Many Americans faced overreaching tax changes with the Tax Cuts and Jobs Act of 2017. Taxpayers’ attention went to items like the Qualified Business Income Deduction, Net Operating Losses, and sweeping tax rate changes across the board. However, an often overlooked change was a revision to Section 174 and the introduction of a new definition for specified research or experimental (SRE) expenditures. This change was not slated to go into effect until the 2022 tax year, and once it arrived, it came with endless taxpayer questions and a lack of federal guidance on implementation.
Section 174 in a Nutshell
Beginning January 1, 2022, amortization of SRE expenditures is a requirement under Section 174. This amortization is divided into domestic and foreign SRE expenditures. Domestic SRE expenditures are amortized over five years, while foreign SRE expenditures are amortized over fifteen years. This means SRE expenditures must be amortized over their respective periods (five or fifteen years) with a half-year convention in the first and last years instead of being fully deducted in the year generated.
For example, if a taxpayer had $1,000,000 in domestic SRE expenditures in a year generated prior to January 1, 2022, the full amount would be deducted in that year. However, with tax years 2022 and forward and the required amortization and half-year conventions for those years, taxpayers would only claim $100,000 in deductions in the year generating the SRE expenditures. The remaining $900,000 would be amortized over a five-year period. Assuming the corporate tax rate of 21%, the taxable income increase due to the lack of the $900,000 deduction results in an additional $189,000 in tax liability in the year generating the SREs. The timing difference would come into play over the next five years with a deduction of $200,000 in years two through five, and the final $100,000 deduction in year six. Each subsequent year would follow the same approach, stacking amortization for that respective year's SREs.
Legislative History and Outlook
You may be asking how and why this would be allowed to come to pass for innovative American businesses. The truth is that most everyone thought a fix would be passed prior to the due date for the 2022 tax returns. This did not happen. The closest fix was with the Tax Relief for American Families and Workers Act of 2024. On January 31, 2024, the House of Representatives passed the Tax Relief for American Families and Workers Act of 2024 with a vote of 354-70. This Act included a fix for the domestic Section 174 SRE expenditures by removing the amortization requirement and allowing a 100% deduction in the current year as it was prior to the 2022 change. It is important to note that the foreign Section 174 SRE expenditures would have kept their amortization requirement over the fifteen-year period. However, this legislation stalled in the Senate and ultimately failed in a vote on August 1, 2024, with a 48-44 yay-to-nay vote (60 votes were needed to pass).
Looking forward, given the Republicans’ control of Congress with a slim majority, bipartisan support will be needed to implement a much-needed fix. As seen with the Tax Relief for American Families and Workers Act of 2024, there is bipartisan interest in fixing Section 174. Retroactivity of a fix to prior tax years is highly unlikely at this point given that 2022 and 2023 have been filed, and the 2024 returns will most likely be filed before a fix is implemented. The current timing for a fix is likely to be alongside a large tax package in late 2025.
Guidance from Treasury
Given that Section 174 amortization is here, the Treasury Department has provided guidance to aid taxpayers with compliance. Procedurally, Revenue Procedure 2023-8 was released in December 2022 to assist with the change in accounting method for Section 174. Since then, it has been superseded by several versions, with the latest being Revenue Procedure 2025-08. Substantive guidance was originally released in Notice 2023-63; this notice also asked for commentary to be submitted. After over 500 commentary letters, Notice 2024-12 was released in an attempt to clarify the definitions for SREs along with several other items.
Section 174 SRE Expenditures
Section 174 SRE expenditures, as clarified by Notice 2023-63, can be identified as those expenditures incident to the development or improvement of a product. Section 174 also specifically includes software development as being an SRE expenditure. Please note that “products” include any pilot model, process, formula, invention, technique, patent, or similar property. The SRE expenditures incident to the development of products and software development may cover a wider breadth than you may think at first glance. SRE expenditures include labor costs, such as full-time, part-time, contract employees, and independent contractors. Notice 2023-63 specifies that all elements of compensation except severance pay for SRE activities are included as part of the SRE expenditures. Material, supply, and patent costs are also included. In addition to these direct expenditures are overhead costs incident to the research activity. Overhead encompasses operational and management costs that can include a portion of rent and utilities for locations with SRE activities. SRE expenditures also involve depreciation expenses for assets used in SRE activities. Patent costs and even certain travel expenses can be included and need to be amortized.
Expenditures specifically excluded from the definition of SRE expenditures include general and administrative service department costs that only indirectly support SRE activities, interest on SRE activity debt, costs for activities excluded from the definition of software development, and classic exclusions from Section 174 activities such as efficiency surveys, consumer surveys, management studies, and historical studies.
Software Development
Software development is considered an SRE activity; specifically, any cost incident to software development is considered a Section 174 expenditure. Notice 2023-63 attempted to provide a definition for software development using an updated version of Revenue Procedures 2000-50. However, the definition leaves lots of uncertainty. The Notice does state that software development includes planning, design, model creation, source code writing, and testing. Computer software is specifically defined as a computer program or routine that is designed to cause a computer to perform a desired set of functions. On this list are system software, programming software, embedded software, and all media in which software is contained. It is also important to note that upgrades and enhancements that result in material improvements in speed or efficiency are included as well; however, this definition is difficult to parse as material is not defined. In addition, computer software developed for internal use also falls under Section 174. One thing to note is that expenditures associated with software that is purchased, installed, and configured to fit a business do not fall under software development.
Contract Research
Another area addressed by the Notices is contract research, wherein some new definitions were provided. The designation of the research provider, who is hired to do the research, and the research recipient, who is the entity that hires the research provider are the two parties in a contract research situation. Expenditures incurred by the research recipient are amortized using the definitions outlined above. Research providers can be required to amortize if they are at financial risk for the research. Further, if the research provider owns the intellectual property, they will be required to amortize as well. These caveats are in place to prevent a situation where neither party would capitalize the SRE expenditures. However, in certain situations there can be double amortization; one example of this occurring is when the research provider is at financial risk, yet the research recipient owns the IP. Under this situation, both would amortize, which was most likely not the intent of the law.
Given the uncertainties above, software development and contract research are two of the main areas that are expected to be updated in an attempt to provide clarification when the Proposed Regulations are released.
Dispositions of Section 174 Property
Regarding the event of a disposition, retirement, or abandonment of any property with respect to which SREs are paid or incurred, no deduction shall be allowed, and such amortization shall continue with respect to that property. Thus, dispositions cannot escape the grasp of the amortization requirement. The basis of recovery is not accelerated when a research project is sold or abandoned. In regard to Section 381(a) transactions, the acquirer gets step-in-the-shoes treatment. The only time the basis is accelerated, according to the Notices, is in the event a corporation ceases to exist in a transaction not described in Section 381(a).
Conclusion
Hopes are high for a prospective fix on the Section 174 amortization requirement in the form of a tax package in late 2025, but until then it is important to understand how Section 174 affects your business. Further, compliance with Section 174 is a requirement and is not optional; if you have SRE expenditures, you must amortize them under Section 174. Finally, it will behoove you to seek out guidance on Section 174 with your facts and circumstances to ensure that you are amortizing no more than what is required.
Robert H. Wallace III currently works for Source Advisors, a leading nationwide specialty tax firm helping CPAs and their clients maximize tax credits and reduce risk, headquartered in Fort Worth, Texas. He earned his Bachelor of Science in Petroleum Engineering from the University of Houston and is currently earning his Master of Science in Accounting from the University of Illinois Urbana-Champaign. Robert has worked as a tax credit and incentive professional for over eight years, providing services for a variety of industries, including software, architecture and engineering, manufacturing, pharmaceutical, and others.