1. Definition

Research or experimental expenditures are costs incurred to eliminate uncertainty about developing or improving a product, process, formula, invention, or computer software. Software development is included in this framework. AI work may also qualify when the business is designing, coding, training, testing, or materially improving software or a model rather than merely using an existing tool.

• Section 174A: governs domestic research or experimental expenditures.
• Section 174: continues to govern foreign research expenditures.

These tax rules do not automatically determine Section 41 research-credit eligibility or financial-statement capitalization.

2. Why It Matters

• Tax and cash impact: Classification affects taxable income, cash taxes, deferred-tax balances, and examination support. A current deduction accelerates the benefit; capitalization delays deductions and may better match future income.
• AI projects are mixed by nature: One contract may include purchased technology, cloud access, model training, data preparation, integration, testing, support, and user training. Separate each workstream and document what was performed, where it was performed, and whether technical uncertainty existed.

3. How It Works

Step 1: Identify Development Activity. Separate development from acquisition and routine use. Potential development activities include architecture design, new or materially modified code, new functionality, model training/fine-tuning for a new capability, and testing alternatives. Purchased licenses, SaaS subscriptions, routine migration/configuration, maintenance, and user training may follow other tax rules. A customized implementation may contain both.

Step 2: Determine Where the Work Was Performed. Work location determines the recovery period. Domestic research generally means work performed in the United States; work performed outside the United States is foreign research even when the customer or contracting company is U.S.-based. Review employee locations, contractor SOWs, subcontractors, and project records—not just the vendor address.

Step 3: Apply Section 174A to Domestic Costs. For tax years beginning after December 31, 2024, Section 174A generally allows a current deduction for domestic R&E costs. A taxpayer may instead elect to capitalize and amortize domestic costs over at least 60 months, beginning when benefits are first realized. Model the accounting-method choice before filing.

Step 4: Apply Section 174 to Foreign Costs. Foreign R&E costs generally must be capitalized and amortized over 15 years using the statutory midpoint convention. No current Section 174A deduction applies to those costs. Businesses using offshore employees or developers should maintain a reliable domestic-versus-foreign cost allocation.

Step 6: Evaluate the Research Credit Separately. Section 174A treatment does not automatically create a Section 41 research credit. The project must separately satisfy the research-credit tests, including permitted purpose, technological uncertainty, process of experimentation, and hard-science principles. Qualified cost categories are also narrower. Model the Section 280C reduced-credit election and expense adjustment with the deduction.

4. Simple Example

Example: A U.S. company spends $600,000 developing an AI forecasting platform in 2026:

• $420,000 domestic development: may generally be deducted under Section 174A unless the company elects amortization.
• $120,000 foreign development: generally capitalized and amortized over 15 years under Section 174.
• $60,000 subscription/configuration/training: analyze under the rules applicable to those activities rather than automatically including it in Section 174A.

Also evaluate Section 41 credit eligibility and the applicable GAAP treatment.

5. Common Mistakes and FAQs

Common Mistakes

• Treating every technology invoice as development: purchased tools, subscriptions, maintenance, and training may not be Section 174A costs.
• Using the vendor address as the work location: identify where employees and contractors actually performed the research.
• Assuming all development earns a research credit: Section 41 uses a separate activity test and narrower cost rules.
• Combining domestic and foreign costs: the recovery periods differ and require supportable allocation.
• Using tax treatment for book accounting: tax deductions and financial-statement capitalization are separate conclusions.
• Waiting until return preparation: project teams may no longer be able to reconstruct activities, locations, and experimentation.

Does Routine AI Use Fall Under Section 174A?

Usually not by itself. Using standard features of a commercial AI tool or routine configuration generally does not become research merely because AI is involved. Substantial coding, model development, or experimentation may require a different conclusion.

6. Practical Checklist and What Comes Next

Assign the following responsibilities before year-end and return preparation:

• Engineering / Project Lead: document objectives, technical uncertainty, experiments, milestones, and personnel.
• Finance / Accounting: create project codes, separate development from routine implementation, and reconcile costs to payroll and vendor invoices.
• Procurement / Legal: confirm contractor work locations, subcontracting rights, ownership, and economic-risk terms.
• Tax Team: classify domestic and foreign costs, model deduction vs. amortization, review transition balances, and evaluate Sections 41 and 280C.
• Controller / CFO: approve the tax method, confirm book-tax differences, and ensure consistent application.

Official References

• IRS Revenue Procedure 2025-28
• IRS Notice 2023-63, as modified by Notice 2024-12
• IRS Instructions for Form 6765
• FASB Accounting Standards Update 2025-06

Disclaimer

This article provides general educational information and is not tax, accounting, or legal advice. The treatment of AI and software costs depends on activities, work locations, contracts, accounting methods, elections, and filing history. Consult qualified advisers before making an election, changing a method, or claiming a credit.