Kilroy v. Commissioner, T.C. Memo. 1980-489, illustrates how sustained inventive activity can constitute a trade or business for purposes of the historical Section 174 research and experimental expenditure deduction. This study examines that holding, the treatment of related office expenses, and the distinction between research deductions and the Section 41 research credit. Modern applications must also account for Section 174A, which restored immediate deductions for qualifying domestic research expenditures for taxable years beginning after December 31, 2024.
The Historical Genesis of Section 174 and the Trade or Business Doctrine
Congress introduced Section 174 in 1954 to reduce uncertainty over the tax treatment of research costs and encourage investment in new products. Before its enactment, the distinction between deductible business expenses and capital expenditures created particular difficulties for ventures conducting research before commercial operations began. The rules did not simply grant deductions to large corporations while denying identical expenses to all small businesses.
The historical statute permitted taxpayers to expense qualifying research costs incurred in connection with a trade or business. Its language differed from Section 162, which generally permits deductions for ordinary and necessary expenses incurred in carrying on a trade or business.
The Business Standards: Section 162 versus Section 174
In Snow v. Commissioner, 416 U.S. 500 (1974), the Supreme Court held that the absence of current sales did not itself prevent a research deduction under Section 174. The case concerned a partnership developing an incinerator. The Court distinguished the broader connection-to-business language from Section 162’s carrying-on requirement. Snow did not eliminate the need for a genuine business nexus or make every speculative investment deductible.
An active business need not earn revenue in every taxable year. Whether operations have begun depends on the nature of the enterprise; it cannot always be reduced to whether a finished product is ready for sale.
| Regulatory Comparison | Section 162 | Section 174 | Section 195 |
|---|---|---|---|
| Primary Standard | Carrying on a trade or business. | Research in connection with a trade or business; current Section 174 concerns foreign research. | Qualifying costs of investigating or creating an active business. |
| Stage of Operation | Business operations have commenced; actual receipts are not always necessary. | A developmental stage can qualify if the required business connection exists. | Generally the pre-operating phase. |
| Tax Treatment | Ordinary and necessary expenses generally deductible, subject to other limitations. | Current foreign research generally amortized over 15 years. Domestic research is now addressed by Section 174A. | Potential initial deduction of up to $5,000, reduced when costs exceed $50,000; remaining qualifying costs amortized over 180 months from business commencement. |
| Exclusions | Capital expenditures and costs subject to other specific provisions. | Separate rules apply to assets, mineral exploration and other excluded costs. | Excludes amounts deductible under Sections 163, 164, 174 or 174A. |
Kilroy v. Commissioner: The Fact Pattern and Judicial Inquiry
The taxpayers were Oliver B. Kilroy and Alice W. Kilroy. The inventing dispute concerned Oliver’s activities and those of Kilroy Enterprises in 1972 and 1973. His work included pallet-and-container and hydraulic mining inventions. His activities also included mining exploration and personal investment management.
The IRS Challenge: Business Status and Profit Motive
The Commissioner disputed the business connection of the inventing expenses and the deductibility of miscellaneous office expenses. Profit intent mattered, but the case should not be described solely as a hobby-loss dispute. An earlier case had involved materially less developed inventive activity.
The Tax Court’s Findings and Decision
The court found a business of inventing, relying on sustained patenting, marketing efforts and consultation with advisers despite the lack of invention income. It allowed the research expenses and the related share of office expenses. Mining-related office costs were separately deductible under Section 617. It allowed 90 percent of incidental expenses for the combined inventing and mining activities, denying the 10 percent attributed to personal asset management for lack of proof. The decision was therefore not an unrestricted taxpayer victory.
Eligible Costs: The Inclusion of Indirect Expenditures
Kilroy supports allocating research-related office expenses to the historical Section 174 deduction. It does not establish that every administrative expense of an innovative business is a research expenditure. Nor does it make those expenses eligible for the Section 41 credit.
Telephone, Travel and Office Costs
In allowing the research-related portion of office expenses, the court referred to earlier authority involving utilities, telephone, travel and labor. The important issue is the connection between the expenditure and the relevant activity. Personal costs and costs connected with other activities require separate treatment.
For the TCJA capitalization regime, Notice 2023-63 provides more detailed allocation guidance. It includes certain research-related labor, materials, facilities and operational costs, while excluding general administrative functions that only indirectly support research. Historical judicial language must be applied alongside the rules governing the particular year.
| Eligible Indirect Costs Under Kilroy and Subsequent Guidance | Description | Judicial/Administrative Source |
|---|---|---|
| Communication Costs | Research-related share of telephone and communication expenses; no automatic credit eligibility. | Kilroy v. Commissioner; applicable research-cost allocation rules. |
| Travel | Travel connected with research, subject to allocation and substantiation requirements. | Earlier authority discussed in Kilroy; Notice 2023-63 for its applicable regime. |
| Facility Costs | Allocable research-facility costs, including relevant utilities and depreciation. | Notice 2023-63, Section 4. |
| Administrative Costs | Distinguish research management from payroll, human resources and accounting functions that only indirectly support research. | Notice 2023-63, Section 4. |
| Overhead | Apply a supported allocation method to costs sufficiently connected with research; exclude unrelated overhead. | Kilroy v. Commissioner; Notice 2023-63, Section 4. |
The Technical Framework: Uncertainty and Experimentation
The later formulation in Treasury Regulation Section 1.174-2 explains research expenditures by reference to uncertainty about capability, method or appropriate design. It should not be presented as the exact test adjudicated in Kilroy in 1980. Research qualification is determined by the nature of the work and the applicable legal rules.
The Nature of the Product
The regulation uses a broad product concept, encompassing inventions, processes, formulas, techniques and similar property. Success is not required. A patent can support the factual narrative, but does not establish that every related activity or expenditure meets the research-credit requirements.
Distinguishing Research from Production
Ordinary production costs after the relevant uncertainty is resolved are distinct from research costs. Filing a patent application or completing a functional prototype does not automatically establish that all uncertainty has ended. Further development may involve different unresolved issues. Conversely, routine production, marketing and quality control do not become research merely because they concern an innovative product.
Interplay with the Section 41 Research Credit
Kilroy addressed deductions, not the research credit. Its recognition of an inventing business does not establish credit qualification. Section 41 has separate activity requirements, expense categories and exclusions. Current Section 41(d)(1)(A) refers to domestic research or experimental expenditures under Section 174A; historical claims require the law applicable to their years.
The Four-Part Test Constraints
- Research expenditure requirement: The work must satisfy the applicable research-expenditure threshold, currently tied to Section 174A.
- Technological nature: The research must rely on principles of physical or biological science, engineering or computer science.
- Permitted purpose: The work must seek a new or improved function, performance, reliability or quality of a business component.
- Process of experimentation: Substantially all relevant activities must involve evaluating alternatives to resolve uncertainty.
The tests apply separately to business components. Treasury Regulation Section 1.41-4 generally defines substantially all as 80 percent or more, measured on a consistent reasonable basis. Routine testing, duplication, certain adaptations and other excluded activities do not qualify merely because technical personnel perform them.
The Carrying-On Distinction and Startup Exception
Section 41 generally requires expenses incurred in carrying on a trade or business. However, Section 41(b)(4) provides an exception for certain startup in-house research expenses intended principally for use in an active future business. Lack of current sales is therefore not a categorical bar to the credit.
| Feature | Section 174 | Section 41 |
|---|---|---|
| Business Standard | In connection with a trade or business; Section 174A uses the same business-connection language for domestic research. | Carrying on a trade or business, subject to the startup exception for qualifying in-house expenses. |
| Incentive Type | Research cost recovery; current Section 174 applies to foreign research, while Section 174A permits domestic expensing. | Credit against tax, subject to computation and utilization rules. |
| Definition of Cost | Broader research-cost classification, potentially including allocable indirect costs. | Specified wages, supplies, computer-use costs and eligible contract research. |
| Process Req. | Applicable research-expenditure rules, including special software treatment. | Separate experimentation test and other qualification requirements. |
Modern Implications: The TCJA and Restoration of Domestic Expensing
For taxable years beginning in 2022 through 2024, the TCJA generally required five-year amortization for domestic research and fifteen-year amortization for foreign research, beginning at the midpoint of the year. Public Law 119-21, enacted July 4, 2025, changed domestic treatment for taxable years beginning after December 31, 2024.
Domestic Research Under Section 174A
Section 174A generally allows an immediate deduction for qualifying domestic research expenditures. Taxpayers may instead elect capitalization and amortization over at least 60 months, beginning when benefits are first realized. Consequently, the assertion that all current domestic research overhead must enter a five-year amortization pool is outdated.
Transition provisions permit accelerated recovery of remaining 2022–2024 domestic balances in one or two years. Certain eligible small businesses also received a retroactive-election option, subject to deadlines and procedural requirements. Revenue Procedure 2025-28 addresses implementation. These provisions should be evaluated for the taxpayer’s filing circumstances rather than assumed to apply automatically.
Foreign Research and Fifteen-Year Amortization
Foreign research remains subject to Section 174’s fifteen-year recovery rule. For this purpose, research location follows the statutory definition, which distinguishes research outside the United States, Puerto Rico and U.S. possessions. The contractor’s mailing address or the payer’s incorporation jurisdiction does not alone establish where research occurred. Foreign research is also excluded from the federal Section 41 credit.
Contract Research and Substantial Rights
Contract analysis must distinguish the Section 41 funded-research exclusion from the rules classifying research expenditures for deduction or amortization. Kilroy did not decide modern contract-research or software-rights issues.
The Economic Risk of Failure
Under the Section 41 regulations, payment contingent on successful research can indicate that a contractor bears the relevant risk. A contractor must also retain substantial rights to avoid the funded-research exclusion. Neither a fixed-price label nor ownership language alone settles the analysis. Review payment obligations, acceptance terms, reimbursement and usable rights together.
For a customer claiming contract research expenses, Treasury Regulation Section 1.41-2 requires, among other things, an agreement made before the research, research performed on its behalf and liability for the expense even if the research fails. The generally applicable inclusion percentage is 65 percent, subject to statutory exceptions.
Research Providers and Notice 2024-12
Notice 2023-63’s interim Section 174 rules can classify a provider’s costs as research expenditures when the provider bears financial risk or retains a qualifying research-product right. Both conditions are not invariably required. Notice 2024-12 clarifies exclusions for certain separately acquired rights and rights limited to performing work for the research recipient.
A provider without financial risk or a qualifying right may have expenses outside that Section 174 classification; this does not mean its ordinary service-business expenses are categorically nondeductible. Nor does an allowable business deduction prove entitlement to the research credit. Apply each rule within its effective period and account for subsequent statutory changes.
Documentation and Substantiation: Lessons for Future Applications
Records should establish business purpose, qualifying activities, amounts and allocation. Patents and commercial outreach may help demonstrate business intent, while technical and financial records address different elements of a modern research claim. No single document establishes every requirement.
Specific Evidence Rather Than General Assertions
Treasury Regulation Section 1.41-4 requires records sufficient to substantiate credit entitlement. Employee titles and broad descriptions of innovation are inadequate substitutes for evidence of actual activities. Under Section 1.41-2, direct supervision means immediate supervision of qualified research, not higher-level management merely overseeing the organization. Testimony may contribute to substantiation, but should be supported by reliable facts and records.
The Documentation Checklist
| Documentation Type | Specific Items to Maintain | Purpose in Audit |
|---|---|---|
| Employee Substantiation | Payroll records, project assignments, time records and relevant meeting notes. | Connect claimed wages to performance, direct supervision or direct support of qualifying work. |
| Supply Substantiation | Invoices, purchase orders, receipts and records of use. | Support eligible supply costs and exclude depreciable property or unrelated materials. |
| Contract Research | Executed agreements, amendments, invoices, payment records and rights provisions. | Establish research scope, payment risk, retained rights and qualifying amounts. |
| Technical Proof | Design specifications, test plans, results, alternative evaluations and development histories. | Explain uncertainties and the actual experimentation performed. |
| Overhead Allocation | Utility bills, facility records, travel logs and documented allocation methods. | Support research-cost classification without treating all overhead as credit-eligible. |
Innovation Policy and Other Creative Activities
Research incentives reflect legislative choices about eligible activities, but they do not establish a universal tax disadvantage for all other creators. Section 263A(h), for example, provides an exception for qualifying creative expenses of freelance writers, photographers and artists. The tax treatment of a novelist’s or songwriter’s costs requires analysis of the applicable provisions rather than a blanket assertion that copyright-creation costs must be capitalized.
Future Outlook: Domestic Expensing and Foreign Capitalization
The practical lesson is to separate business status, research-cost classification, credit qualification and cost-recovery timing. An expense can be deductible as domestic research while remaining outside Section 41’s narrower credit categories. An inventor’s genuine business purpose does not by itself resolve the technical requirements.
The Role of Software Development
Sections 174 and 174A expressly address software development costs. Domestic development can fall under Section 174A, while foreign development falls under Section 174. 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states here at swanson read the biggest problem we see as specialized r d tax advisors is self-censorship companies believing they are not eligible for the r d tax credit when in reality the irs has a very broad definition of what it considers r d does your company design engineer or manufacture its own products do you look to improve the functionality performance or reliability of these products do you create new or improved processes in order to make things better faster or cheaper do you develop prototypes or computer generated models or do you develop software technology or other intellectual property if you answered yes to any of the previous questions your company may qualify for the r d tax credit congress has created a four-part test to help you identify activities that would be considered qualified research your work must satisfy these four main requirements it must be technological in nature a process of experimentation there must be technical uncertainty and a permitted purpose let’s go through these one by one one technological in nature this means the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences engineering or computer science two process of experimentation this is defined as a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result or the design of that result is uncertain the beginning of the research three technical uncertainty as a taxpayer you must intend to discover information that would eliminate uncertainty concerning the development or improvement of the business component and four permitted purpose it is a qualified purpose if research relates to a new or improved function increased performance enhanced reliability or enhanced quality it is not a qualified purpose if research relates to aesthetics meaning style taste cosmetics or seasonal design companies that are 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