Understanding Section 174 and Section 41 of the tax code can help educe compliance risks and avoid exposing clients to penalties during an audit, say Rick Kleban and James Bean of Sycamore Growth Group.

Recent changes to the tax code have left some business owners and CPAs with their heads spinning. Who can blame them? Understanding the tax code is challenging, particularly when it comes to resolving the treatment of research and development expenses in light of the changes to Section 174 that went into effect in 2022.

While uncertainty abounds in how to apply these changes, some aspects can be made clear by fully understanding the interplay between Section 174, which governs the amortization of R&D expenditures, and Section 41, the credit for increasing research activities.

Failing to understand these nuances could expose a taxpayer to underpayment penalties. By taking proactive measures, the potential risks in compliance with the rules and regulations can be mitigated.

Unraveling the Connection

Section 41 defines qualified research as research or experimental expenses that may be eligible under Section 174. In other words, Section 174 acts as a qualifier for research expenses, or QREs, under Section 41, but doesn’t require QREs to be recorded as R&D expenditures under Section 174 on tax returns.

This understanding is supported by the IRS’s Section 174 test in the “Audit Techniques Guide: Credit for Increasing Research Activities IRC Section 41.”

More importantly, this understanding is consistent with the fact that taxpayers routinely don’t have to make any changes after IRS audits of their R&D claims, even though these expenses were recorded under code sections other than Section 174.

Proper Expense Classification

Regardless of whether taxpayers elect to claim R&D tax credits under Section 41, they still need to assess whether their expenses adhere to the definition of research and experimentation as outlined in Section 174.

The decision to forego claiming Section 41 R&D credits has no bearing on the Section 174 amortization question, but incorrectly classifying expenses can lead to potential tax liabilities and penalties if audited by the IRS. Under audit, both the taxpayer and the preparer would be required to defend the classification of expenses.

A Common Misunderstanding

There are those who assert that if taxpayers don’t claim the Section 41 credit, they need not evaluate their expenses under Section 174. This interpretation is incorrect and can have severe consequences if the taxpayer faces an IRS audit.

For example, Taxpayer A, a specialty manufacturer, claims $2 million in qualified research expenses every year between 2015 and 2021, resulting in $200,000 in R&D tax credits for each year. In 2022, the nature of their business didn’t change. However, the company decides not to claim the Section 41 R&D tax credit on its 2022 tax return, with the mistaken belief that they no longer have to explain how Section 174 may or may not change how its expenses are recorded.

After filing their tax return, the IRS audits Taxpayer A’s claim. To the IRS, the reason for the audit is either to confirm the nature of the taxpayer’s business materially changed or the taxpayer is intentionally understating their tax liability. Under audit, the IRS could seek penalties or worse.

The IRS would examine all of Taxpayer A’s activities to see which met the broad definition of research and experimentation as per Section 174. Unless the manufacturer could substantiate that they no longer did the same type of work, Taxpayer A wouldn’t have a rationale for failing to make a Section 174 determination.

Legislative Intent

To understand why the relationship between Sections 174 and Section 41 operates as it does, let’s look at their legislative and judicial history.

Congress enacted Section 174 in 1954 in response to concerns that established companies could deduct R&D expenditures but start-up businesses couldn’t. In 1980, Congress added Section 41 to the tax code, which provided R&D tax credits as a way to offer businesses incentive to invest in research and experimentation.

While Section 41 references the definition of R&D expenses found in Section 174, it doesn’t mandate Section 174 treatment. Instead, it allows taxpayers to use Section 41 for the purposes of R&D tax credit calculations if the expenses may have been eligible for Section 174 treatment. The actual recording of expenses remains unaffected by Section 41.

Taking Proactive Measures

While the Section 174 rule change is new to both the industry and the IRS, steps can be taken to ameliorate its impact.

Build written substantiation. Be prepared to defend the determination regarding which expenses do and don’t meet the definition of research and experimentation. Start by looking at activities that are related to or have a component of engineering and programming expenses. Back up this determination with written substantiation of why the activities in question don’t rise to the level of research and experimentation.

Don’t attempt to sidestep Section 174. Don’t fall into the trap of forgoing R&D tax credit claims in hopes of avoiding amortization. Instead, take the results of a carefully conducted Section 174 audit to address the rule change. Use that information to begin evaluating eligibility for the Section 41 R&D tax credit.

Identify potential safe harbors. Last spring, Scott Vance, IRS associate chief counsel of income tax and accounting, conceded that the agency has work to do in creating clear guidance on what must be amortized. Encouragingly, Vance noted that the IRS received formal input regarding potential safe harbors for Section 174. As of yet, there is no consensus as to the identification of these exceptions. Accordingly, the burden falls on preparers to conduct rigorous research to understand whether their taxpayers’ facts and circumstances allow R&D that historically was treated as ordinary and necessary business expenses to remain so.

Stay informed. Because the relationship between Section 174 and Section 41 was never material to a taxpayer’s tax liability, it’s often misunderstood. Fortunately, as some in the industry go back and study the labyrinth of rules and regulations, we are gaining insight as to the correct application of Section 174. Keep apprised of new industry analyses that hold the promise to present more nuanced and accurate understandings of how Section 174 is applied across various situations.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Rick Kleban is founder and president of Sycamore Growth Group, an Ohio-based firm that specializes in helping small and medium-sized businesses attain and substantiate R&D tax credits.

James Bean is senior analyst at Sycamore Growth Group, specializing in investigating clients’ tax issues.