Deducting Research and Experimentation Expenses
If you learn only one section of the Internal Revenue Code, the one to learn is IRC Section 174
If you learn only one section of the Internal Revenue Code, the one to learn is IRC Section 174 because it is the inventor’s best tax friend. Congress enacted IRC Section 174 to encourage inventors and companies engaged in research and development of new technologies.
IRC Section 174 is deceptively simple. It says that “a taxpayer may treat research or experimental expenses which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account.” The phrase “not chargeable to capital account” is key: It means that the entire amount of these expenses may be currently deducted from an inventor’s gross income.
What Is Research and Experimentation?
Only expenses for research and experimentation (R&E) are deductible under Section 174. Research and experimentation is all the work you do as part of your inventing business to discover information that helps eliminate scientific or technical uncertainty concerning the development or improvement of an invention, patent, process, prototype, formula, technique or similar product.
In other words, you must work to develop or discover something new in the laboratory or experimental sense. You can’t, for example, claim a Section 174 deduction to develop an invention that has already been patented or to repeat something that has already been done. Nor can Section 174 be used to claim deductions to discover information that is not scientific or technical in nature -- for example, marketing or sales information.
So long as you’re doing R&E, it makes no difference if you’re attempting to develop a particular invention or are engaged in a general research project. Moreover, your research and experimentation need not be successful -- that is, end up as a patented invention or salable product. Indeed, your R&E, may not even have a high probability of being successful.
What Research and Experimentation Expenses Are Deductible?
Subject to one very important exception covered in the following section, any money you spend to perform R&E is currently deductible. Courts have allowed inventors to deduct both direct and indirect R&E expenses.
Direct R&E expenses are the monies you spend for the things you use to actually perform R&E -- for example, the laboratory and computer supplies you use for your R&E activities, equipment you rent to conduct R&E, or the money you pay to an employee or independent contractor to assist you in your research.
Indirect R&E expenses are those expenses that help you perform R&E, but are not directly used for that purpose. These primarily consist of the overhead expenses you incur while performing R&E -- for example, the rent for your office, lab or workshop, utilities, telephone bills arising from R&E, travel expenses incurred for R&E purposes, and dues and publication expenses incurred for R&E purposes.
Although it may not seem like an R&E expense, the cost of obtaining a patent is also currently deductible under Section 174. This includes both attorney fees and patent filing fees. This is one of the largest expenses many independent inventors have.
Cost of Long-Term Property Not Deductible Under Section 174
The one thing you buy for R&E that you can’t currently deduct under Section 174 is the entire purchase price of long-term property -- that is, property that has a useful life of more than one year. This is so even though the property is used for R&E purposes.
EXAMPLE: Mary purchases a $10,000 microscope to aid her in her research to develop a new type of glue. Because a microscope has a useful life of more than one year, the $10,000 expense is not currently deductible under Section 174.
The “useful life” of an asset is not its physical life, but rather the period during which it may reasonably be expected to be useful in your business. Usually it’s fairly clear which expenses have a useful life of more than one year -- for example, durable lab equipment, vehicles, machinery, buildings, furniture and computer software.
Expenses that Can’t be Deducted Under Section 174
In addition to the money you spend on long-term assets as described above, you can’t currently deduct under Section 179 routine expenses to purchase, study, market, sell, test or manufacture an invention or product that already exists. These include, for example:
- quality-control testing
- efficiency surveys
- management studies
- consumer surveys
- advertising or promotions, and
- the cost of buying someone else’s patent
- or trademark.
Indeed, once your invention is perfected, you’ll likely have no more R&E expenses deductible under Section 174 (but you may deduct the cost of obtaining a patent as mentioned above).
However, these non-R&E expenses may be currently deductible as ordinary and necessary business expenses.
Expenses Must Be Incurred “In Connection with a Trade or Business”
Section 174 requires that R&E expenses be incurred “in connection with a trade or business” to be currently deductible. This requirement is easy to satisfy. An inventor need not be engaged in a long-established, up-and-running business. All that is required is that there be a “realistic prospect” that the inventor’s efforts will result in a trade or business at some time. (Harris v. Commissioner, (5th Cir. 1994) 16 F.3d 75.)
In practical terms, this means you can just be starting out in inventing and still currently deduct your R&E expenses using Section 174. You’re entitled to a deduction even if the only “business” you’re conducting is the research itself. You need not have patented any inventions or earned any money from inventing.
All that is required is that there be a realistic prospect that you could have an active business some time in the future using the fruits of your research, assuming it proves successful. The future business can involve the licensing or sale of an invention derived from the research, manufacturing and selling products or services derived from the research, or both.
Expenses Must be Reasonable
There is no dollar limit on the amount of Section 174 deductions you can take each year, but your deductions must be reasonable in amount. “Reasonable” means that the amount you spend for R&E must be about what would ordinarily be paid for similar expenses by similar types of businesses.
When to Claim Section 174 Expenses
You must claim your Section 174 deductions in the first year R&E expenses are incurred. If you fail to claim these deductions on your Schedule C for the year in which they were incurred, you must ask the IRS for permission to use Section 174 in subsequent years.