How Research and Development Expenses are Treated Under Section 174 and Section 174A

Introduction to Section 174 and Recent Legislative Changes

Section 174 of the Internal Revenue Code governs how businesses treat research and development (R&D) expenses for tax purposes. These expenses typically include costs related to software development, product design, engineering, and testing activities undertaken to create or improve products and services. The treatment of these costs directly impacts taxable income, cash flow, and overall tax planning.

Prior to 2022, businesses were allowed to deduct the full amount of their R&D expenses in the same year in which they were incurred. This approach was simple and provided an immediate tax benefit.

However, this changed under the Tax Cuts and Jobs Act (TCJA). For tax years beginning after December 31, 2021, businesses are required to capitalize and amortize R&D expenses instead of deducting them immediately. Domestic R&D costs must be amortized over five years, while foreign R&D costs must be amortized over fifteen years. This change increased complexity and resulted in higher taxable income in the early years, as only a portion of the expense could be deducted annually.

Due to concerns raised by businesses and industry groups regarding increased tax burden and administrative complexity, further changes were introduced through the One Big Beautiful Bill Act. This legislation added Section 174A, which provides greater flexibility in the treatment of domestic R&D expenses. Under Section 174A, businesses can choose to deduct their US-based R&D expenses immediately or amortize them over a period of five or ten years, depending on their tax planning needs. However, foreign R&D expenditures continue to be subject to the fifteen-year amortization requirement.

To support implementation, the Internal Revenue Service issued Revenue Procedure 2025-28, which outlines procedures for making elections, changing accounting methods, and applying these updated rules. The guidance also provides certain simplifications for small businesses that meet the applicable gross receipts threshold.

Understanding R&D Expense Treatment Under Section 174

Immediate Deduction vs Amortization

The key difference under Section 174 lies in whether a business can deduct its R&D expenses immediately or must spread them over time.

An immediate deduction allows a business to reduce its taxable income in the same year the expense is incurred. In contrast, amortization requires the business to spread the deduction over several years, reducing taxable income gradually rather than all at once.

Under the TCJA framework, immediate deduction was no longer allowed, and all R&D costs had to be amortized. With the introduction of Section 174A, businesses now have the flexibility to choose between immediate deduction and amortization for domestic R&D expenses.

Domestic vs. Foreign R&D Treatment

The location where R&D activities are performed determines how the expenses are treated.

•    R&D performed within the United States qualifies as domestic R&D and may be deducted immediately or amortized over five or ten years under Section 174A.

•    R&D performed outside the United States is treated as foreign R&D and must be amortized over fifteen years, with no option for immediate deduction.

It is important to note that this classification depends on where the work is physically performed, not where the company is headquartered or where the product is sold.

Catch-Up Provisions for Prior Years

Businesses that incurred R&D expenses between 2022 and 2024 were required to follow the TCJA rules and amortize those costs. The updated provisions allow taxpayers to adjust the treatment of these prior expenses.

Taxpayers may either:

•    Deduct the remaining unamortized balance in a single year, or

•    Spread the remaining deductions over two years

For example, consider a company that incurred ₹1 crore of U.S.-based R&D expenses in 2023. Under the TCJA rules, this amount was required to be amortized over five years, resulting in an annual deduction of ₹20 lakh. By the end of 2024, the company would have claimed ₹40 lakh, leaving ₹60 lakh unamortized.

Under Section 174A, the company can now revise this treatment. It may choose to deduct the remaining ₹60 lakh entirely in 2025, resulting in a larger one-time tax benefit. Alternatively, the company may spread this remaining amount evenly over two years, claiming ₹30 lakh in 2025 and ₹30 lakh in 2026, thereby smoothing the tax impact across multiple periods.

This change is implemented through a Section 481(a) adjustment, which allows taxpayers to align prior-year treatment with the newly adopted method without the need to amend previously filed tax returns. Instead, the adjustment is recognized in the current year, simplifying the transition while ensuring compliance.

Interaction with the R&D Tax Credit

In addition to deductions, businesses may also be eligible for the R&D Tax Credit, which directly reduces the amount of tax owed.

However, businesses cannot fully benefit from both a deduction and a credit on the same expenses. If a taxpayer claims the R&D tax credit, they must reduce the corresponding deduction. This adjustment is commonly referred to as a Section 280C adjustment.

Understanding this interaction is important to avoid errors and ensure compliance.

Compliance Requirements and Filing Considerations

Applying the treatment of R&D expenses under Section 174, as modified by Section 174A, is not automatic. Businesses are required to formally communicate their chosen method of treating R&D expenses to the IRS through their tax filings. This is done by making an election in the tax return, where the taxpayer specifies whether the expenses will be deducted immediately or amortized over a selected period, such as five or ten years for domestic R&D under Section 174A. If this election is not properly made, the IRS may default to standard treatment, and the intended tax benefit may not be available.

In situations where a business changes how it treats its R&D expenses, such as moving from amortization under the Tax Cuts and Jobs Act (TCJA) to immediate deduction under Section 174A, it is generally considered a change in accounting method. In such cases, the taxpayer is typically required to file Form 3115. This form notifies the IRS that the company is changing its method of accounting and ensures that the transition is properly documented and approved. As part of this process, the taxpayer must also calculate a Section 481(a) adjustment, which reflects the cumulative impact of the change and allows prior-year differences to be accounted for in the current year without amending earlier returns.

To guide taxpayers through this process, the IRS issued Revenue Procedure 2025-28. This guidance provides a structured approach for implementing the updated rules under Section 174A. It explains when and how to file Form 3115, how to compute the Section 481(a) adjustment, and how to properly make elections in the tax return. It also outlines specific procedures for taxpayers who want to apply the catch-up provisions for prior years. Following this guidance is important, as incorrect or incomplete filings may lead to delays, denial of deductions, or additional scrutiny from the IRS.

From a practical perspective, businesses should also ensure that they maintain detailed documentation supporting their R&D expenses. This includes clearly identifying which costs qualify as R&D, determining whether the work was performed within or outside the United States, and maintaining calculations for amortization or immediate deduction. Proper documentation not only supports compliance but also becomes critical in the event of an IRS review or audit.

Conclusion

Section 174 has undergone significant changes in recent years, transitioning from a system of immediate expensing to mandatory amortization under TCJA and now to a more flexible framework under Section 174A introduced by the One Big Beautiful Bill Act.

These changes provide new opportunities for tax planning but also introduce additional complexity. Businesses must evaluate their options carefully, ensure proper compliance, and align their R&D expense treatment with their overall financial strategy.