Offsetting §174 R&E Software Development Tax Liability with R&D Tax Credits

Deb Roth

Practice Leader/Managing Director

The new changes to §174 have a significant impact on software development costs. For tax year 2022, any cost that has been paid or incurred related to software development is now considered a §174 R&E expenditure. This means it must be capitalized and amortized over 5 years (15 years for foreign software development). 

Which Software Development Costs fall under the new §174 R&E Amortization rules? 

While guidance related to what costs constitute §174 Expenditures is still vague, potential expenditures can include: 

  • Salaries and wages including employer costs
  • Software licensing
  • Equipment rental costs
  • Occupancy costs, including office rent and research facilities costs
  • Travel expenditures that have been incurred for R&E purposes
  • Heat, light, telephone bills, and similar overhead utility costs
  • Depreciation
  • Dues and publication expenses that have been incurred for R&E purposes
  • Attorney fees or filing fees related to patents

Recent Changes To §174 Amortization for Software Development

As mentioned, there are several recent changes to §174 that directly affect software development in relation to the new guidance released by the IRS under Rev. Proc. 2023-11. It includes the following:

  • Taxpayers that have software development costs must now amortize the costs over 5 years for domestic research costs and 15 years for foreign research costs.
  • The costs can no longer be fully deducted in the year paid or incurred. 

While historically §174 Research & Experimental (R&E) expenditures allowed for the deduction or amortization of direct and indirect costs for R&E activities, the Tax Cuts and Jobs Act (TCJA) of 2017 changed the treatment of R&E expenditures. This change now requires the amortization.

How Does This Affect Taxpayers Claiming the R&D Tax Credit for Software Development? 

Whether or not taxpayers claim the R&D tax credit, they are still required to amortize costs in compliance with §174.

  • 174 and §41 (R&D tax credit) are separate tax sections and have separate rules. However, both sections have similar definitions of R&D. This means that while the software development costs that are amortized under §174 may also be qualified for R&D tax credits under §41, which helps offset the tax liability from the §174 amortization. 

What Is The Difference Between §174 R&E Expenditures And §41 R&D Tax Credit Expenses For Software Development? 

R&D tax credits are claimed for direct research expenses (wages, contractor expenses, supplies, etc.). §174 also includes these amounts but is expanded to include certain indirect research costs (including facility costs) which are excluded from the R&D credit calculation.

So while most R&D tax credit expenses will qualify as a §174 expenditure, not all §174 expenditures will attain the level of qualification needed to claim the R&D tax credit. Many companies will therefore have §174 expenditures even if they do not claim the R&D tax credit.

Claiming R&D Tax Credits for Software Development

The following are examples of qualified research activities for software development companies to claim under the R&D tax credit:

  • Design and development of new software components
  • Design and development of new or improved software applications
  • Internal Use Software development
  • Virtual reality or game development
  • Developing data mining techniques including big data analysis and processing
  • Development of firmware
  • Development of POS systems
  • Integrating hardware and software components
  • Development of document management systems
  • Development of education-based software
  • Design and development of CRMs
  • Design and development of compliance systems
  • Healthcare system and application development
  • Development of financial and accounting software
  • Developing simulators
  • Development of data center tools
  • Development of monitoring systems
  • Development and integration of databases
  • Designing and experimenting with computer hardware
  • Reducing system latency
  • Developing messaging technologies
  • Network development and optimization
  • Building QA or testing environments
  • Integrating disparate or legacy systems with new software

By claiming any of the above-qualified activities towards the research credit, taxpayers will be able to offset some of the §174 amortization.

Get Help From Industry Leaders

One of the best ways to offset additional taxes as a result of these new, mandatory changes to §174 is to take advantage of the R&D credits. If you have any §174 costs and are developing a product, process, or software, it is likely you can also claim R&D credits. Our team at Source Advisors can help you navigate these changes through webinar offerings and direct meetings with our R&D tax professionals.

Enhanced R&D Tax Credit Study with §174

Source advisors assists taxpayers in identifying departments and cost center where §174 R&E activities are taking place.

Our Enhanced R&D Tax Credit studies include §174 study to ensure compliance and to help reduce tax liability.

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