Understanding Section 174 and Its Impact
Section 174 of the Internal Revenue Code governs the treatment of Specified Research or Experimental (SRE) expenditures. The Tax Cuts and Jobs Act (TCJA) of 2017 amended Section 174, requiring businesses to amortize SRE expenditures over time rather than deducting them in full in the year incurred. For tax years beginning after December 31, 2021, companies must amortize:
- Domestic SRE expenditures over five years
- Foreign SRE expenditures over fifteen years
Understanding this change is important for businesses engaged in research and development, as it impacts cash flow and taxable income. CPAs play a key role in educating clients on these requirements to ensure compliance and strategic tax planning.
Important Notice
It is unlikely that a Section 174 Amortization fix will be retroactive. Your clients should be following the current rules to avoid potential penalties.
Source Advisors has an analysis that can help:
- Calculate the financial impact of compliance
- Spotlight the true benefit of continuing to claim the R&D Tax Credit
- Educate your client and get them into compliance with the law
Learn More on how R&D Tax Credit Studies can Mitigate Section 174 Challenges for Your Clients
Key Points to Communicate to Clients
1. What is Amortization Under Section 174?
Amortization requires businesses to spread out their SRE expenditures over a set period instead of deducting the full amount immediately. This increases short-term taxable income, potentially leading to higher tax liabilities. CPAs should help clients assess how this affects their financial planning and explore mitigation strategies such as tax credits.
2. Section 174 vs. Section 41 (R&D Tax Credit)
Clients often confuse Section 174 with Section 41 (R&D Tax Credit). It is important to clarify that:
- Section 174 covers a broader range of SRE expenditures, including both direct and indirect costs such as payroll, supplies, patent expenses, rent, utilities, and overhead.
- Section 41 is more limited and applies only to taxable wages, research-related supplies, 65% of qualified contractor costs, and certain cloud computing expenses.
- Most Section 41 expenses qualify under Section 174, but not all Section 174 expenses qualify for the R&D tax credit.
- Amortizing Section 174 expenses is mandatory, regardless of whether a company claims the R&D tax credit.
How CPAs Can Help Clients Navigate Section 174
1. Assess the Impact on Tax Liability
Since immediate deductions are no longer allowed, CPAs should help businesses model how amortization will affect taxable income and plan accordingly.
2. Identify Eligible Section 174 Expenses
CPAs should work with clients to identify all qualifying SRE expenditures and ensure proper classification between Section 174 and Section 41 expenses.
3. Explore Tax Mitigation Strategies
Clients may need strategies to offset the higher short-term tax burden caused by amortization. These may include:
- Maximizing Section 41 R&D Tax Credits
- Leveraging other tax incentives
- Adjusting financial forecasts to account for tax timing differences
4. Ensure Compliance and Documentation
Proper documentation is crucial for IRS compliance. CPAs should guide clients in maintaining detailed records of SRE expenditures, ensuring accurate classification and preparation for potential audits.
