Section 174 capitalization
Beginning in 2022, Section 174 requires capitalization and amortization of R&E expenditures: 5 years for domestic R&E and 15 years for foreign R&E. Software development costs are explicitly included. The change ended decades of immediate-deduction treatment and has had a significant cash-flow impact on R&D-heavy small businesses.
What counts as R&E
Section 174 R&E is broad — activities intended to discover information that would eliminate uncertainty about the development or improvement of a product, process, technique, formula, or invention. Software development is included even when not technically novel. Many product-based small businesses have more R&E than they realize.
Section 41 R&E credit
Many R&E expenditures also qualify for the Section 41 research credit, which is broader than people assume. Eligible activities include developing or improving products, processes, software, formulas, inventions, or techniques where there is technological uncertainty resolved through experimentation. The credit can be claimed by amending returns up to three years back.
Small-business credit benefits
Qualified small businesses (typically gross receipts under $5 million and no gross receipts more than 5 years prior) can elect to apply up to $500,000 (post-IRA) of the R&E credit against payroll taxes — providing a cash benefit even when the business has no income tax liability.
Documentation matters
R&E activities require contemporaneous documentation: project descriptions, time tracking by activity, technical uncertainties identified, experimentation conducted, results. Many credits are reduced or denied in audit due to thin documentation, even when the underlying activity clearly qualified.
Documentation that survives an exam
An IRS examination of this deduction will request three things: proof of payment (bank or card statement), proof of the underlying transaction (invoice or receipt), and proof of business purpose (a contemporaneous note or calendar entry). The first two are usually trivial to produce; the third is where most filers fall short. Capturing business purpose at the moment of the expense — a one-line note in your bookkeeping software or a category and memo on the receipt-capture app — converts a generic charge into a documented deduction that will withstand scrutiny three to six years later when memory has faded.