A: Section 174 covers a broader range of activities and costs than those that qualify for the R&D tax credit under section 41. Generally, costs that qualify for the R&D credit will also be treated as section 174 costs; however, the inverse is not true.
For example, wages that qualify for the R&D tax credit are limited to Box 1 wages (or self-employment earnings in the case of a sole proprietorship). But section 174 qualifying wages include additional wage amounts, such as nontaxable benefits and retirement contributions. There is a so-called “substantially all” rule for the R&D credit where taxpayers may claim 100% of Box 1 wages for employees that spend 80% or more of their time performing qualifying activities—this does not exist for section 174.
When it comes to payments made to third parties to perform contract research, only 65% of eligible contract research expenses are included toward the R&D credit, whereas 100% may be eligible for inclusion as a section 174 cost. Additionally, section 174 costs include allocable overhead costs, such as rent and utilities, as well as the depreciation of equipment used in the R&D process, and patent legal expenses that aren’t included in qualifying R&D tax credit costs.
It's important to note that all computer software development costs are now considered section 174 costs. For R&D credit purposes, there is a higher threshold for software development initiatives to be eligible for the credit in the case of software developed by the taxpayer for internal use. There is no such threshold for section 174, so taxpayers may notice a much higher section 174 cost compared to what is claimed for R&D credit purposes for software development initiatives.