Section 174: The R&D Amortization Rule Every Tech Startup Must Understand
Section 174 is the most consequential tax change for software and tech companies in recent memory — and most founders still don’t fully understand its impact. Here’s what it means, what it costs, and where things stand legislatively.
What Section 174 Changed
Before January 1, 2022, businesses could immediately deduct all research and experimental (R&E) expenditures under Section 174. A company spending $3M on engineering salaries got a $3M deduction in the same year.
The TCJA change: Starting with tax years beginning after December 31, 2021, Section 174 requires capitalization and amortization of R&E expenditures:
- Domestic R&E: 5-year amortization (with a half-year convention in year 1)
- Foreign R&E: 15-year amortization (with a half-year convention in year 1)
This is no longer a choice — it’s mandatory.
The Real Cash Tax Impact
The half-year convention means you only get half a year of amortization in year one. On $2M of domestic R&E expenses:
| Year | Deduction (5-year, half-year) |
|---|---|
| Year 1 | $200,000 (10% of $2M) |
| Years 2–5 | $400,000/year (20% of $2M) |
| Year 6 | $200,000 (remaining half-year) |
Compare to the pre-2022 immediate deduction: you’d have deducted the full $2M in Year 1. Under the new rules, you deduct $200,000 in Year 1.
What this means for a typical SaaS startup:
A Series A company with $3M in engineering payroll (qualifying as R&E) used to deduct $3M. Now they deduct $300,000 in year one, paying taxes on the remaining $2.7M of “income” that doesn’t reflect actual cash position. For a company in the 21% corporate tax bracket with $5M in revenue, this can create a $567,000 unexpected tax liability.
Many SaaS companies that expected to owe little or no federal income tax for 2023, 2024, and 2025 have been surprised by significant tax bills entirely due to Section 174.
What Counts as R&E Under Section 174
The IRS definition of R&E is broader than the R&D tax credit definition (which is more restrictive). Under Section 174, R&E expenses include:
- Engineering and development payroll (salaries, bonuses, benefits for engineers working on qualifying activities)
- Contractor costs for software development
- Cloud computing costs directly used in development (AWS, GCP usage for development environments)
- Materials and supplies used in research
- Overhead allocable to R&E activities
Software development is explicitly included: IRS Notice 2023-63 provided guidance confirming that software development costs generally qualify as R&E under Section 174. This means virtually every SaaS and tech company is affected.
Foreign development: If you offshore development to contractors or employees in India, Eastern Europe, or elsewhere, those costs are subject to the 15-year amortization period — making offshore development three times as tax-costly as domestic development under Section 174.
Legislative Status in 2026
Congress has attempted to retroactively restore immediate deduction for Section 174 multiple times since the change took effect. As of early 2026, all efforts have failed:
- The Tax Relief for American Families and Workers Act (2024): passed the House but stalled in the Senate
- Various standalone bills: introduced but not enacted
Current status: Section 174 amortization remains in effect. You must capitalize and amortize R&E expenses for tax years 2022 through the present.
There continues to be bipartisan support for fixing Section 174 — it’s one of the few tax issues where Republicans and Democrats broadly agree a fix is needed. However, legislative timing is unpredictable. Do not file or plan your taxes expecting a retroactive fix to arrive. Budget for the current law and treat any future legislative fix as upside.
The Interplay with the R&D Tax Credit
The R&D tax credit (Section 41) and Section 174 amortization are different rules that affect the same expenses, and they interact:
- Section 41 R&D credit: a tax credit equal to 20% of qualifying research expenses (QREs) above a base amount. For startups, up to $500K of R&D credit can be used to offset payroll taxes.
- Section 174: mandatory capitalization of qualifying R&E expenses.
Many of the same expenses that qualify for the R&D credit also must be capitalized under Section 174. The credit still offsets your tax liability dollar-for-dollar — but you can’t deduct the full R&E expense in the year it’s incurred.
Running both analyses simultaneously is essential. The R&D credit may partially offset the increased tax burden from Section 174 amortization, but it doesn’t eliminate it.
Planning for Section 174
Short-term: If you haven’t already, get a Section 174 analysis for your 2025 tax year before filing. Calculate the amortization schedule for every year since 2022. The cumulative unamortized balance (amounts you’ve capitalized but not yet deducted) is an asset on your balance sheet — your tax accountant needs to track this explicitly.
Entity structure: C-Corps pay the highest effective tax rate impact from Section 174 because they pay corporate tax directly. Pass-through entities (LLCs, S-Corps) push the impact to individual owners’ tax rates. If your company is unprofitable at the entity level but Section 174 creates phantom income, the cash tax hit is real regardless.
Cash forecasting: If you have a significant engineering team, model Section 174 explicitly into your 12-month cash forecast. The tax liability arrives on the same timeline as your quarterly estimated payments — it doesn’t wait for year-end.
Domestic vs. offshore mix: Given the 5-year vs. 15-year disparity, domestic R&E has a significantly better tax profile than offshore R&E. This isn’t an argument to reshore development decisions — but it’s a factor worth knowing when modeling total cost of development.
Frequently Asked Questions
Does Section 174 apply to my SaaS company if we outsource development to contractors?
Yes — contract research expenses are explicitly included in Section 174 qualifying R&E. If you pay contractors to develop software, those costs must be capitalized and amortized under Section 174 just like internal engineering payroll. One important wrinkle: if the contractors are located outside the United States, those costs are subject to the 15-year amortization period rather than the 5-year domestic rate. This means a SaaS company with $500,000/year in offshore development costs gets only about $17,000 in deductions in year 1 (using the half-year convention on 15-year amortization), compared to $50,000/year if the same team were domestic. The offshore vs. domestic split of your contractor costs is now a meaningful tax consideration.
Is there any chance Section 174 gets fixed retroactively?
There’s genuine bipartisan support for fixing Section 174 — it’s one of the few tax issues where both parties agree the current treatment is economically damaging to innovation. Multiple bills have passed the House with strong margins, only to stall in the Senate. As of early 2026, Section 174 amortization remains the law. A retroactive fix is possible but has been ‘about to happen’ for three years without materializing. The prudent approach: file your taxes under current law, don’t depend on a fix arriving, and treat any legislative change as unexpected upside. If a fix does pass retroactively, you’d likely file an amended return to recover refunds from prior years. Your accountant should be tracking this and can quickly recalculate your liability if the law changes.
We capitalized our R&D costs under Section 174. Does this show up on our balance sheet?
Yes — capitalized Section 174 R&E appears as an intangible asset on your GAAP balance sheet, being amortized over 5 or 15 years. This creates a timing difference between your GAAP books and your tax return that generates a deferred tax asset. Here’s why: under GAAP, you may be expensing R&D immediately per ASC 730 (which still requires immediate expensing for most R&D) — but your tax return is capitalizing and amortizing the same costs under Section 174. Your tax basis for the capitalized R&E is different from your GAAP book basis. Your accountant needs to track these differences to properly compute your deferred tax assets and liabilities — which matter for GAAP financial statements and investor-facing reporting.
How does Section 174 interact with the R&D tax credit?
They’re separate but related. Section 174 governs how you deduct R&E expenses (mandatory 5 or 15-year amortization). Section 41 governs the R&D tax credit (a credit equal to a percentage of qualifying research expenses). The expenses that generate the Section 41 credit are often the same expenses being amortized under Section 174 — but the credit is calculated on the gross QREs, not the amortized deduction. When you claim the Section 41 credit, you must reduce your Section 174 deduction base by the amount of the credit (to prevent double-dipping). Alternatively, you can elect to reduce the credit itself by the tax benefit of the deduction. This calculation requires doing both analyses simultaneously — which is why your R&D credit study and your Section 174 analysis should be done by the same team, not separately.
Our startup has no taxable income because we're burning cash. How does Section 174 affect us?
Section 174 creates ‘phantom income’ — it reduces your tax deductions below your actual cash expenses, potentially creating taxable income even when you’re cash-flow negative. A startup burning $3M/year in engineering costs (with $1M in revenue) would expect a $2M loss for tax purposes. Under Section 174, you might deduct only $300,000 of engineering costs in year 1 (10% of $3M), creating a potential $2.4M swing in taxable income. For loss companies, this often means smaller net operating losses (NOLs) that carry forward — rather than an immediate cash tax bill. But it reduces the NOL that would have offset future income. The long-term impact: when you become profitable, you’ll have less NOL to shelter income because Section 174 reduced the losses you accumulated while burning cash.