Section 174 and R&E Cost Classification (2026 Guide)

Section 174 Has Changed: Here’s What You Need to Know

The One Big Beautiful Bill Act (OBBBA) has brought relief to many organizations for the 2025 tax year.

Previously, R&E expenditure had to be capitalized and amortized over five years, which was considered harsh by many and stifled research endeavors.

However, Section 174 has changed for the better and now gives taxpayers options for both new and old Section 174 costs regarding domestic expenditure:

• For tax years beginning after 12/31/2024, Section 174A now lets you fully deduct domestic R&E expenditures in the year they are paid or incurred.
• The 5-year amortization for R&E expenditure is still available if an organization chooses to elect into it.
• Foreign R&E expenditures remain the same and must be capitalized and amortized over 15 years.
• Any remaining unamortized domestic Section 174 costs from 2022-2024 can be immediately deducted or ratably over two years.
• Businesses with gross receipts of $31 million or less can apply the new Section 174 rule back to 12/31/2021.

Section 174 vs. Section 41

Here’s where a lot of the confusion lies. And not understanding these sections properly affects an organization's ability to claim the R&D tax credit and expense R&E activities.

Here’s what they mean in plain English:

• Section 174: This is the rule applied to expensing R&E costs, including direct and indirect labor, supplies, some overheads, and both domestic and foreign activity.
• Section 41: This is the R&D tax credit that provides a dollar-for-dollar reduction of tax for qualified research activities (QRE) only.

Think of it like this: R&E is the large bucket of research spending, and the R&D credit is a smaller, stricter portion of that bucket that earns you the credit.

It is incredibly important to classify and distinguish between what comes under Section 174 and what is considered Section 41. One reason is to ensure your organization maximizes its returns, but also because the two sections interact with each other.

Since R&E expensing is becoming more advantageous again, the law has also tightened around taxpayers who expense R&E and claim the R&D credit.

Here’s what has changed:

• Taxpayers must either reduce the deduction of R&E costs by the amount of credit they receive or elect to receive a reduced credit.
• For retroactive Section 174A deductions on prior-year capitalized costs, taxpayers may have to adjust prior R&D credits or capitalized R&E balances to align with the updated rules.

Therefore, organizations must take care not to overclaim under each section.

How to Classify Work: A Practical, Ops-Friendly Framework

The easiest way for engineering teams to correctly classify work is to split it into three separate buckets:

• Non-R&E
• Section 174 SRE (specified research or experimental)
• Section 41 QRE (qualified research expense eligible for the tax credit)

When workers track their hours, the correct classification must be applied to the activity in question.

Non-R&E

Non-R&E activities do not typically fall under Section 174 and are, therefore, expensed normally. Examples of such include:

• Routine maintenance and bug fixes
• Minor enhancements
• Purely cosmetic changes
• Customer-specific customizations
• Implementation of known specs
• Data labeling with no experimentation
• Customer support
• Onboarding
• Training
• Sales engineering

Workers should code these hours to standard cost centers (like HR, support, COGS, etc.) to avoid assigning them to Section 174 or 41.

Section 174 SRE

This incorporates quite a broad set of activities, either aimed at developing or improving a product or resolving an uncertainty:

• Development of new features or modules
• Significant architectural changes
• Performance or scalability improvements
• Experimental or exploratory work (including spikes and prototypes)
• Support work that is integral to development (like DevOps for new environments or test harnesses)
• Iterative experiments to achieve target performance, reliability, or scalability where the outcome is uncertain.

Often, entire projects are treated as Section 174 SRE unless there is a clear way to differentiate non-R&E activities.

Section 41 QRE

Activities and costs that meet the R&D credit’s four-part test and are tied to a business component can be classified within this section. This includes:

• Direct engineering time spent designing, building, and testing solutions to technical uncertainties.
• Direct supervision and direct support of those engineers.
• Supplies and cloud/computing costs used in the experiments.

Why Classification Consistency Matters

Section 174 is method-of-accounting driven. That means that once you adopt a certain way of identifying SRE, the IRS expects you to follow it consistently across the years.

Your organization’s financial statements and tax returns need a coherent system that allows engineering classifications to flow into accounting processes (like book capitalization policies and tax 174 amortization schedules). 

If you use an erratic form of classification, then it makes it difficult for finance teams to reconcile accounts and defend the numbers.

Additionally, any inconsistencies between the R&D credit claims and Section 174 are a red flag, and your organization will be pulled up for an audit.

The solution is to pick a simple, defensible method and taxonomy and use it across all systems.

How to Classify R&E in Practice

Classification should be applied at the time and cost tracking level and across all other linked systems (accounting, payroll, etc.).

Using time tracking software is a good solution because it allows you to add classifications directly to time entries. By creating custom tags, you can ensure that employees assign the right classification according to the work they carry out.

Our advice is to: 

• Create separate tags for Section 174 and Section 41, because that will allow you to filter them when generating reports.
• Create separate tags for all non-R&E cost centers
• Use a small set of work-type tags to label activities

Some examples of tagging time entries might look like this:

• Core Dev -Experimental, S174, S41
• SRE-Supporting, S174
• QA -Customer support, Non-R&D, CC332

Organize entries into clients, projects, and tasks

Time tracking software also lets you split work into clients, projects, and tasks, further supporting claims for Section 174 expenses.

In doing so, you define the intent, ownership, and activity in one straightforward hierarchy and provide a nexus that links time to activity.

Clients

Clients let you define who the work is for. Typical client buckets might include:

• Internal/company: Most R&E work will go here
• Customer: Will consist mostly of non-R&E
• Partner/third-party: Can be a mixture of R&E and non-R&E, depending on the nature of the work

Projects

Projects define why the work exists. For instance, naming the business component that the work applies to. For instance:

• New reporting engine
• Search algorithm redesign
• Production stability Q3

Projects should be specific and named initiatives, not generic “catch-all” phrases.

Tasks

Tasks distinguish each activity that takes place under a specific project. These are crucial because some activities might fall under Section 174 but not Section 41, some might fall under both, and some may be classified as non-R&E.

For example:

• Experimental ranking model (S174, S41)
• Data pipeline changes (S174 only)
• Product bug fix (Non-R&E)

Time entry summary

For each time entry that is eligible for the Section 41 tax credit, it’s necessary to include a summary description that answers:

1. What technical problem was worked on
2. What the uncertainty is and how it was resolved
3. What changed or was learned

This can be added in the description field of the time entry, along with any links to corresponding documentation.

Why?

Because Treasury Regulation 1.41-4 specifically states that any taxpayer who is claiming the credit must:

“Retain records in sufficiently usable forms and detail to substantiate that the expenditures claimed are eligible for the credit.”

What Finance Teams Ask Engineering Teams to Provide for Section 174

Finance and tax teams need documentation from three key areas. Therefore, they will ask engineering teams to provide the following:

Project and activity scope

• A list of active and completed projects, including brief technical descriptions and technical uncertainty
• Project phases that are identified as SRE vs. non-SRE
• A mapping document linking projects to business components 

Time and cost data

Timesheets must include the following:

• Time tracked by person, project, and activity
• Role titles and team information 
• Activity summary
• Identifiers (classification codes, project codes, sprint ID, etc.) that can be cross-referenced in payroll, general ledger, and tax papers for reconciliation

Contemporaneous technical evidence

Anything tagged as SRE must be substantiated, so finance will typically request engineering assets, such as:

• Design documents
• Architecture diagrams
• Experiment plans
• Sprint tickets
• Test plans
• Hypotheses
• Tests and results

Other types of requested documentation include:

• Version control logs
• Build pipelines
• Test runs
• High-level narratives from technical leads that summarize the R&E process for each major business component

Final Thoughts

By incorporating a clear classification process into business workflows, your organization can ensure its claims for Section 174 and 41 are correct and contain exactly what the IRS looks for.

As a final tip, it’s wise to have tax, finance, and engineering leads review the mapping and classification process at least on an annual basis.

This will confirm that all tags and projects align with Section 174 policy and that they are consistently applied.