How does Section 174 work with the R&D credit (Section 41)?

In order to understand the impact of this legislation, it’s crucial to understand the relationship between Section 174 Expenses and Section 41 Expenses. Section 174 Expenses are known as Research and Experimentation, or R&E Expenses. The expenses that fall under Sec. 174 can be divided into two categories, based on how essential each is to the activity being performed. Section 174 expenses encompass both direct and indirect research expenses (onshore and offshore) but are not necessarily eligible for the tax credit.  

Section 41 Expenses are known as Research and Development, or R&D Expenses. These are known as “Direct Research Expenses,” and are what usually come to mind when you imagine research and development.  Section 41 expenses is a subset of Section 174 expenses, focusing only on direct research expenses that qualify for the R&D Tax Credit. 

While the R&D tax credit calculations, including the definition of QREs, are not changing, Section 41 expenses will no longer be deductible on businesses tax returns in the year they are incurred. By default, Section 41 expenses are classified as a Section 174 expense. The new Section 174 rules require companies claiming R&D credits to capitalize and amortize their expenses on their tax return—potentially increasing their tax bill and reducing their anticipated cash flow. As a result, the calculation of Section 41 should be the starting point in determining the potentially qualifying Section 174 expenditures and should be done concurrently.