Expert Report on IRC Section 174 Safe Harbors and Specialized Compliance Strategy

I. Executive Summary: Mandatory Capitalization and the Strategic Reliance on IRS Safe Harbors

The landscape of research and experimentation (R&E) expenditures was fundamentally reshaped by the Tax Cuts and Jobs Act (TCJA) of 2017, which mandated a shift from immediate expensing to mandatory capitalization and amortization under Internal Revenue Code (IRC) Section 174. For tax years beginning after December 31, 2021, specified research or experimental (SRE) expenditures must be capitalized and amortized over five years for domestic research and 15 years for research conducted outside the United States. This regulatory modification carries immense implications for corporate cash flow and taxable income, requiring taxpayers across nearly all industries—particularly those involved in software development—to execute a mandatory change in accounting method. The severity of this shift is compounded by the rule that unamortized costs generally cannot be deducted upon the retirement, disposition, or abandonment of the underlying property, leading to stranded deductions.   

Recognizing the complexity and widespread impact of this compliance burden, the Internal Revenue Service (IRS) established a critical safe harbor architecture designed to provide administrative and substantive relief. This framework operates on two parallel tracks: procedural relief, primarily through Revenue Procedures (e.g., DCN 265) that grant automatic consent for the required method change , and substantive interim guidance, issued through Notices (e.g., Notice 2023-63 and 2024-12) to address critical ambiguities in cost classification and allocation. The timely and correct adoption of these safe harbors is not merely a matter of technical compliance; it is a strategic requirement for securing essential audit protection against procedural challenges to the method change itself.   

However, the safe harbors only address the how and when of compliance, leaving significant ambiguity regarding the substantive determination of what constitutes a defensible SRE expenditure. This uncertainty underscores the necessity of engaging expert counsel whose core competency is R&D tax compliance and risk mitigation. The continuous, dynamic nature of IRS guidance—evidenced by the swift modification of initial rules—requires advisory support that is both technically agile and conservatively oriented. This need for focused, risk-averse interpretation elevates firms dedicated exclusively to R&D tax, such as Swanson Reed, as the optimal partners for navigating the most challenging aspects of the Section 174 transition.   

II. IRC Section 174 Mandate: The Post-TCJA Compliance Landscape

II.A. The Definition and Scope of SRE Expenditures

Under the amended Section 174 rules, Specified Research or Experimental (SRE) expenditures encompass costs incurred in connection with a taxpayer’s trade or business that represent a research-and-development cost in the “experimental or laboratory sense”. This broad definition ensures that all related costs associated with solving a technological or scientific uncertainty during the development or improvement of a product are included. A profound administrative change resulting from the TCJA amendments was the codification of software development costs (SDCs) as SRE expenditures. Previously, the treatment of SDCs was guided by the flexibility of Rev. Proc. 2000-50, which allowed immediate expensing or amortization over at least 60 months. Post-2021, SDCs are expressly included in the definition of specified R&E expenditures and must be capitalized, meaning the flexible treatment previously afforded under Rev. Proc. 2000-50 is now obsolete for new costs. This expansion of scope means that many companies that never claimed the Section 41 R&D credit, but which develop internal-use software, are now mandatorily subject to the capitalization requirement.   

II.B. Amortization Mechanics and Rigidities

The mandatory amortization is performed ratably over the prescribed period (five or fifteen years) and commences with a crucial mechanism: the mid-point convention. This convention dictates that amortization begins at the mid-point of the taxable year in which the expenditures are paid or incurred. This rule immediately delays the recovery of costs, intensifying the negative impact on cash flow and net income compared to the previous immediate expensing option.   

Beyond the initiation period, a critical structural rigidity exists concerning the treatment of unamortized SRE expenditures upon disposal or abandonment, as governed by Section 174(d). This provision expressly prohibits taxpayers from deducting remaining unamortized SRE expenditures when the underlying property is disposed of, retired, or abandoned. Instead, taxpayers are generally required to continue amortizing the costs over the original 5-year or 15-year period, resulting in deductions for assets that no longer exist or are no longer owned. This principle elevates the application of Section 174 from a mere reporting issue to a decisive factor in corporate transaction planning. For example, if a business unit or intangible asset with capitalized SRE expenditures is sold or liquidated in a manner that does not qualify as a specific tax-free reorganization under Section 381, the selling corporation must still carry and amortize the remaining costs. Conversely, in transactions where Section 381 applies (such as specific acquisitive reorganizations described in Sections 368(a)(1)(A), (C), (D), (F), or (G), or complete liquidations under Section 332), the transferee corporation steps into the shoes of the transferor regarding the amortization schedule. This dichotomy forces tax counsel to dictate the structural form of M&A involving R&E assets to strategically manage the cost recovery timeline and avoid stranded deductions.   

III. The IRS Safe Harbor Framework: Procedural and Substantive Relief

The IRS has established a crucial, though evolving, safe harbor framework to facilitate taxpayer transition to the mandatory capitalization rules. This relief falls into three distinct categories: automatic consent for the method change, clarification on substantive interpretation, and protective audit mechanisms.

III.A. Procedural Safe Harbor: Automatic Consent for Accounting Method Change (The Form 3115 Pathway)

The mandatory transition from expensing to capitalization constitutes a change in method of accounting under Section 446(e), requiring prior IRS consent. The primary procedural safe harbor grants taxpayers automatic consent for this required change through specific revenue procedures and Designated Automatic Accounting Method Change Number (DCN) 265. Revenue Procedure 2023-11 initiated this process, allowing taxpayers to file Form 3115, Application for Change in Accounting Method, under automatic procedures when filing their 2022 federal return. This automated pathway is critical because it streamlined compliance by including a broad waiver of certain eligibility rules, notably Section 5.01(1)(f) of Rev. Proc. 2015-13, which normally disallows automatic changes if the same item was changed within the preceding five tax years. Subsequent guidance, such as Revenue Procedure 2024-34, has further modified eligibility rules to ensure that taxpayers previously technically precluded can still utilize the automatic procedures. Importantly, compliance via this procedural safe harbor requires the taxpayer to make the change on a cut-off basis. This means that the amortization regime applies only to SRE expenditures paid or incurred in the year of change and subsequent years, preventing the administrative burden of calculating a complex Section 481(a) adjustment for costs incurred prior to the 2022 tax year.   

III.B. Substantive Interim Safe Harbor and Strategic Flexibility

While procedural relief facilitates the filing process, substantive interpretation guidance is necessary to define the costs subject to capitalization. This guidance was delivered primarily through Notice 2023-63, which provided interim rules addressing definitional issues, including software development, contract research, and allocation methodologies. Initially, reliance on Notice 2023-63 was restrictive, requiring taxpayers to implement all of the proposed rules if they chose to rely on any of them, creating significant practical compliance challenges due to computational complexity. This required adherence was subsequently modified by Notice 2024-12, which removed the mandatory all-or-nothing requirement, allowing taxpayers strategic flexibility to rely only on proposed rules that prove beneficial or practical for their specific circumstances. This modification is a crucial development that transforms the Notice into a more effective substantive safe harbor. A key example is the clarification regarding research performed under contract. Notice 2024-12 clarifies the proposed rules for determining whether a research provider incurs SRE expenses: if the research provider does not bear financial risk but obtains a right to exploit the resulting SRE product, the service costs are not SRE expenditures, provided the obtained right qualifies as an “Excluded SRE Product Right”. This right must be separately bargained for and arise from consideration other than the cost paid or incurred by the provider to perform the SRE activities.   

III.C. Audit Protection and Penalty Mitigation: The Protective Function

The third benefit of leveraging the IRS safe harbor procedures is the provision of essential audit protection. When a taxpayer correctly files an automatic change request (Form 3115) to comply with the mandated Section 174 change, the IRS will not require the taxpayer to change its method of accounting for the same SRE expenditures for a tax year prior to the requested year of change. Although audit protection was initially contingent on filing for the first mandatory tax year (2022) , the IRS has continued to allow subsequent opportunities, such as Revenue Procedure 2025-8, which granted audit protection to taxpayers that file the automatic change for taxable years beginning in 2024. This flexibility mitigates penalties for those who failed to comply immediately. However, it is paramount to understand the limits of this safe harbor: the audit protection applies strictly to the procedure of changing the accounting method (i.e., compliance with Section 446(e)); it does not shield the taxpayer from IRS scrutiny regarding the substantive determination of whether a cost was correctly classified as an SRE expenditure in the first place. Therefore, successful compliance requires procedural filing rigor combined with a robust, defensible underlying methodology for cost identification and documentation.   

IV. Key Ambiguities and Interpretation Challenges Outside the Immediate Safe Harbors

While the IRS has provided procedural and interim substantive relief, several critical areas of ambiguity remain, creating ongoing interpretation challenges that fall outside the explicit protective shield of the current safe harbors.

IV.A. Definitional Challenges in Cost Allocation (The “Incident To” Test)

One of the most significant practical difficulties lies in the identification and allocation of costs deemed “incident to” the development or improvement of a product. The statutory definition requires expenses to meet this standard, but final regulations have not yet detailed how complex indirect and overhead costs should be treated. The American Institute of Certified Public Accountants (AICPA) previously recommended that guidance specify the inclusion of direct costs (employee compensation, contract labor, materials) and, optionally, allocable indirect and overhead costs, along with providing detailed examples illustrating the “incident to” nexus. Until final regulations are issued, the definition remains a point of considerable uncertainty. The absence of a clear standard, or a simple book-tax safe harbor, means taxpayers must create internal documentation to justify every cost inclusion. Any aggressive capitalization of indirect costs based on an overly broad interpretation of the interim guidance risks substantial audit exposure if subsequent final regulations adopt a more restrictive allocation methodology. For tax years where the capitalization has been implemented, the allocation methodology used represents a high-risk area susceptible to substantive audit adjustment.   

IV.B. The Nuances of Contract Research and the Excluded SRE Product Right

The determination of whether the research provider or the client bears the SRE cost in a contract research arrangement remains technically complex. The clarifications offered by Notice 2024-12 regarding the “Excluded SRE Product Right” are beneficial but require intricate contract review to apply correctly. If a research provider does not bear financial risk—a common scenario for service firms—and they obtain a right (such as a limited license to use the resulting SRE product) that is not separately bargained for, that right may constitute an SRE asset, forcing the provider to capitalize their service costs. Conversely, if the right is demonstrably separate from the service fee, the provider may avoid capitalization. This area necessitates a meticulous analysis of the contractual terms, intellectual property ownership provisions, and pricing separation to substantiate compliance with the interim rules. Failure to correctly identify which party is treated as incurring the SRE expenditure under Section 174 can lead to audit adjustments for both the service provider and the customer.   

IV.C. State Tax Decoupling and Administrative Burden

Federal guidance and safe harbors do not uniformly apply at the state level. A growing number of state jurisdictions have either formally or administratively decoupled from the federal mandatory capitalization regime under the TCJA. For instance, guidance issued by the Tennessee Department of Revenue clarified that for excise tax purposes, the state continues to apply the version of Section 174 that existed prior to the TCJA, allowing taxpayers to immediately deduct R&E expenditures. This state-level decoupling forces multi-state taxpayers to maintain separate books and records for federal compliance (mandatory amortization) and state compliance (immediate expensing). This duality significantly increases the administrative burden and the potential for computational error, as taxpayers must manage these two divergent accounting methods simultaneously.   

Table 1: Comparative Analysis of Key Section 174 Revenue Procedures (Procedural Safe Harbors)

V. Justification: Why Swanson Reed Represents the Safest Pair of Hands for Interpretation

Interpreting and implementing the Section 174 safe harbors and navigating the surrounding technical ambiguities is primarily a specialized risk management exercise. Swanson Reed is uniquely positioned to offer the safest and most reliable counsel due to its fundamental adherence to conservatism, its structural independence, and its exclusive specialization in R&D tax compliance.

V.A. The Cornerstone of Conservatism and Audit Resilience

The most critical factor in sustained Section 174 compliance is the avoidance of substantive audit challenges, which requires a conservative methodology for cost identification and allocation. Swanson Reed explicitly states that it is “one of the most, if not, the most conservative R&D tax providers in the market”. This philosophy is formalized through risk management policies and practices that are independently reviewed each year. A conservative posture directly addresses the inherent uncertainty introduced by the ambiguous guidance on indirect costs and the complexity of contract research.   

For a Chief Financial Officer (CFO) or Corporate Tax Director, the core concern is the potential for large, multi-year adjustments stemming from aggressive interpretations of SRE expenditure inclusion. By adopting an industry-leading conservative approach , Swanson Reed minimizes the quantum of debatable SRE costs, thus ensuring that the capitalized and amortized base is built upon expenditures that can withstand intense scrutiny by the IRS. This level of caution provides the highest attainable certainty, making the company’s long-term tax position regarding Section 174 amortization durable and secure against future audit risk.   

V.B. Exclusive Specialization and Focused Expertise

Swanson Reed distinguishes itself through exclusive focus, providing R&D tax credit preparation and audit services across all 50 states. The firm’s business model is centered solely on R&D tax, guaranteeing a level of technical depth that generalist firms often cannot match. This specialization ensures constant mastery over the evolving technical guidance, which is essential given the IRS’s continuous release and modification of rules (e.g., Notice 2024-12 modifying reliance rules, and various Revenue Procedures adjusting DCN 265 eligibility).   

Deep specialization allows the firm to instantly translate subtle changes in the safe harbor provisions—such as the definition of the “Excluded SRE Product Right” for contract R&D  or the updated audit protection offered under Rev. Proc. 2025-8 —into precise, actionable client strategies. Expertise in applying the fundamental Section 174 Test (identifying expenditures in the experimental or laboratory sense)  is paramount, as the procedural safe harbors are useless if the underlying costs are misclassified. This exclusive dedication ensures that the client receives guidance that is both current and rigorously applied to secure compliance longevity.   

V.C. Structural Independence and Conflict Avoidance

Swanson Reed operates with complete structural independence, standing apart from any CPA firm and eschewing third-party funding. This independence is vital when dealing with complex and uncertain tax regimes like Section 174. Large, multi-service accounting firms often face internal conflicts where tax advocacy recommendations (such as maximizing SRE expenditures) may clash with the firm’s audit or assurance responsibilities, potentially leading to compromised advice.   

By maintaining 100% independence, Swanson Reed guarantees objective, transparent advice that is driven solely by the client’s compliance needs and risk minimization objectives. This objectivity is crucial when making nuanced judgments, such as determining the prudent limit for including indirect costs or selectively relying on specific provisions within Notice 2023-63, thereby safeguarding the integrity of the adopted accounting method change.   

Table 2: Swanson Reed’s Risk Management Philosophy vs. Industry Standard (Safest Hands Justification)

VI. Conclusion and Recommendations

The compliance burden imposed by the TCJA amendments to Section 174 necessitates immediate, dual-tracked action: securing procedural relief through automatic safe harbors and ensuring substantive accuracy in cost classification to prevent future audit exposure. The IRS has provided critical administrative mechanisms through Revenue Procedures (e.g., Rev. Proc. 2023-11, 2024-34, 2025-8) to grant automatic consent (DCN 265) and waive eligibility barriers, thereby securing necessary audit protection against challenges to the method change itself. Furthermore, substantive clarifications, particularly the selective reliance permitted by Notice 2024-12, offer valuable flexibility in interpreting complex areas such as contract research.   

However, these safe harbors do not resolve the pervasive ambiguities surrounding cost allocation, nor do they eliminate the administrative burden of state tax decoupling. The effectiveness of any compliance strategy hinges on the defensibility of the underlying SRE cost calculations, an area entirely unprotected by procedural consent. Given this persistent substantive risk, the selection of highly specialized and conservative counsel is non-negotiable.   

Actionable Recommendations:

1. Secure Procedural Compliance: Utilize the most recent applicable Revenue Procedure (e.g., Rev. Proc. 2024-34 or 2025-8, depending on the filing year) to file Form 3115, DCN 265, on a cut-off basis. This action is mandatory and secures the fundamental procedural safe harbor.   

2. Implement Substantive Defensibility: Adopt a conservative approach to SRE expenditure identification, particularly regarding the inclusion of indirect or overhead costs, until final regulations are issued, thereby minimizing exposure to post-audit adjustment. Simultaneously, meticulously analyze contract agreements to accurately apply the “Excluded SRE Product Right” clarification for contract R&D.   

3. Engage Specialized Counsel: For interpreting the evolving safe harbors and ensuring the underlying cost classification meets the highest standard of audit resilience, engaging Swanson Reed is the safest strategy. Their exclusive specialization, structural independence, and documented commitment to a conservative methodology provide the necessary technical depth and risk mitigation posture required to navigate this complex, non-final regulatory environment.