That change? Businesses may again deduct research and development costs, or R&D costs, as incurred.

Note: The current law says firms must capitalize R&D costs and then amortize the costs over a number of years.

But this change is trickier than you might at first guess. Some complexities exist. Also you have some tax planning opportunities related to any existing, capitalized R&D costs your tax return shows.

In this post, I walk you through the newly restored R&D deduction rules. And then I’ll explain not just how to recover deductions from prior years, but also how to maximize the tax savings you enjoy when you do this.

But let’s review how we got here.

R&D Deductions Pre-2022, The Golden Era

Prior to January 1, 2022, taxpayers had two primary options for handling R&D expenses:

1. Taxpayers could deduct R&D expenses in the year incurred. This applied to in-house R&D costs and certain contract expenses, and was the most common treatment.
2. Alternatively, businesses could elect under §174(b) to amortize R&D over at least 60 months.

The ability to expense R&D immediately had two tax accounting benefits. First, it reduced a taxpayer’s income which meant it also reduced a taxpayer’s tax burden. Second, it simplified the accounting by avoiding complex capitalization and amortization tracking. Then the rule changed.

R&D Deductions 2022 – 2024, The Dark Era

From 12/31/2021 through 12/31/2024, tax law required taxpayers to capitalize R&D costs. Those costs were amortized over 60 months if domestic R&D and over 180 months if foreign R&D.

That all sounds reasonable enough. But some practical observations about the capitalization policy. The policy:

• Increased the tax burden for tax payers involved in R&D activities
• Reduced cash flow reinvested in R&D activities, thereby hindering innovation
• Burdened firms with complex accounting treatment
• Boosted tax return preparation fees
• Increased chance of tax return errors due to limited IRS guidance

The good news is R&D expenses are, potentially, immediately deductible again.

The American Innovation and Growth Act of 2025

The American Innovation and Growth Act of 2025, also known as the “One Big Beautiful Bill,” or “OBBB” for short, ends the capitalization policy of TCJA. Further, it allows taxpayers the ability to deduct still capitalized R&D costs from 2022 – 2024.

Domestic R&D

Domestic R&D costs, generally, qualify for immediate expensing if they meet the definition of R&D expenditures, which include:

• Wages paid to employees directly engaged in qualified research
• Supplies used in the conduct of research
• Contracted research
• Software development costs
• Cloud computing and data hosting costs

Activities must be performed in the United States or a US territory, including contractor work, for immediate expensing.

Foreign R&D

Foreign R&D costs are still required to be capitalized and amortized over 180 months. Some foreign R&D examples include:

• Wages paid to employees outside of the United States (frequently in Canada, India, UK, and other EU countries)
• Third party vendors or contractors located outside of the United States
• Foreign software development costs
• Materials and supplies used in foreign R&D activities

Note, too, foreign R&D costs no longer qualify for R&D credits beginning 1/1/2025.

Reversing 2022 – 2024 Capitalization

The OBBB introduced two methods to claim R&D deductions that were missed during the capitalization period.

Method 1, Small Business Amendment Option

This allows small taxpayers (average 3-year revenue under $31 million) to file an amended return for any of the open 2022 – 2024 tax years to expense previously capitalized R&D expenses.

This method results in the fastest cash recovery, however, there is some preparation cost for amending previously filed tax returns, and possibly greater IRS examination risk.

Our recommendation is to look at the taxpayer’s marginal tax rate in the year in question to see if it makes sense to amend.  You probably don’t want to do this if the taxpayer’s marginal rate is low.  If the marginal rate is high, 35 or 37%, for example, amending may make the most sense.

Method 2, Catch-Up Deduction Election

This method allows any taxpayer, big or small, to either:

1. Deduct 100% of the unamortized basis of capitalized R&D in 2025, or
2. Deduct 50% of the unamortized basis in 2025, and 50% in 2026

The taxpayer must make the election on their originally filed 2025 tax return, making this likely the least expensive option with a lower amount of examination risk.

With this method, however, the taxpayer won’t realize the tax benefit until they file their 2025 or 2026 tax returns, which will occur in 2026 or 2027.

You will want to do some forecasting to optimize this.  It probably doesn’t make sense to spread the deduction over two years if you anticipate 2025 to be a big income year and 2026 to be a small income year, for example.  And you will want to analyze the tax benefits between the catch-up deduction and small business amendment options.

An Example to Illustrate

Say a taxpayer’s tax return capitalized $500,000 of R&D wages in 2024, and then amortized $100,000 of this spending. That leaves $400,000 of yet-to-be-amortized R&D costs at the start of 2025.

This taxpayer chooses between four options:

1. Continue amortizing the capitalized R&D wages at the rate of $100,000 a year.
2. Amend the 2024 tax return and adding the $400,000 of capitalized 2024 R&D wages to the 2024 tax return.
3. Take the $400,000 of still capitalized R&D wages as a deduction all on the 2025 tax return.
4. Split the $400,000 of capitalized R&D wages evenly across the 2025 and 2026 tax returns thereby putting a $200,000 deduction onto each return.

Taxpayers, probably with the help of their tax accountants, will want to “run the numbers” to see which option delivers the best savings. But the two general rules to consider are, first, sooner is better than later. (This is the ol’ time value of money.) But the second thing to consider is, if a firm can, it wants to use its deductions on the years where the marginal tax rates are highest.

Next Steps

Here is a small checklist of things to check if you are involved with R&D activities:

• How much unamortized basis is left in capitalized R&D after 2024?
• Try to estimate 2025 and 2026 income
• Compare the income in the period of capitalization to estimated 2025 and 2026 income
• Estimate the tax savings of each period and choose the one with the largest benefit.

I should also mention that deducting R&D does not prohibit or limit your ability to claim R&D credits.

As you can see, the change to R&D expensing is hugely consequential. Tens of thousands of small and mid-size business will be affected by this change.

This is one of the most tax-payer friendly developments we’ve seen in years. If you are a tax practitioner, you want to be looking closely at your R&D clients.  If you are a taxpayer involved in R&D activities, you want to be discussing this with your tax preparer.

Want to know how R&D tax credits work?  Click on this link.

The post One Big Beautiful Bill’s New R&D Deductions appeared first on Evergreen Small Business.

I hear you. We had more than a few client questions last tax season about how to handle this complexity. Thus a quick overview.

But one clarification: This discussion of Section 174 and software development cost capitalization rests on the new § 174 statute, which appeared in late 2017. And then on IRS Notice 2023-63, which was published in September 2023.

However, taxpayers and tax accountants really all need updated Treasury Regulations to plan ahead. And to get the bookkeeping right for 2024.

That qualification made? We can dig into the details.

Section 174 in a Nutshell

Section 174 changed in the 2017 Tax Cuts and Jobs Act, as noted. The old law said you could just currently deduct these expenditures.

The (sort of) “new” law says you need to capitalize “specified research or experimental” (aka “SRE”) expenditures. And then you amortize the capitalized amounts.

If you do the research in the US, you amortize the expenditures over five years. If you do the research outside the US, you amortize over fifteen years.

The law includes another big change. Tax law now wants to treat software development costs as a SRE expenditure. Quoting the statute, Section 174(c)(3), says this:

For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.

I added the boldfacing to the statutory language. But you see this is big. Apparently, nearly every software development cost a developer pays or incurs should be capitalized and amortized.

To put this into perspective, if you spend $1,000,000 developing a piece of software? You might think you get to deduct the $1,000,000 when you spend the money. But you don’t. You deduct $200,000 a year over five years. Or you deduct $66,666 a year over fifteen years.

Example of Section 174 Software Development Accounting

Notice 2023-63 provides a good example of precisely how a taxpayer handles the accounting. Tax advisors and company accountants want to read those pages carefully or their updated replacement in the regulations.

But essentially, you or your accountants add up all the direct and indirect costs of your software development activities. Pull that cost out of your profit and loss statement. Temporarily hold those dollars on your balance sheet. And then, as noted earlier, amortize this cost over either five or fifteen years.

One thing to note: You use a mid-year starting point for the first year. For example, if a taxpayer incurred $1,000,000 of direct and indirect costs of software development in year 1, this results in a $200,000 amortization expense each full year. (Because $1,000,000 divided by five years equals $200,000.) But the first year? A taxpayer only amortizes a half-year.

For year 1 in this example, then, the taxpayer deducts $100,000 of software development costs. The next four full years, he or she deducts a full $200,000. The last “half year?” The taxpayer deducts $100,000 of remaining software development costs.

Two Weird Accounting Aspects of Section 174

Two weird things to note about the Section 174 statute’s accounting.

First, the amortization starts in the year the costs are paid or incurred. Not the year the software developed is finished and placed into service. A two year software development project that costs $1,000,000 a year? You amortize each year’s $1,000,000 separately. And starting the middle of each year.

A second point: If you sell or retire or abandon the software you develop before the full five years runs? Like, say, in year 3? You ignore the sale, retirement or abandonment. And you keep on amortizing. You do not, in other words, start amortizing and then just “write off” the remaining unamortized bit.

Many Research and Experimentation Costs Don’t Need to Be Capitalized

After a bit of fiddling, I got ChatGPT 4o to summarize in a table the general SRE costs Notice 2023-63 says you should and shouldn’t capitalize. A crude replica of that table, lightly edited, follows:

Not All Software Development Costs Need to be Capitalized

And then the following computer-y costs (again I’m mostly quoting directly from Notice 2023-63) also don’t need to be capitalized:

• Training employees and other stakeholders that will use the computer software a business develops internally
• Maintenance activities after the computer software is placed in service that do not give rise to upgrades and enhancements (for example, corrective maintenance to debug, diagnose, and fix programming errors)
• Data conversion activities, except for activities to develop computer software that facilitate access to existing data or data conversion
• Installing the computer software and other activities relating to placing the computer software in service
• For software developed for external users, maintenance activities that do not give rise to upgrades and enhancements, distribution activities (for example, making the software available via remote access), and customer support activities.

The Notice explains that upgrades and enhancements to software in order to be capitalized and amortized need to be “significant.”

In defining what’s significant, the Notice appears to look at whether the software development resulted in “additional functionality.”  The language seems say “additional functionality” means the software can perform tasks it was previously incapable of performing. Or that it works with material increases in speed and efficiency.

Thus, not everything a software programmer does creates Section 174 software development costs a taxpayer needs to capitalize.

What If You Didn’t Do the Section 174 Accounting Correctly?

I’m going to guess if you’re a developer working on games or apps, you probably haven’t been doing this completely right. Thus, the $64 question: Where does this leave you? And, yeah, that’s a tricky question.

The new “capitalize software development costs” rule became effective January 1, 2022. But the IRS didn’t provide meaningful instructions until September 23, 2023. Just to gripe a bit here, roughly six years after the law was passed in 2017. And nearly two years after the law became effective on January 1, 2022. Thus, don’t beat yourself up about finding yourself late. Looking backwards? I’m not sure what you should or could have realistically done.

But looking forward? Unless Congress changes the law before next tax season, you want to get your accounting working right. Thus, talk with your bookkeeper. Or your accountant.

Make sure you tax advisor knows you’ve got software development costs you’re possibly not handling correctly.

Finally, do stay alert so you spot the new regulations when they appear. They should explain how taxpayers handle any honest fumbles. And how to request and make accounting method changes which are surely needed if prior to 2022 you followed the old conventional approach.

Related Articles

We’ve got a good discussion about how the research and development credit works here: Research and Develop Credits Explained.

The post Section 174 Software Development Accounting Primer appeared first on Evergreen Small Business.