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Product. The term “product” includes any of the following items. • Formula. • Invention. • Patent. • Pilot model. • Process. • Technique. • Property similar to the items listed above. It also includes products used by you in your trade or business or held for sale, lease, or li- cense. Costs not included. Research and experi- mental costs do not include expenses for any of the following activities. • Advertising or promotions. • Consumer surveys. • Efficiency surveys. • Management studies. • Quality control testing. • Research in connection with literary, his- torical, or similar projects. • The acquisition of another's patent, model, production, or process. When and how to elect. You make the elec- tion to deduct research and experimental costs by deducting them on your tax return for the year in which you first pay or incur research and experimental costs. If you do not make the elec- tion to deduct research and experimental costs in the first year in which you pay or incur the costs, you can deduct the costs in a later year only with approval from the IRS. Research credit. If you pay or incur qualified research expenses, you may be able to take the research credit. For more information, see Form 6765 and its instructions. Payroll tax credit. The payroll tax credit is an annual election made by a qualified small busi- ness specifying the amount of research credit, not to exceed $250,000, that may be used against the employer portion of social security liability. The credit is the smallest of the current year research credit, an elected amount not to exceed $250,000, or the general business credit carryforward for the tax year. The election must be made on or before the due date of the originally filed return (including extensions). An election cannot be made for a tax year if an election was made for 5 or more preceding tax years. The election made by a partnership or S corporation is made at the entity level. A qualified small business that elects to claim the payroll tax credit and files quarterly employment tax returns, will claim the payroll tax credit on its employment tax return for the first quarter that begins after it files the return re- flecting the payroll tax election. For more infor- mation, see Form 6765 and its instructions. Intangible Drilling Costs The costs of developing oil, gas, or geothermal wells are ordinarily capital expenditures. You can usually recover them through depreciation or depletion. However, you can elect to deduct intangible drilling costs (IDCs) as a current business expense. These are certain drilling and development costs for wells in the United States in which you hold an operating or work- ing interest. You can deduct only costs for drill- ing or preparing a well for the production of oil, gas, or geothermal steam or hot water. You can elect to deduct only the costs of items with no salvage value. These include wa- ges, fuel, repairs, hauling, and supplies related to drilling wells and preparing them for produc- tion. Your cost for any drilling or development work done by contractors under any form of contract is also an IDC. However, see Amounts paid to contractor that must be capitalized, later. You can also elect to deduct the cost of drill- ing exploratory bore holes to determine the lo- cation and delineation of offshore hydrocarbon deposits if the shaft is capable of conducting hydrocarbons to the surface on completion. It does not matter whether there is any intent to produce hydrocarbons. If you do not elect to deduct your IDCs as a current business expense, you can elect to de- duct them over the 60-month period beginning with the month they were paid or incurred. Amounts paid to contractor that must be capitalized. Amounts paid to a contractor must be capitalized if they are either: • Amounts properly allocable to the cost of depreciable property, or • Amounts paid only out of production or proceeds from production if these amounts are depletable income to the recipient. How to make the election. You elect to de- duct IDCs as a current business expense by taking the deduction on your income tax return for the first tax year you have eligible costs. No formal statement is required. If you file Sched- ule C (Form 1040), enter these costs under “Other expenses.” For oil and gas wells, your election is bind- ing for the year it is made and for all later years. For geothermal wells, your election can be re- voked by the filing of an amended return on which you do not take the deduction. You can file the amended return for the year up to the normal time of expiration for filing a claim for credit or refund, generally, within 3 years after the date you filed the original return or within 2 years after the date you paid the tax, whichever is later. Energy credit for costs of geothermal wells. If you capitalize the drilling and development costs of geothermal wells that you place in serv- ice during the tax year, you may be able to claim a business energy credit. See the Instruc- tions for Form 3468 for more information. Nonproductive well. If you capitalize your IDCs, you have another option if the well is non- productive. You can deduct the IDCs of the nonproductive well as an ordinary loss. You must indicate and clearly state your election on your tax return for the year the well is comple- ted. Once made, the election for oil and gas wells is binding for all later years. You can re- voke your election for a geothermal well by filing an amended return that does not claim the loss. Costs incurred outside the United States. You cannot deduct as a current business ex- pense all the IDCs paid or incurred for an oil, gas, or geothermal well located outside the Uni- ted States. However, you can elect to include the costs in the adjusted basis of the well to fig- ure depletion or depreciation. If you do not make this election, you can deduct the costs over the 10-year period beginning with the tax year in which you paid or incurred them. These rules do not apply to a nonproductive well. Exploration Costs The costs of determining the existence, loca- tion, extent, or quality of any mineral deposit are ordinarily capital expenditures if the costs lead to the development of a mine. You recover these costs through depletion as the mineral is removed from the ground. However, you can elect to deduct domestic exploration costs paid or incurred before the beginning of the develop- ment stage of the mine (except those for oil and gas wells). How to make the election. You elect to de- duct exploration costs by taking the deduction on your income tax return, or on an amended income tax return, for the first tax year for which you wish to deduct the costs paid or incurred during the tax year. Your return must ade- quately describe and identify each property or mine, and clearly state how much is being de- ducted for each one. The election applies to the tax year you make this election and all later tax years. Partnerships and S corporations. Each partner, not the partnership, elects whether to capitalize or to deduct that partner's share of exploration costs. Each shareholder, not the S corporation, elects whether to capitalize or to deduct that shareholder's share of exploration costs. Reduced corporate deductions for explora- tion costs. A corporation (other than an S cor- poration) can deduct only 70% of its domestic exploration costs. It must capitalize the remain- ing 30% of costs and amortize them over the 60-month period starting with the month the ex- ploration costs are paid or incurred. A corpora- tion may also elect to capitalize and amortize mining exploration costs over a 10-year period. For more information on this method of amorti- zation, see section 59(e). The 30% that the corporation capitalizes cannot be added to its basis in the property to figure cost depletion. However, the amount amortized is treated as additional depreciation and is subject to recapture as ordinary income on a disposition of the property. See Section 1250 Property under Depreciation Recapture in chapter 3 of Pub. 544. These rules also apply to the deduction of development costs by corporations. See Devel- opment Costs, later. Recapture of exploration expenses. When your mine reaches the producing stage, you Chapter 7 Costs You Can Deduct or Capitalize Page 25