[GLOS84_code]

The Mandate and Implications of Specified Research or Experimental Expenditures (SRE) Under Amended IRC Section 174

I. Executive Summary: The Critical Shift of SRE Capitalization

Specified Research or Experimental Expenditures (SRE) are foundational costs governed by Internal Revenue Code (IRC) Section 174, defining the universe of expenditures related to a taxpayer’s inventive activity. The term refers to costs incurred in connection with a taxpayer’s trade or business that constitute “research and development costs in the experimental or laboratory sense”.1 This definition is generally broad, encompassing costs incident to the development of new processes, formulas, inventions, techniques, patent procurement, and, significantly, computer software development.2 However, the scope is not limitless; the Code and regulations explicitly exclude expenditures for activities such as market research, advertising, sales promotions, quality-control testing after commercial production has begun, and research funded by another party where the taxpayer retains no substantial rights.4 While Section 174 historically permitted immediate deduction, it concurrently serves as the essential gateway for determining costs eligible for the Credit for Increasing Research Activities under IRC Section 41 (the R&D Tax Credit). Specifically, Section 41, which offers a dollar-for-dollar reduction in tax liability, utilizes a restrictive subset of these SREs—known as Qualified Research Expenditures (QREs)—including qualified wages, supplies, and contract research.5

The importance of SRE was fundamentally redefined by the Tax Cuts and Jobs Act (TCJA) of 2017, effective for tax years beginning on or after January 1, 2022. Prior to this date, taxpayers enjoyed the option to immediately deduct R&E costs in the year incurred, providing a substantial and immediate tax benefit.6 The TCJA repealed this option, replacing it with a mandatory requirement to capitalize and amortize SREs over statutory periods.7 Domestic research expenditures must now be amortized over a 5-year (60-month) period, while SRE expenditures attributable to foreign research must be amortized over a 15-year (180-month) period.2 This structural change necessitates a mandatory accounting method change for all affected taxpayers.2 Strategically, the shift from immediate expensing to long-term amortization creates a severe timing difference, compelling companies to recognize significantly higher taxable income in the initial years of development, which directly impacts cash flow, financial modeling, and the economic viability of R&D funding activities.8 Consequently, SRE compliance has transitioned from an annual deduction calculation to a complex, critical element of long-term corporate tax planning, demanding sophisticated tracking and allocation methodologies.

II. Detailed Regulatory Framework and Definition of Specified Research or Experimental Expenditures (SRE)

2.1 Statutory Basis and Definitional Scope (IRC §174)

The core characteristic of an R&E expenditure under Section 174 revolves around the uncertainty inherent in the development process, requiring activities in the “experimental or laboratory sense”.1 The costs must be incurred in connection with the taxpayer’s trade or business, leading toward the development or improvement of a product or process.

A significant statutory clarification provided by the TCJA amendments confirmed that software development costs are explicitly treated as Specified R&E expenditures.3 This formal inclusion eliminated previous ambiguity and the reliance on administrative rules that had allowed similar treatment for software costs regardless of patent or copyright status.3 The scope extends to all costs incident to the development of an SRE product, which includes any pilot model, process, formula, invention, technique, patent, computer software, or similar property subject to protection under applicable domestic or foreign law.2

2.2 Exclusions and Boundary Setting

To prevent the capitalization mandate from capturing routine business costs, Section 174 provides specific exclusions. These include commercial activities such as market research, advertising, and sales promotions.4 Furthermore, testing or inspection efforts designed solely for quality control, or research conducted after the commencement of commercial production of the product, are not considered SRE.4

A critical delineation exists for foreign research. While not technically excluded from SRE treatment, expenditures attributable to research conducted outside of the United States are subject to the significantly extended 15-year amortization period.2 This statutory mechanism reflects a policy choice within the TCJA intended to incentivize R&E activities to be performed domestically.6

2.3 Comprehensive Cost Identification and Allocation (Notice 2023-63)

Identifying the universe of costs that constitute SRE is challenging because the requirement extends beyond direct development labor and materials to include certain indirect costs. IRS Notice 2023-63 provides administrative guidance clarifying that SRE includes costs incident to development, such as: salaries and wages of personnel providing the service or performing direct support 9; materials and supplies consumed; and essential indirect costs like overhead, occupancy, and related equipment costs that directly support SRE activities.10 Travel costs directly incurred for the performance or direct support of SRE activities must also be capitalized.10

Crucially, the guidance draws a line between necessary, direct support costs and general business administration. Costs related to general and administrative (G&A) service departments are explicitly not classified as SRE expenditures.10 Examples of excluded G&A costs include the costs of accounting personnel who track research expenses, human resource staff who hire research personnel, or payroll processing for research employees.10

The explicit distinction between includible direct overhead and excludible G&A costs 10 imposes a new and rigorous standard of functional accounting on taxpayers. Businesses can no longer rely on general departmental expense categories but must implement processes to trace time, materials, and facility usage directly to the R&E activity to justify capitalization under Section 174. This need for regulatory precision in cost segregation places a vastly increased administrative burden on corporate finance and accounting departments that previously could deduct these costs without such granular tracking.11

III. The New Compliance Reality: Mandatory Capitalization and Amortization

3.1 Amortization Mechanics and the Geographic Split

The TCJA mandate requires that all SRE costs be capitalized to a specified capital account and amortized over the statutory period.3 The amortization for both domestic and foreign research begins with the mid-point of the taxable year in which the expenditures are paid or incurred.3

Table 2: SRE Amortization Schedule Requirements

This required capitalization structure severely delays the timing of the tax benefit. Where a taxpayer previously received a full deduction in Year 1, they now receive only a fraction of that cost recovery over the subsequent five or fifteen years, significantly increasing near-term taxable income.8

3.2 Accounting Method Change and Procedural Compliance

The application of the amended Section 174 rules is treated as a mandatory change in the taxpayer’s method of accounting, initiated by the taxpayer and requiring the consent of the Secretary of the Treasury.3 This change must be applied on a cutoff basis to SRE expenditures paid or incurred in taxable years beginning after December 31, 2021.2 Critically, because the change applies on a cutoff basis, no adjustments under IRC Section 481(a) are required or permitted with respect to expenditures paid or incurred in tax years before 2022.2

The IRS provided procedural relief for implementing this change, particularly for the first effective tax year (2022). Taxpayers making the change in that initial year filed a simplified statement rather than the standard Form 3115, Application for Change in Accounting Method.12 Taxpayers making the change in subsequent years are required to file Form 3115.12

This mandatory change in federal tax accounting creates significant complexities regarding state conformity. States that have not adopted the TCJA amendments, such as California and Texas, continue to operate under the provisions of “old” Section 174, which permits immediate deduction of R&E costs.6 This disconnect mandates that taxpayers maintain separate federal tax records (capitalization and 5/15-year amortization) and state tax records (immediate deduction), significantly increasing the compliance complexity and reconciliation efforts required for multinational and multistate businesses.

3.3 The Disposition and Abandonment Rule (IRC §174(d))

A particularly harsh element of the amended statute is the rule regarding the disposition, retirement, or abandonment of property resulting from SRE. IRC Section 174(d) stipulates that no deduction is allowed for unamortized SRE expenditures when the associated property is disposed of, retired, or abandoned.2 Instead, amortization deductions must continue over the entire original 5-year or 15-year statutory period.2

This rule creates a substantial risk of stranded tax basis. In traditional asset cost recovery, a failed or abandoned asset often generates a deductible loss. Under the current Section 174 regime, however, the expense is disconnected from the asset’s physical or functional life; it is purely a period cost tied to the statutory amortization schedule.13 For R&D-intensive companies, this mandates rigorous internal controls to track unamortized SRE balances and requires careful analysis within financial reporting (ASC 740). Deferred tax assets resulting from SRE capitalization must be evaluated against future projected taxable income to ensure that the continued statutory amortization can be absorbed, even for research that proves fruitless.

IV. Interplay with the R&D Tax Credit (IRC Section 41)

4.1 Scope Discrepancy (SRE vs. QRE)

While both Sections 174 and 41 are designed to incentivize R&D activities, they serve distinct roles and possess different expenditure scopes.5 Section 174 defines the broad universe of expenditures that must be capitalized (SRE). Section 41, conversely, is more restrictive, defining a subset of these costs as Qualified Research Expenditures (QRE) used solely to calculate a tax credit.14

Table 3: Comparison of IRC Section 174 (SRE) and Section 41 (QRE)

This functional difference requires taxpayers to maintain rigorous dual tracking. For example, costs incurred for the procurement of a patent generally qualify as SRE under Section 174 and must be capitalized, but these same costs do not satisfy the requirements of Section 41 and cannot be included in the calculation of the R&D tax credit.14

4.2 Research Providers and Contractual Arrangements

Clarity regarding SRE ownership is essential in contractual research settings. Notice 2024-12 clarified that the costs incurred by a research provider constitute SRE expenditures (and must be capitalized by the provider) only if the provider meets one of two conditions: they must bear the financial risk related to the potential failure of the research, or they must retain the right to use or exploit the resulting SRE product (e.g., through sale, lease, or license).12

If the research recipient pays for the research and retains all financial risk and rights to the resulting product, the recipient is the party required to capitalize the costs. This requires explicit documentation and understanding of contractual terms to correctly assign the capitalization requirement. Furthermore, the guidance specifies that mere know-how gained by a research provider through the performance of services does not, by itself, create an SRE product if that know-how is not subject to applicable legal protection.2

V. Practical Application and Financial Impact

5.1 Case Example: Capitalization and Amortization of Domestic R&E Costs

The most immediate and critical consequence of the TCJA amendments is the negative impact on cash flow resulting from accelerated taxable income.

Example: A U.S.-based technology startup, TechCo, incurred $2,000,000 in domestic SRE costs (including qualified wages, materials, and allocable direct overhead) in Tax Year 1 (TY1, beginning January 1, 2022).

Under the pre-2022 rules, TechCo would have deducted the full $2,000,000 in TY1, resulting in a negative adjustment to taxable income. Under the current rules, TechCo must capitalize the cost and amortize it over five years, starting at the mid-point of TY1:

The capitalization requirement results in an immediate $1.8 million increase in taxable income in TY1 compared to the previous regime. This mandatory increase in current tax liability places significant pressure on cash flow, especially for early-stage companies that may be in a pre-profitability phase but are required to pay tax on costs that were previously deductible.8

5.2 Ancillary Tax Effects: FTC and FDII Implications

While the primary effect of SRE capitalization is an adverse timing difference, the increased taxable income can have favorable ancillary effects in other areas of the tax code.11

First, regarding the Foreign Tax Credit (FTC) limitation, special rules require R&D expenses to be apportioned between U.S. and foreign source income. The capitalization of SRE costs reduces the overall amount of R&D expense currently deductible, thereby lowering the amount that must be apportioned against foreign source income. This reduction in apportionment expense can relax the FTC limitation, increasing the taxpayer’s ability to claim foreign tax credits.11

Second, regarding the Foreign Derived Intangible Income (FDII) deduction, the FDII calculation is partially dependent on U.S. taxable income. Where Section 174 capitalization increases U.S. taxable income, this may proportionally increase the available FDII deduction.11

VI. Recommendations and Future Actionable Steps for Clarification

The IRS has issued multiple administrative guidance notices (including 2023-63 and 2024-12) to ease the transition and clarify ambiguities. However, comprehensive, definitive regulations necessary for long-term compliance are still pending, leaving critical technical and practical gaps. Further clarification is essential to explain and apply Specified Research or Experimental Expenditures more fully.

6.1 Areas of Persistent Ambiguity Requiring Further Regulatory Guidance

6.1.1 Allocation of Costs for Remote and Hybrid Workforces

The most significant financial consequence of SRE classification is the difference between the 5-year amortization period for domestic research and the 15-year period for foreign research.2 In a modern economy relying heavily on remote and hybrid work models, clear rules defining what constitutes “foreign research” are critically needed. Current guidance does not adequately address situations where a researcher may work remotely from various jurisdictions, or split time between domestic and international locations during the year. Regulations must provide objective, quantitative criteria—such as the number of days spent performing the research activity in a jurisdiction, or the contractual situs of the service delivery—to provide taxpayers with a reliable basis for classifying and allocating labor costs subject to the amortization periods. Relying solely on employee domicile or corporate headquarters location for classification risks encouraging non-economic geographic arrangements.

6.1.2 Standardized Methodologies for Overhead and General and Administrative (G&A) Allocation

Although Notice 2023-63 provided useful examples distinguishing between includible direct overhead (e.g., occupancy costs) and excludible G&A (e.g., general accounting staff) 10, it did not prescribe a standardized methodology for the allocation process. Taxpayers are currently left to adopt their own methods, which are subject to high scrutiny. Future regulations should introduce safe harbors or clear, acceptable allocation formulas. These methodologies should provide defensible standards—such as ratios based on direct labor costs, full-time equivalent (FTE) headcount dedicated to R&E activities, or proportional facility utilization—to help taxpayers confidently allocate shared costs and reduce the risk of audit adjustments arising from subjective cost classifications.

6.1.3 Application of Disposition Rule to Pass-Through Entities

The strict disposition and abandonment rule under IRC 174(d), which mandates continued amortization even after asset failure 2, was addressed for corporate transactions (Section 381) by Notice 2023-63.10 However, detailed guidance is urgently needed for complex pass-through entities, particularly partnerships. Issues arise regarding how the unamortized SRE balance is treated upon a technical termination, a significant transfer of partnership interest, or the direct abandonment of a research product by the partnership. Clear rules are necessary to ensure the consistency of basis adjustments and the appropriate continuation of amortization at the partner level, particularly since partnership tax rules differ substantially from corporate provisions.

6.1.4 Interaction with Long-Term Contract Accounting (Section 460)

Regulations are necessary to clarify the precise relationship between mandatory SRE capitalization and the requirement to allocate costs to long-term contracts under IRC Section 460.10 If R&E activities are incident to a contract that spans multiple years, the interaction between the Section 174 amortization schedule and the cost allocation requirements of Section 460 is ambiguous. Definitive rules must establish a framework for precedence to prevent the improper double counting of costs or, conversely, the failure to recover costs entirely.

6.2 Recommended Taxpayer Strategies for Enhanced Compliance and Data Capture

To manage the compliance and financial burdens inherent in the new SRE regime, taxpayers should adopt immediate strategic measures:

1. Systemic and Granular Cost Tracking: Taxpayers must move beyond historical reliance on post-year-end R&D studies. Financial and operational systems must be integrated to capture SRE costs—including direct labor, materials, and allocable overhead—contemporaneously by project, function, and, most critically, geographic location. This granular data capture is the only way to accurately apply the 5-year vs. 15-year amortization split and correctly segregate includible overhead from excludible G&A costs.8
2. Contractual Due Diligence: Companies engaged in contract research must rigorously review all related agreements to explicitly define which party bears the financial risk and who retains the rights to exploit the resulting SRE product. This contractual clarity is non-negotiable for accurately determining the capitalizing party under the guidance provided by Notice 2024-12.12

Proactive Financial Modeling: Given the profound cash flow impact, companies must incorporate the full amortization schedules into their long-term financial projections. This modeling should calculate the impact of accumulating SRE balances, particularly the longer 15-year amortization period for foreign research, on projected taxable income. Such proactive modeling is essential for accurate quarterly and annual tax provisions (ASC 740) and for making informed strategic decisions about the level and placement of future R&D investments.

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/