When Section 174 hit in 2022, it changed everything for companies doing R&D.

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Instead of writing off research expenses immediately, businesses now have to spread them out over five years (or 15 for foreign research). This creates a real headache when you're also trying to maximize your R&D tax credit.

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Here's the frustrating thing business owners: the National Association of Manufacturers found that 65% of companies saw their effective tax rate jump after Section 174 kicked in.

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Most are struggling to figure out how to handle the new capitalization rules and still get the most from their R&D credits.

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The problem is that these two tax provisions seem to work against each other. Section 174 forces you to amortize R&D expenses over multiple years, while the R&D credit lets you claim benefits immediately on the same expenses.

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It's like trying to optimize two different engines that are pulling in opposite directions.

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Too many companies think they have to pick one or the other, but that's leaving money on the table. The truth is, you can maximize both benefits if you know how they work together.

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This article will show you how to do this. You'll learn practical strategies for categorizing expenses, timing your R&D activities, and structuring projects so you get the best of both worlds without creating compliance issues or audit red flags.

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An Overview of Section 174 Capitalization

The Tax Cuts and Jobs Act (TCJA), effective for tax years beginning January 1, 2022, changed how companies account for research and development (R&D) costs under IRC Section 174.

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Before this, R&D expenditures (such as employee wages, lab supplies, contract research, and software development) could be deducted immediately.

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Today, these costs must be capitalized and amortized, with a 5-year schedule for domestic expenses and a 15-year schedule for foreign costs, both applying a mid-year convention.

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As a result of this change, instead of enjoying full upfront deductions, businesses now spread these costs over multiple years, thus impacting not only cash flow and short-term profitability but also financial reporting.

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Moreover, even expenses ineligible for the R&D tax credit (such as software development and certain overhead) must still be capitalized.

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Qualified Expenditures

Under IRC Section 174, businesses must capitalize Research & Experimental (R&E) expenses, which include:

• Employee wages (salaries, benefits, payroll taxes for staff engaged in R&D)
• Supplies and materials consumed during experimentation
• Contract research paid to third-party labs or service providers
• Computer software costs, including in-house development tools and internal-use software

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The scope of Section 174 often goes beyond the narrower definition used for the R&D credit, covering overhead and depreciation even when expensed outside the credit framework.

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Required Amortization Schedules

Rather than immediate expensing, R&E costs must now be amortized under a straight-line method over:

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This treatment is mandatory for tax years beginning on or after January 1, 2022, under the Tax Cuts and Jobs Act. Although interim IRS guidance (Notice 2023-63) is available, the requirement stands even before final regulations are issued.

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Cash Flow and Financial Reporting Effects

Previously, firms enjoyed flexibility by expensing all R&E costs in the year incurred. That front-loaded deduction scheme is now gone. The main impacts include:

• Taxable income spikes in the initial years after adoption, due to delayed deductions → increased current tax liability
• Cash flow reduction as upfront deductions convert to multi-year amortization
• Financial statement shifts, with long-term R&E assets appearing on the balance sheet rather than expense line items
• Strategic reinvestment hurdles, especially for startups and small businesses lacking large cash buffers

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R&D Tax Credit Fundamentals

To enjoy the full potential of your research expenditure, you must understand the federal R&D Tax Credit under IRC § 41.

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This incentive rewards businesses for qualified innovation but complying with its rules requires understanding eligibility, calculation, refundability, and state-level variations.

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Eligibility

Not all Section 174 expenditures automatically qualify for the Section 41 R&D credit. To be eligible, expenses must align with the IRS-defined Qualified Research Activities (QRAs), commonly known as the four-part test:

• Technological
• Intended to eliminate uncertainty
• Permitting experimentation
• Related to a new or improved business component

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Typical qualifying costs include wages for employees engaged in R&D, supplies used during experimentation, and contract research (capped). The rest, such as general overhead or routine data collection, usually do not qualify.

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Calculating the Credit: RRC vs. ASC Methods

There are two paths to computing your R&D credit:

• Regular Research Credit (RRC): Credit equals 20% of current-year Qualified Research Expenses (QREs) that exceed a calculated base amount based on historical spend
• Alternative Simplified Credit (ASC): It offers 14% of QREs exceeding 50% of the three-year average. For companies without prior QRE, the rate drops to 6%

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Evaluate both methods annually. RRC often favors startups or businesses with low historical spending, while ASC may benefit those with higher or irregular R&D spend.

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Contract Research Limit

If part of your R&D involves outsourcing (like university partnerships or commercial labs), these costs count toward your QREs at only 65% of actual payments.

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In special cases, such as payments to non-profits or consortia, higher percentages may apply (e.g., 75–100%). However typical third-party research is capped.

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Refundability and Carryforward Rules

At the federal level, the R&D credit is non-refundable, but it remains valuable. Unused credits can be carried back one year or forward up to 20 years. Some startups might be able to offset payroll taxes, especially under Section 41's workforce credit rules.

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State-Level Credits

As of 2025, 37 states offer their R&D credits to complement the federal incentive. Some examples include:

• Connecticut: Often allows more expenses under Section 174 to qualify as QREs. The state-to-federal ASC link makes applying simpler
• California: Uses federal definitions but calculates gross receipts differently (excludes service-based revenues)
• Texas: Offers a franchise tax credit equal to 5% of QREs or 25% of the tax due, whichever is lower
• Maine, Maryland, and Massachusetts: Each has a tiered structure tied to excess QREs and limits based on tax liability

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Since eligibility, rates, and caps are different, research each state program carefully before filing.

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The Intersection Between Section 174 vs. R&D Credit

While the aim of Section 174 and R&D Credit is to promote innovation, they operate differently. This creates areas of overlap, timing mismatches, and compliance complexities. Businesses that don't plan appropriately may leave money on the table or run into audit risk.

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Here's what you need to know:

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Expense Overlap: Qualifying for Both, But Not Equally

A common misconception is that all R&D expenses treated under Section 174 also qualify for the R&D tax credit under Section 41.

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While there is an overlap, Section 174 covers a broader category of "specified research or experimental (SRE) expenditures," which includes employee wages, supplies consumed in R&D, software development costs, contract research, and certain overhead and indirect costs.

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However, not all Section 174 costs qualify for the R&D tax credit. For example:

• Overhead and administrative costs (e.g., HR, utilities, rent) are amortizable under Section 174 but not credit-eligible under Section 41
• 100% contract research costs are included under Section 174, but only 65% of qualified third-party research payments are eligible for the R&D credit, provided the taxpayer retains substantial rights to the research and bears the economic risk
• Non-taxable fringe benefits such as employer-paid health insurance or retirement contributions may be capitalized under Section 174 but are excluded from R&D credit computations

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Timing Mismatch: Deduction Delays vs. Immediate Credit

One of the most frustrating elements of Section 174 reform is the timing disconnect between capitalization and credit recognition.

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Under the Tax Cuts and Jobs Act, R&D expenses must now be capitalized and amortized over five years (domestic) or fifteen years (foreign)—spreading out the deduction and delaying tax relief.

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On the other hand, the R&D tax credit can be claimed immediately in the year the qualified expenses are incurred. This means businesses may lose out on upfront deductions for innovation costs but still benefit from R&D credits, provided expenses are tracked and categorized correctly.

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Proper timing strategies, such as aligning project launches with high-taxable-income years or front-loading domestic R&D activities, can help balance these cash flow implications.

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Documentation Synergy

To avoid duplication of effort and ensure compliance, implement a documentation system that satisfies Section 174 and Section 41 requirements. This includes:

• Time-tracking logs for employees involved in R&D
• Project cost breakdowns separating direct and indirect expenses
• Contract terms clarifying rights, risks, and responsibilities
• Geolocation tracking to distinguish domestic vs. foreign research efforts

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Robust tracking tools or ERP integrations can allow your finance and tax teams to efficiently extract the data needed to support amortization schedules and credit claims during audits.

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Strategic Planning Approaches

The goal is to maximize credit opportunities while minimizing the adverse effects of mandatory capitalization and amortization.

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The following planning strategies can help you make the right decisions, structure your R&D operations effectively, and avoid common tax issues.

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Categorization of R&D Expenses

One of the most important steps in optimizing Section 174 and the R&D tax credit is accurate expense categorization. While many costs may fall under the umbrella of R&D for accounting purposes, not all are treated equally for tax purposes.

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Credit-eligible expenses (Section 41) usually include:

• Direct wages paid to employees conducting qualified research
• Supplies used in research (not including land or depreciable property)
• Contract research costs (limited to 65% if the taxpayer retains substantial rights and bears the economic risk)
• Certain software development costs

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Non-credit but capitalizable under Section 174:

• Indirect costs such as rent, utilities, and depreciation
• Overhead and administrative support
• Certain internal-use software expenses not meeting Section 41 criteria

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You can avoid double-counting or underreporting by distinguishing between Section 41 QREs and broader Section 174 R&E expenses. This separation also improves audit preparedness and financial forecasting.

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Timing R&D Spend

Timing is important considering the shift to mandatory amortization under Section 174.

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Since R&D credits are realizable in the same tax year, but amortization spans 5 to 15 years, companies benefit most when they front-load R&D investments into years with high taxable income.

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Here's why this works:

• You immediately offset high tax liability with R&D credits
• Although deductions are delayed, you retain current-year cash benefits via credits
• You're better positioned to manage cash flow and avoid underutilized credits during low-income years

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Align R&D activities, like major development projects or software builds, with periods when your company is expecting a revenue spike or a new product launch.

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Structuring Contracts

Many companies outsource part of their R&D to third-party vendors or contractors. However, how you structure those contracts impacts eligibility for Section 41 credits and Section 174 capitalization.

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To qualify for the R&D tax credit:

• The taxpayer must retain substantial rights to the research results
• The taxpayer must bear the economic risk if the research fails

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Contracts should:

• Avoid terms that grant exclusive ownership to the vendor
• State the company retains IP rights or joint development rights
• Assign cost responsibility and risk to the company, not the contractor

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According to The Tax Adviser and IRS audit guidance, poorly structured contracts can lead to disqualification of major R&D credits, even if the costs are still subject to amortization under Section 174.

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Therefore, collaboration between tax, legal, and procurement teams is important during contract negotiation.

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Multi-Year Planning

Tax planning for R&D shouldn't be reactive, it should be multi-year and forward-looking. With the need to amortize Section 174 expenses over multiple years, you must consider how R&D spending affects your long-term tax position.

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Consider the following:

• Forecast amortization schedules: Know how current-year expenses will affect deductions in future years
• Track R&D credit carryforwards: Maximize utilization by aligning future profits with unused credits
• Model taxable income trajectories: Use scenario planning to test how future R&D investments impact cash flow, credit eligibility, and tax liability
• Evaluate upcoming product roadmaps or expansion plans: Time R&D spending to coincide with periods of high-margin growth

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You can also explore cost segregation studies and software tools to automate amortization tracking and credit allocation across projects and tax years.

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Practical Implementation Strategies

Successfully navigating the complexities of Section 174 capitalization and maximizing the R&D tax credit requires accurate execution. Once your plan is in place, your next step is implementation.

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That means creating the right documentation, using purpose-built tools, streamlining internal processes, and collaborating with tax professionals who understand the technical and strategic aspects of R&D tax incentives.

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Here are four strategies to ensure you maintain compliance and fully capture your tax benefits:

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Documentation

Strong documentation is mandatory for audit defense and IRS scrutiny. Since many Section 174 and Section 41 (R&D credit) expenditures overlap, maintain records that outline:

• Employee time logs allocated specifically to qualified research activities
• Project cost breakdowns with direct and indirect expenses separated
• Project charters or technical documentation to support the "qualified purpose" test
• Contract research agreements, especially those proving "substantial rights" and risk retention

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Use project-based accounting codes that map to 174 and 41 eligibility to prevent confusion during audits.

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Software and Systems

Manual tracking of research expenses across multiple departments can lead to errors and missed opportunities. That's why scalable R&D operations rely on specialized accounting and tax automation tools. These systems help you:

• Flag R&D-eligible vs. non-eligible costs in real time
• Track amortization schedules required under Section 174
• Integrate payroll, project management, and accounting data for seamless cost aggregation
• Generate reports needed for federal and state tax filings

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Some popular solutions include BPM R&D Tax Credit Software, Thomson Reuters ONESOURCE, and ERP systems with R&D modules (like NetSuite or QuickBooks with custom tagging).

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Internal Process Improvements

The disconnect between R&D teams, finance, and tax departments often leads to under-claimed credits or misclassified expenses.

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To avoid this, create internal processes that promote real-time communication and proactive planning:

• Schedule quarterly reviews where R&D managers provide updates on ongoing and upcoming projects
• Establish standard operating procedures (SOPs) for tracking qualifying activities and expenditures
• Educate teams on what qualifies under Sections 174 and 41 (especially when it comes to foreign vs. domestic costs)
• Create a centralized documentation repository accessible by finance and tax teams

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Cross-functional collaboration ensures the tax team gets accurate, timely inputs while R&D leaders understand the financial impact of their activities.

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Advisor Collaboration

Section 174 and R&D credit rules always change. That's why it's important to work with a specialized tax advisor or CPA year-round. Advisors help you:

• Interpret IRS guidance and apply relevant Rev. Procs. (e.g., Rev. Proc. 2023-11 for Section 174 method changes)
• Handle change-in-accounting-method filings to stay compliant with updated capitalization rules
• Plan for legislative changes, such as the potential reinstatement of full expensing under proposed tax reform
• Maximize federal and state-level R&D credits with tailored strategies

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Your tax advisor should be fluent in Section 174 amortization rules and Section 41 credit opportunities, ensuring your company doesn't lose one benefit trying to claim another.

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Streamline Your R&D Tax Strategy With Expert Back-Office Support

Managing Section 174 capitalization requirements and R&D tax credits requires accurate documentation, error-free expense tracking, and strategic financial planning. These complex tax provisions can consume valuable time and resources that should be invested in core business activities.

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Chore's fractional operations team specializes in the financial and compliance infrastructure that R&D-intensive businesses need to maximize their tax benefits.

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The dedicated Chore CEOs handle the important back-office functions that impact your ability to optimize Section 174 deductions and R&D credit eligibility.

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Here are areas where Chore supports R&D tax optimization:

• Financial operations and bookkeeping: Proper expense categorization and documentation are important for Section 174 compliance and R&D credit qualification
• Payroll management: Since qualified research expenses often include employee wages, accurate payroll records are important for maximizing your R&D credits while properly capitalizing Section 174 expenses
• Document management: Maintaining organized digital archives of research documentation, project records, and supporting materials helps substantiate tax benefits during audits
• Regulatory compliance: State-level R&D credits and multi-jurisdiction Section 174 requirements demand ongoing compliance attention

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Rather than diverting your technical talent toward administrative tasks or hiring expensive internal operations staff, Chore provides the specialized back-office support that enables your team to focus on innovation while ensuring your tax optimization strategies are properly executed.

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Ready to maximize your R&D tax benefits without the administrative burden? Schedule a demo with Chore to discover how fractional operations support can strengthen your tax planning while freeing your team to focus on breakthrough research and development.

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FAQs

What is section 174 of the R&D tax credit?

Section 174 governs how businesses deduct research and development (R&D) costs, requiring them to capitalize and amortize expenses over time. It's separate from the R&D tax credit under Section 41, which provides a dollar-for-dollar tax reduction for qualified R&D activities.

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What qualifies as R&D credit?

To qualify for the R&D tax credit, a business activity must meet the IRS four-part test:

• Permitted Purpose: Aims to improve a product or process
• Technological in Nature: Based on hard sciences like engineering or computer science
• Elimination of Uncertainty: Seeks to resolve unknowns in design or methods
• Process of Experimentation: Involves testing, modeling, or prototyping

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What is the purpose of Section 174?

The purpose of Section 174 of the Internal Revenue Code is to define how businesses must treat research and experimental (R&E) expenditures for tax purposes.

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Originally, Section 174 allowed companies to immediately deduct qualified research and development (R&D) costs in the year they were incurred, which encouraged innovation by offering upfront tax relief.

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However, starting in tax year 2022, due to changes from the Tax Cuts and Jobs Act, the law now requires companies to:

• Capitalize all R&E expenses
• Amortize them over 5 years (for domestic research) or 15 years (for foreign research)
• Apply these rules even if the company isn't yet profitable

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