or experimental (SRE) expenditures, including those related to software development, must be capitalized and amortized.²⁴ This meant that instead of deducting the full amount of Section 174 expenses in the year they were paid or incurred, domestic R&E costs had to be amortized over five years, and foreign R&E costs over 15 years, with amortization beginning at the midpoint of the taxable year.²³ This change was enacted to generate revenue to offset other tax cuts within the TCJA.²²

However, as of August 2025, new legislation, commonly referred to as the "One Big Beautiful Bill" (H.R. 1), has aimed to restore the ability for businesses to immediately deduct domestic R&E costs. This bill seeks to reverse the mandatory five-year amortization rule for domestic research, with options for how companies can treat previously capitalized costs from 2022 through 2024.²¹

Key Takeaways

• Section 174 expenses cover costs related to research and experimental activities, including software development.
• Prior to 2022, businesses could typically deduct these expenses in the year incurred, or elect to amortize them.
• The Tax Cuts and Jobs Act (TCJA) of 2017 mandated capitalization and amortization of Section 174 expenses for tax years beginning after December 31, 2021 (5 years for domestic, 15 years for foreign).
• Recent legislation, the "One Big Beautiful Bill," aims to restore immediate deductibility for domestic Section 174 expenses for tax years beginning after December 31, 2024, with options for retroactive treatment for eligible small businesses.
• The change from immediate deduction to amortization significantly increased the taxable income for many R&D-intensive companies between 2022 and 2024.

Interpreting Section 174 Expenses

Interpreting Section 174 expenses primarily involves understanding their treatment for tax purposes and their impact on a company's financial statements. Under the TCJA's amendment, when a business incurs Section 174 expenses, these costs are no longer fully expensed against net income in the current year. Instead, they are treated as capital expenditures and are spread out over a period of years through amortization.

For domestic R&E, this means recognizing a portion of the expense (1/5th for a full year) over five years. For foreign R&E, it's 1/15th over fifteen years. The amortization begins at the midpoint of the year the expenditure is incurred.²⁰ This change significantly impacts a company's current-year tax liability and its cash flow, as a smaller portion of the expense is deductible upfront.

Hypothetical Example

Consider a hypothetical software development company, "InnovateTech Inc.," that incurred $1,000,000 in domestic Section 174 expenses (primarily developer salaries) during its tax year beginning January 1, 2023.

Under the TCJA's Section 174 rules for 2023 (before the "One Big Beautiful Bill" took effect for subsequent years), InnovateTech Inc. could not immediately deduct the entire $1,000,000. Instead, it had to capitalize and amortize these costs over five years.

• Year 1 (2023): $1,000,000 / 5 years = $200,000 per year.
  • Since amortization begins at the midpoint of the year, only half of the annual amortization is deductible in the first year: $200,000 / 2 = $100,000.
  • The remaining unamortized balance is $900,000.
• Year 2 (2024): $200,000 is deductible.
• Year 3 (2025): $200,000 is deductible.
• Year 4 (2026): $200,000 is deductible.
• Year 5 (2027): $200,000 is deductible.
• Year 6 (2028): The remaining $100,000 (from the first year's half-year convention) is deductible.

This deferral of deductions effectively increased InnovateTech's taxable income in the early years compared to immediate expensing, thereby increasing its tax liability and reducing its available cash for operations and further development.

Practical Applications

The treatment of Section 174 expenses has broad implications across various aspects of business and finance. For many companies, especially those heavily invested in innovation like tech startups or biotech firms, these expenses represent a significant portion of their overall business expenses.

The mandatory capitalization under the TCJA, effective from 2022, impacted businesses by increasing their immediate tax burdens. This could lead to a decrease in profitability and reduced cash flow, potentially hindering further investment in R&D.¹⁹ Some businesses reported significant increases in their taxable income, forcing them to explore strategies to alleviate financial pressures, including taking out loans or re-evaluating their R&D spending.¹⁸

From an accounting methods perspective, this change necessitated updates to how companies recorded and reported their R&D activities on their income statement and balance sheet. The requirement to track domestic versus foreign R&E expenses also added layers of complexity to tax compliance.

However, the recently enacted "One Big Beautiful Bill" (H.R. 1), as of August 2025, changes this landscape again by restoring full expensing for domestic research costs for tax years beginning after December 31, 2024.¹⁷ This legislative reversal provides substantial immediate tax relief and improves cash flow for businesses engaged in R&D, and for eligible small businesses, offers options to retroactively apply full expensing to prior years.¹⁶

Limitations and Criticisms

The mandatory capitalization and amortization of Section 174 expenses, as implemented by the TCJA from 2022 to 2024, faced significant criticism from businesses and industry groups. Critics argued that the change disincentivized domestic research and development and could stifle innovation, particularly for small businesses and startups that rely on immediate deductions to manage cash flow.¹⁵ Unlike depreciation of physical assets, R&D expenses often don't yield immediate, tangible income streams that align with a multi-year amortization schedule.

The forced capitalization meant that companies could owe taxes on "phantom income" – income that appeared on paper due to the inability to fully deduct R&D costs, even if the company was not yet profitable or generating sufficient cash. T¹⁴his disproportionately impacted smaller firms with limited cash reserves.

¹³Furthermore, the rule stating that no deduction is allowed upon disposition, retirement, or abandonment of property related to the R&E expenditures, and that amortization must continue, was also a point of contention. T¹²his meant that even if a research project failed or was abandoned, the company still had to amortize the associated costs over the prescribed period, adding to their financial burden.

The bipartisan support for reversing the TCJA's Section 174 changes, culminating in the "One Big Beautiful Bill" (H.R. 1), underscored these concerns. The reintroduction of immediate expensing for domestic R&D is a direct response to the perceived negative impacts on innovation and economic competitiveness.

¹¹## Section 174 Expenses vs. Research and Development (R&D) Tax Credit

While often discussed together, Section 174 expenses and the Research and Development (R&D) Tax Credit are distinct aspects of the tax code, though they are related.

The key distinction is that Section 174 dictates how R&D costs are accounted for on the income statement, while the R&D tax credit is a separate incentive that reduces a company's tax bill. Even if a business doesn't claim the R&D tax credit, it is still obligated to follow the Section 174 rules for its research and experimental expenses. C⁶onversely, to qualify for the R&D tax credit, expenses must first meet the definition of R&E under Section 174.

⁵## FAQs

Q: What types of costs are typically covered by Section 174 expenses?
A: Section 174 expenses generally include direct costs associated with research and experimentation, such as wages for employees conducting research, costs of supplies used in R&D, and certain contract research expenses. Importantly, it also explicitly covers costs related to software development.

⁴Q: Did the Tax Cuts and Jobs Act (TCJA) eliminate the R&D tax credit?
A: No, the TCJA did not eliminate the R&D tax credit (Section 41). However, it changed the treatment of the underlying research and experimental expenses (Section 174), requiring them to be capitalized and amortized instead of immediately deducted. This change impacted a company's taxable income, making the R&D tax credit even more crucial for offsetting increased tax liabilities during that period.

³Q: How do Section 174 changes impact a company's cash flow?
A: When Section 174 expenses must be capitalized and amortized over several years, it means a business cannot immediately deduct the full cost of its research activities. This results in a higher current-year taxable income and, consequently, a higher tax bill. This reduces the immediate cash flow available to the company, potentially hindering further investment or operations. T²he restoration of full expensing for domestic R&D aims to mitigate this negative impact.

Q: Are there any exceptions to the Section 174 capitalization rules for small businesses?
A: Prior to the recent "One Big Beautiful Bill" (H.R. 1), there were generally no exceptions to the Section 174 capitalization requirements for small businesses under the TCJA. However, the "One Big Beautiful Bill" offers eligible small businesses a valuable option to retroactively apply full expensing to R&D costs incurred in tax years beginning after December 31, 2021.

¹Q: What is the current tax treatment of domestic vs. foreign Section 174 expenses?
A: As of the recent "One Big Beautiful Bill" (H.R. 1), domestic Section 174 expenses (costs for research conducted within the U.S.) can generally be fully expensed in the year they are incurred, or taxpayers can elect to capitalize and amortize them over 60 months. However, foreign Section 174 expenses (costs attributable to research conducted outside the U.S.) still remain subject to the mandatory 15-year amortization rule.