Guidance for 174 R&D Deduction Expenses 

In Brief

  • Based on IRS Notice (2023-63), companies might not be capturing all costs for 174 
  • 174 costs includes Overhead Labor, Depreciation allowance, and others.  
  • 174 deduction excludes costs from Administrative Departments. 

A lot of companies had their first introduction filing the 174 R&D deduction (“174”) this past year. If a company had software development or wanted to claim the R&D Credit, they did not have a choice. The Tax Cuts and Jobs Act required all taxpayers with research expenses to capitalize and amortize these expenses over a 5- or 15-year period, depending on whether the expenses were domestic or foreign.  

Although the 174 deduction is intricately connected with the R&D credit, what qualifies for the 174 deduction is broader, both in qualification and the scope of expenses. As with the R&D Credit, there is a level of judgement needed to determine what activities should be qualified under the 174 deduction. Initially there was a surprise in the level of unambiguity about which expenses should be included.  

The Internal Revenue Service stepped in to help and gave some much-needed guidance (Notice 2023-63) on many things surrounding the 174 deduction, one of which was the scope of expense to include. From the IRS notice, they helped specify which 174 costs should and should not be included. The notice categorizes expenses that are “incident to the development or improvement of a product, a component of a product, or subcomponent of a product,” which is a key definition found in the R&D deduction regulation.  

Based on the guidance the IRS gave, in the initial year most companies did not capture all the expenses for the 174 deduction.  This will most likely lead to adjustment in the next year to the scope of expenses included for the 174 deduction.  Also, this article does not cover software development, which is also included in the notice and required to be included under 174.    

R&D Deduction Cost Categories 

Any company that has research activities needs to review and make sure they examine whether they had any of the expense categories the IRS specified. Here are categories the IRS wants companies to review and add to their R&D deduction expenses: 

Overhead Labor Costs:  

In addition to wages, companies need to pick up all elements of compensation including stock-based compensation, overtime pay, vacation pay, holiday pay, sick leave pay, payroll taxes, pension costs, employee benefits, and payments to a supplemental unemployment benefit plan. A surprise is companies do not have to account for severance compensation. Yet, aside from this exception, companies should include all fringe benefits expenses that are attributed to qualified employees.  

Overhead Materials and Supply Costs:  

If there were materials and supplies, including tools and equipment that were used and consumed in qualified activities these should be part of the 174 expenses. Similar to the R&D Credit, these should be only tangible items, software or software licenses would be excluded.  Software is included in 174 but addressed separately in the notice and not addressed in this article.   

Cost Recovery Allowances:  

This would be property that is depreciated and amortized for a company. It should only be depreciated property that was necessary in qualified activity. The notice gave the example of a “test bed” for research as property costs that should be included. 

Patent Cost:  

These costs connected with obtaining a patent, such as attorneys’ fees expended in making a patent application. 


Any travel expenses related to the direct involvement or support of qualified activities.  

Operational Costs:  

Certain operation or management expenses should be included, including costs that were a part of maintaining facilities and equipment used for qualified activities. The IRS notice highlights rent, utilities, insurance, taxes, repairs and maintenance and security costs as expenses that fit into the category. 

Excluded R&D Deduction Costs 

The IRS does make clear certain types of expenses that should be excluded, which provides clarity for 174.  

In the notice, the IRS stated any costs from general or administrative departments should not be treated as 174 expenses. There are many departments that only indirectly support or benefit qualified activities. Payroll, Human Resources, and Accounting were all departments called out as excluded in the notice. This gives companies an important boundary around qualified expenses. Not all expenses that could relate to qualified activities are qualified expenses. There is a clear fence that stops administrative departments from being included in R&D deduction.  The notice also excludes debt interest, software costs after development and website content costs as also excluded from 174.   

Some more guidance? 

Although this notice is welcomed, companies should be aware more could be coming. The IRS stated companies should have confidence with their areas in which they clarified, but more clarification—and possible expansion to expenses—could be given. Yet with this new guidance from the IRS, companies should have a better understanding as to what expenses should be in their 174 deductions, and most importantly, what should not. The expenses that should be included might be more than companies initially thought, but it is important to note that there were also limits given on the scope of 174 expenses. 

IRS Circular 230 Required Notice‐‐IRS regulations require that we inform you that to the extent this communication contains any statement regarding federal taxes, that statement was not written or intended to be used, and it cannot be used, by any person (i) for the purpose of avoiding federal tax penalties that may be imposed on that person, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein. 

Invoices and AI’s Intelligent Document Processing 

In Brief

  • AI (Artificial Intelligence) can allow companies to dynamically gather data through IDP 
  • IDP does have limitations in how it analyzes and extracts data. 
  • AI has tools to incorporate OCR into IDP to expand data analysis. 

As AI is still being hashed out for its maximum potential, there are aspects of this newly founded technology that can benefit a company in its everyday processes or tasks. 

AI models and programs are still being developed. Some companies are already using AI for intelligent Document Processing (IDP). But what does a company do when their data is poor? Normally, a company can use Optical Character Recognition (OCR) technology to take document images and convert them to digitized text. But this process is isolated, only being able to analysis one document at a time. But with the assistance of AI tools, OCR data can be captured and used for IDP, making it more consumable for the company.  

IDP Example 

IDP can occur by extracting information from various areas within an organization. This could be from invoices, text found in photos and PDFs, receipts, and information from documents.  

Many of these items are used in applications that are limited in their ability to process data as well. Adobe is an application that hosts pdfs but does not engage in any data processing activities. Microsoft, with its Power Automate, can process and load data into tables and models but needs access from IT departments. 

But when setup, Power Automate can take good and bad invoice documents and perform IDP and extract invoice data correctly. And even after completing the task, it can offer a confidence score as this is AI making and attempt to pull the correct fields and information for how the user requests it. The higher the confidence score the more reliable the IDP process. 

This is not just a guess for the AI model, when creating the model, you can set the fields and pick out where that field should be within the document. For the IDP aspect of power automate, it will attempt to match what the user set as training material to what it is given for a test and try its best to give the correct output.  

Challenges with IDP 

IDP is capable at some levels, yet even with a confidence score, there will be times when finding and connecting data is too difficult. Too much volume (data size). Too much velocity (rate of change). Too much variety (breadth of sources). Experiences like this for data connectivity are too fragmented and data often needs to be reshaped before consumption. But any shaping is one-off and not repeatable. 

So, there are limitations to IDP as it may never be 100% confident. Especially when the source document is custom and complex due to its readability or over presentation of information. For other documents, it may make sense for time to be spent cleaning up documents for it to become easier for AI programs to read them. Correcting documents is not a one size fits all type of change as some documents, especially scanned in documents may have portions where the data quality is poor, which makes it difficult for IDP to occur.  

It would take enormous amounts of effort and non-value add time to convert files and sometimes boxes of invoices into consumable data for detailed analysis. One goal might be getting all those invoices and extracting the data into a table.  

AI to use OCR to convert PDF 

There are AI tools available that can convert these files into data that is more consumable, but it is important to evaluate the tool in comparison to the specific technology requirements at your organization. Here is a simple list of areas to review when deciding on an OCR conversion tool. 

  • Does it connect to other tax processes? 
  • Will my IT department allow access? 
  • Can it extract data from a table on the PDF/invoice/agreement? 
  • Can I use it as a model to train for other types of documents? 
  • Are there any firewall/security issues with the data being extracted? 
  • Easily drag/drop multiple files to have mass data extraction? 
  • Processing time? 
  • Cost structure? 

One of the most notable features of using AI to extract data is if the model can be trained: learning about the specific types of invoices (vendors, locations, etc.) a company might produce. Yet, it is important that whatever model or tool is selected, it allows the tax department to easily train the model to pick the data off the document.  

IRS CircIRS Circular 230 Required Notice‐‐IRS regulations require that we inform you that to the extent this communication contains any statement regarding federal taxes, that statement was not written or intended to be used, and it cannot be used, by any person (i) for the purpose of avoiding federal tax penalties that may be imposed on that person, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.