What is Section 174 and why it is important to a startup?
In summary, the impact of Section 174, is that it requires the reclassification of contractor labor costs from a direct expense to an amortizable expense spread over years. This change could affect both your income tax and self-employment tax liability. It’s important you carefully evaluate whether your contractor payments qualify as Section 174 expenses (which are capitalized and amortized) or if they qualify as ordinary and necessary business expenses. The reclassification could significantly alter your tax position.
Some Details:
IRS Section 174 refers to a provision of the U.S. tax code that deals with research and development (R&D) expenses. Traditionally, businesses could deduct R&D costs in the year they were incurred. However, with changes introduced by the Tax Cuts and Jobs Act (TCJA), starting in 2022, businesses are now required to capitalize and amortize these R&D expenses over a period of 5 or 15 years, rather than deducting them all in the year they were incurred.
Key points about Section 174 expenses:
Amortization Requirement: Under the new rules, businesses can no longer fully deduct R&D expenses in the year they are incurred. Instead, the costs must be capitalized and amortized over a period of 5 years (for domestic costs) or 15 years (for foreign costs).
What Counts as Section 174 Expenses: Section 174 applies primarily to expenses related to research and experimentation (R&E). This includes costs incurred for:
Developing new products, processes, or software.
Improving existing products or services.
Activities that aim to develop new knowledge or technology.
Typical R&D expenses that fall under Section 174 may include:
Wages and salaries for employees involved in R&D work.
Supplies used in research activities.
Contractor payments related to R&D.
Depreciation on equipment used for research.
Impact on Taxable Income: Since businesses can no longer deduct these expenses immediately, they will see a delay in the tax benefit of R&D spending. This may result in higher taxable income in the short term, as the costs must be capitalized and amortized over several years, reducing the immediate deductions.
Ordinary Business Expenses: Before the 2022 changes, businesses could generally deduct R&D expenses as ordinary and necessary business expenses under Section 162. However, under the new Section 174 rules, R&D expenses must be capitalized and amortized, which can change the tax treatment.
Tax Strategy: Since Section 174 expenses are amortized, this would delay the deductibility and in essence potentially change a loss year into a taxable year. Also note that for self-employed individuals reporting as a Disregarded Entity, a self-employment tax on any net profit would have to be calculated.
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