IRS Section 174 Guidance: Domestic Expensing, Foreign Amortization

For tax years beginning after December 31, 2024, domestic research and experimental expenditures are once again immediately deductible under the new Section 174A, while foreign R&E costs must still be capitalized and amortized over 15 years under Section 174. That split is the core of the current Section 174 R&E expensing and amortization rules, created when the One Big Beautiful Bill Act was signed into law on July 4, 2025.¹ Calendar-year taxpayers see the change starting with their 2025 returns.² If you perform research both inside and outside the United States, you now have to track your costs under two parallel regimes.

Domestic R&E: Immediate Deduction Under Section 174A

Section 174A lets you deduct all domestic research and experimental expenditures in the tax year they are paid or incurred, restoring the pre-TCJA treatment.¹ Software development performed in the United States also qualifies for the immediate deduction, because software development remains classified as R&E under both Sections 174 and 174A.³

The Optional 60-Month Amortization Election

Instead of deducting domestic R&E immediately, you can elect under Section 174A(c) to capitalize the costs and amortize them over a period of at least 60 months.¹ Unlike the TCJA’s midpoint convention, this optional amortization starts in the month you first realize benefits from the expenditure. The election has to be made on a timely filed return (including extensions), and once made it locks in the method for that year and every year after unless the IRS approves a change.² Most taxpayers will take the immediate deduction. The amortization option is useful mainly for smoothing large R&E deductions to manage taxable income or alternative minimum tax exposure.

Retroactive Election for Small Businesses

The OBBBA includes a retroactive fix for small businesses. If your average annual gross receipts are $31 million or less (using the Section 448(c) test, computed for the first tax year beginning after December 31, 2024), you can elect to apply Section 174A retroactively to domestic R&E paid or incurred in tax years beginning after December 31, 2021.² You make the election either by amending returns for each affected year or by filing an accounting method change. For a small business that capitalized substantial domestic R&E during 2022 through 2024, this is the mechanism for recovering deductions the TCJA deferred.

Foreign R&E: 15-Year Amortization Continues

The OBBBA did not change the treatment of foreign research expenditures. Costs attributable to R&E activities physically performed outside the United States must still be capitalized and amortized over 15 years.³ What matters is where the research work happens, not where the taxpayer is headquartered or where the results are ultimately used. Software developed abroad follows the same 15-year rule.

The amortization period begins at the midpoint of the tax year in which the expenditure is paid or incurred. For a calendar-year taxpayer, that means amortization starts on July 1, so only a half-year deduction is available in the first year.⁴ Full-year deductions follow until the entire capitalized amount is recovered. Annual amortization is reported on Form 4562.⁵

No Write-Off on Abandonment

One of the harshest features of Section 174 stays in effect for foreign R&E: if the underlying research property is sold, retired, or abandoned before the 15-year period ends, the remaining unamortized balance cannot be written off immediately.³ You keep amortizing on the original schedule as if nothing happened. This applies even when the research product turns out to be completely worthless. A taxpayer who abandons a foreign R&E project in year three still carries the remaining costs on the books for another 12 or more years, and the unamortized balance cannot be used to compute gain or loss on a transfer.

What Counts as an R&E Expenditure

Not every innovation-related cost qualifies. An expenditure falls under Section 174 or Section 174A only when the underlying activity is intended to discover information that resolves genuine uncertainty about the development or improvement of a product. The product can be a formula, invention, technique, patent, or pilot model. Uncertainty exists when available information does not establish the capability, method, or appropriate design for developing the product.

The distinction from ordinary business expenses under Section 162 matters. Routine quality control testing, market research, consumer preference studies, and efficiency surveys are generally Section 162 costs, not R&E. The practical difference is large: Section 162 costs are deducted immediately regardless of where they occur, while foreign R&E must be amortized over 15 years. Treating Section 162 costs as R&E delays deductions unnecessarily. Treating genuine R&E as Section 162 invites IRS challenges and penalties.

The Uncertainty Test

The uncertainty test is the gatekeeper. The activity must relate to a specific technical challenge where the taxpayer does not know at the outset whether the desired result is achievable, what method will work, or what the appropriate design should be. Simply wanting a faster or cheaper process does not qualify if the path is already established. Costs to integrate disparate systems, create novel algorithms, or improve a product’s functionality, performance, or reliability through genuine technical risk generally do qualify. Document what was unknown at the start of each project and how the research addressed it.

What’s Excluded

Certain spending is excluded regardless of technology content. Costs to acquire another person’s patent, model, production process, or similar property do not qualify. Routine testing or inspection for quality control is excluded. Costs capitalizable under other Code sections as tangible property follow those provisions instead. Notice 2023-63 clarifies that an expenditure qualifies as R&E only under Section 174 and cannot simultaneously be deducted under Section 162 or capitalized under Sections 263(a), 263A, or 471.⁶

Software Development

Software development is explicitly classified as R&E under both Sections 174 and 174A.³ The definition covers planning, designing, model building, code writing, and testing through internal deployment or through development of product masters for external sale. Whether the software is built for internal use or for sale does not change the R&E classification. The relevant question is whether the development involves technical uncertainty. Building a novel database architecture or an advanced machine learning model meets that threshold. Installing, maintaining, or routinely debugging existing software does not. Neither does purchasing off-the-shelf software with minor customizations.

Which Costs Go Into the R&E Pool

Once an activity qualifies, you have to capture all costs associated with it, both for domestic R&E (to compute the immediate deduction) and for foreign R&E (to compute the amortization base). Notice 2023-63 provides the framework.⁶

Labor

Labor is typically the largest category. Include all compensation for employees who perform, supervise, or directly support R&E: base salary, overtime, vacation and holiday pay, stock-based compensation, payroll taxes, health insurance, pension contributions, and other fringe benefits. Direct support personnel such as lab technicians, R&E-dedicated administrative staff, and maintenance workers assigned to research facilities are also included.⁶ When an employee splits time between R&E and non-R&E work, use a reasonable method to allocate compensation. General executive and administrative functions not specifically dedicated to R&E are excluded. Severance compensation is also excluded.

Overhead and Facilities

Allocate a portion of overhead to R&E: rent, utilities, insurance, property taxes, repairs, maintenance, and security for facilities and equipment used in the work.⁶ When a building or piece of equipment serves both R&E and non-R&E purposes, the allocation must reflect a cause-and-effect relationship or another method that reasonably connects the cost to the R&E activity. A common approach is the ratio of R&E labor hours to total labor hours.

Depreciation of R&E Equipment

Depreciation and other cost recovery allowances on property used in R&E are themselves R&E expenditures.⁶ This is a nuance that trips people up. The purchase price of lab equipment is capitalized and depreciated under the normal rules (Sections 263 and 168). The resulting annual depreciation then flows into the R&E calculation. For domestic equipment, that depreciation is part of the immediate Section 174A deduction. For equipment used in foreign R&E, the depreciation gets swept into the 15-year amortization pool. This applies even to equipment placed in service before the TCJA changes took effect in 2022.

Patent Costs

Costs to obtain a patent are R&E: attorney fees for drafting and filing patent applications, patent search costs, and fees for interference proceedings.⁶ Legal fees for licensing a patent to others or defending against infringement claims are ordinary business expenses, not R&E.

Contract Research

When you pay a third party to perform R&E, the payment is your R&E expenditure. Whether the cost is domestic or foreign depends on where the contractor actually performs the work, not where the contractor is based. Get documentation from the contractor confirming the geographic location. If you are the provider performing research under contract for a client, Notice 2023-63 provides that costs are your R&E if you bear financial risk under the contract, or if you retain rights to use or exploit the resulting research product through sale, lease, or license.⁶ If the client retains all rights and bears all risk, the client capitalizes the payment and the provider treats its costs as ordinary business expenses.

Legacy Domestic R&E From 2022 Through 2024

Domestic R&E paid or incurred in tax years beginning after December 31, 2021, and before January 1, 2025, was subject to the TCJA’s mandatory five-year capitalization and amortization rules.⁴ Those rules used the same midpoint convention as foreign R&E, and the no-acceleration-on-disposition rule under Section 174(d) applied to those domestic costs as well.³

If you capitalized domestic R&E during that window and do not qualify for the small business retroactive election, keep amortizing those costs over their original five-year schedules. Unamortized balances from 2022, 2023, and 2024 do not disappear because Section 174A now allows immediate expensing on new spending. Those legacy costs continue their scheduled amortization alongside current-year deductions, which means overlapping tracking for several more years.

Accounting Method Change Procedures

Switching between R&E accounting methods requires IRS consent. Revenue Procedure 2025-28 consolidates the automatic consent procedures for changes under both Section 174 (foreign R&E capitalization) and Section 174A (domestic immediate expensing or optional amortization).²

Moving to Section 174A for Domestic R&E

Taxpayers switching from TCJA-era capitalization to the Section 174A immediate deduction method use designated automatic change number 273.² The IRS waived the requirement to file a full Form 3115 for this change. You file a statement in lieu of Form 3115 with your timely filed return, including your name and identification number, the designated change number (273), and a declaration that you are changing to the Section 174A deduction method on a cut-off basis. A similar statement applies if you are electing the Section 174A amortization method.

Changes Under Section 174 for Foreign R&E

The designated automatic change number for switching to the TCJA Section 174 capitalization method, which still governs foreign R&E, remains 265.² This change requires a full Form 3115, Application for Change in Accounting Method, filed with the timely filed return for the year of change. The form must include a general description of the R&E expenditures, the tax years in which the costs were paid or incurred, and a declaration explaining the reason for the change. A duplicate copy goes to the IRS National Office.

Section 481(a) Adjustment

Any accounting method change produces a Section 481(a) adjustment so that income or deductions are not counted twice or missed. If you change to Section 174A on the cut-off method, the adjustment applies only to expenditures going forward, so there is no cumulative catch-up. If you change to Section 174 capitalization for foreign R&E, you may compute a modified Section 481(a) adjustment that accounts only for expenditures paid or incurred in tax years beginning after December 31, 2021.² Filing through the automatic consent procedures is the cleanest path. Miss that window and you are in the non-automatic procedures, which are more complex and can produce less favorable adjustments.

Coordination With the Section 41 R&D Credit

Section 174 expenditures and Section 41 R&D credits overlap but are not identical. Section 41 qualified research expenses are a narrower subset of Section 174 costs. The R&D credit covers wages (Box 1 W-2 only), supplies, cloud computing costs, and contract research at 65 cents on the dollar, and only for research performed in the United States. Section 174 sweeps in a much broader pool: gross wages plus all benefits, depreciation, patent fees, overhead, software licenses, and foreign research costs. Running the Section 41 calculation first identifies the baseline of qualifying costs that then feeds into the broader Section 174 analysis.

When you claim the R&D credit, Section 280C requires an adjustment to prevent a double benefit. The default rule reduces your R&E deduction by the amount of the credit. Alternatively, you can make an irrevocable Section 280C(c)(2) election to claim a reduced credit and preserve the full R&E deduction.⁷ The reduced credit equals the gross credit minus the product of the gross credit and the maximum corporate tax rate (currently 21%), which works out to roughly 79% of the full credit. This election must be made on an originally filed return and cannot be changed after the fact.

1
Office of the Law Revision Counsel. 26 U.S. Code 174A – Domestic Research or Experimental Expenditures
2
Internal Revenue Service. Rev. Proc. 2025-28
3
Office of the Law Revision Counsel. 26 U.S. Code 174 – Amortization of Research and Experimental Expenditures
4
Internal Revenue Service. Rev. Proc. 2023-8
5
Internal Revenue Service. About Form 4562, Depreciation and Amortization (Including Information on Listed Property)
6
Internal Revenue Service. IRS Notice 2023-63
7
Office of the Law Revision Counsel. 26 U.S. Code 280C – Certain Expenses for Which Credits Are Allowable