Innovation is often rewarded in many ways, but the US tax code isn’t one of them. Fortunately, IRC section 174 can provide some relief for inventors who are engaged in research. This section of the tax code is intended to encourage individuals and companies to explore new technologies.
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What Does IRC Section 174 Say?
While nobody would probably describe the US tax code as simple, the language in this code section isn’t too difficult to decipher. It says that a taxpayer may treat expenses related to experimentation and research as deductible expenses. The only requirement is that the individual taking the deduction must personally incur the costs. The language specifically explicitly costs charged to a capital account.
In numerical value, this means that if an individual makes $80K in one year and they incur research and experimentation-related costs totaling $20K in that same year, their taxable income is $60K for that year.
What Qualifies as Research and Experimentation?
Research and experimentation (R&E) encompasses all activities related to designing, creating, and improving an invention. These activities are rooted in scientific and technological discoveries, including filing patents, developing processes, creating prototypes, and developing formulas, techniques, or products.
The key here is that it has to be new or unique in nature. Inventors cannot claim a section 174 deduction for repeating an invention that has already been patented. You also cannot claim the deduction for discoveries that are not specifically scientific or technological in nature. This means that technical data for sales and marketing does not qualify.
The good news is that your R&E deductions do not have to be for a specific invention, and these deductions can be taken on research that is general in nature. It also does not need to be prosperous or stable to qualify for the deduction.
What Expenses Can You Deduct?
The Internal Revenue Service (IRS) has a reputation for being sticklers for the rules. Since the rules for IRC Section 174 are so specific, you may be wondering exactly what type of expenses you can deduct.
Both direct and indirect R&E expenses are typically allowed. Direct expenses include things like laboratory equipment, computers, and fees paid to employees or contractors that are directly related to your research. Indirect expenses like rent for lab space, travel expenses, and membership dues that support, but are not directly related to your research, are also deductible.
It’s important to note that there are some oddball exceptions that you cannot deduct. One of those exceptions is the cost of the long-term property. If you purchase property with a useful life greater than one year, you cannot deduct that expense under section 174. This could be expensive lab equipment like a microscope. These types of equipment purchases can likely be depreciated with your business assets, though.
Other common activities like quality control testing, management studies, consumer research, and more cannot be deducted under section 174. Most of these activities are considered business and sales expenses and not inventor expenses.
Parachor Consulting can help you make sense of your tax deductions. Our firm is made up of tax code experts from a range of backgrounds in accounting, legal, engineering, and statistics. We use a custom-tailored process to help you make the most out of your tax benefits. Learn more today.
Other Requirements for Section 174 Deductions
The first requirement you need to satisfy for R&E deductions is that all expenses must be incurred as part of a trade or business. This requirement is simple to satisfy because the R&E activities often qualify as a business or trade by themselves. This means that even new inventors who are not affiliated with an existing business can take these deductions.
The second requirement is that the expenses must be reasonable. While the IRS does not specify a dollar limit for these deductions, large dollar amount deductions in proportion to low-income levels is a red flag for an audit. And like all other deductions, if the IRS finds that the deduction is abused, your tax bill will be adjusted, and you will owe a penalty.
Finally, section 174 expenses must be deducted in the year that they were incurred.
Section 174 News to Keep Your Eye On
The Tax Cuts and Jobs Act of 2017 is threatening how section 174 deductions can be taken. The new rule takes effect on January 1, 2022, unless specific legislative action prevents it. R&E expenses have always been deductible in the year they were incurred. However, with this change, inventors may be required to amortize their costs over multiple years instead.
If you are hoping for a hail Mary on the pending changes to this tax code, many groups and Fortune 100 companies lobby against it. There is still hope that new legislation could reverse this decision before December 31.
Final Thoughts on Section 174 Deductions
Research and innovation are what move us forward as a country and as a society. This is why there is a special provision in the US tax code to allow deductions related to research and experimentation that support innovation in science and technology. This deduction has always been deductible within the year that the expenses were incurred; however, new legislation is threatening to change this effective January 2022, forcing businesses and individuals to amortize their costs over a five- or fifteen-year period.
Parachor Consulting are the experts in tax incentives. Our team is made up of CPAs, attorneys, engineers, and statisticians who know the tax code inside and out. Our goal is to help you legally maximize your tax benefits. Start a conversation with our firm today.