Inventors often face different taxation issues than other professionals. Fortunately, there are provisions in the U.S. tax code that offer some relief. If you learn only one section of the Internal Revenue Code (IRC), it should be IRC Section 174. Some might call it the inventor’s best friend. Congress enacted IRC Section 174 specifically to encourage inventors and companies engaged in research and development of new technologies.
How can you use Section 174 of the Tax Code to your benefit?
IRC Section 174 is deceptively simple. It provides, in part: "A taxpayer may treat research or experimental expenditures 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 expenditures so treated shall be allowed as a deduction."
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.
In other words, if you earn $100,000 per year but spend $20,000 in a manner that fits the definition of Section 174, your taxable income would only be $80,000.
Only expenses for research and experimentation ("R&E") are deductible under Section 174. What exactly is R&E?
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 by way of scientific or technical experimentation.
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 you use Section 174 to claim deductions to discover information that is not scientific or technical in nature. Marketing and sales information would, unfortunately, fall into this latter category. (An ad campaign to promote your great new invention, for example, would not be deductible.)
As long as you are conducting R&E, it makes no difference whether you attempting to develop a particular invention or are engaged in a general research project. Moreover, your research and experimentation need not be successful and end up as a patented invention or salable product. Indeed, your R&E may not even have a high probability of being successful.
Subject to one very important exception covered in the following section, any money you spend to perform R&E is currently deductible from your federal taxable income. Courts have allowed inventors to deduct both direct and indirect R&E expenses. Let's explore how these categories are defined.
Direct R&E expenses are the monies you spend for the equipment or materials you use to actually perform R&E. For example, the laboratory and computer supplies you use for your R&E activities, scientific equipment you rent to conduct R&E, or the money you pay to an employee or independent contractor to assist you in your research all qualify.
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 are all indirect expenses.
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. (Patents are an important form of intellectual property that allows inventors to maintain exclusivity over their inventions).
The one thing you buy for R&E that you cannot currently deduct under Section 174 is the entire purchase price of long-term property. Specifically, property that has a useful life of more than one year does not qualify. This is so even though the property is used for R&E purposes.
For example, imagine that 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 is fairly clear which expenses have a useful life of more than one year. The most common examples are durable lab equipment, vehicles, machinery, buildings, furniture, and computer software.
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:
Indeed, once your invention is perfected, you will 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.
Section 174 requires that R&E expenses be incurred “in connection with a trade or business” in order 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.
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.
There is no dollar limit on the amount of Section 174 deductions you can take each year. However, you should not abuse this provision. There is a general requirement that your deductions 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.
Remember, the IRS conducts random audits. If you find yourself facing an investigation, you will not want to appear as if you have been abusing this deduction by "overcharging" for your expenses. Consequently, be sure you act in an honest manner in calculating the amount you will deduct.
You must claim your Section 174 deductions in the first year the 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.