A 9-person SaaS shop spent $280,000 in 2025 on engineers and contractors building a new routing engine — all domestic, all wages and contractor costs that would have been a current deduction for decades. Under Section 174 as it has applied since January 1, 2022, only about $28,000 of that $280,000 is deductible in 2025. The remaining $252,000 is capitalized and dribbled out over five years, half in the ramp year, while payroll hit the bank in full in December. The founder's P&L says profitable; the tax return says $252,000 more taxable income than expected; and the April estimate is due on the phantom profit. A retroactive bill called OBBBA may let the shop undo three years of amortization and get that cash back — but only if the books can prove what was Section 174 in the first place.
Since the Tax Cuts and Jobs Act, Section 174 changed from an elective expense-or-capitalize regime to mandatory capitalization. For tax years beginning after December 31, 2021, specified research or experimental expenditures — including software development costs — must be capitalized and amortized ratably over 5 years (domestic) or 15 years (foreign), beginning at the midpoint of the year incurred. No immediate deduction, no 10-year election, and no skipping the rule because you are small. In 2026, every small business that writes software, iterates on a physical product, or pays engineers to solve technical uncertainty is living inside this rule. The One Big Beautiful Bill Act (OBBBA) proposes to restore immediate expensing retroactively to 2022 — which, if enacted, turns the last three tax years into an amended-return and accounting-method-change project.
This guide explains what must be capitalized, how the 5-year math actually works, why software is caught, how Section 174 differs from the Section 41 research credit, and the practical bookkeeping that lets you file correctly whether OBBBA passes or not.
What Must Be Capitalized — Broader Than "Lab Coats"
Section 174 captures specified research or experimental expenditures paid or incurred in connection with the taxpayer's trade or business that represent research and development costs in the experimental or laboratory sense — essentially, costs to develop or improve a product where technical uncertainty exists.
In practice for small businesses:
- Software development — wages, contractor costs, cloud costs directly associated with developing or significantly improving software (including internal-use software). IRS guidance after 2022 explicitly includes software development in Section 174; you cannot carve out SaaS features as "just coding."
- Engineering and design — prototyping, CAD, testing, materials consumed in trials.
- Direct research labor — W-2 wages for employees doing research, including the research portion of a founder who codes.
- Contract research — amounts paid to contractors for research on your behalf.
- Overhead allocable to research — supplies, certain cloud and tooling costs, and depreciation allocable to research activities where the guidance requires allocation.
Not Section 174 (generally): pure market research, quality-control testing of existing products, market surveys, management studies, advertising, and — critically — costs of acquiring another's patent/model/formula where you simply purchase completed technology without undertaking research yourself. Land and depreciable property (other than cost recovery allocable to research) are also excluded in their acquisition cost, though depreciation on property used in research can be.
The small-business trap: A solo developer who assumes "Section 174 is for pharma and chip companies" while paying two contractors $120,000 to build a new product module has $120,000 of Section 174 costs. There is no small-business exemption and no de minimis.
The 5-Year (and 15-Year) Math — Midpoint Means Half in Year One
For domestic specified research or experimental expenditures, amortize ratably over 5 years (60 months), beginning at the midpoint of the taxable year in which the costs are paid or incurred. For foreign research, 15 years. If the research is disposed of, retired, or abandoned, you continue amortizing over the remainder of the period — no acceleration on abandonment.
Midpoint example — $180,000 domestic paid evenly through calendar 2025, calendar-year taxpayer:
- Year 1 (2025): $180,000 × (6/60) = $18,000
- Years 2–5 (2026–2029): $180,000 × (12/60) = $36,000 each year
- Year 6 (2030): remainder $18,000
That 6/12/12/12/12/6 pattern surprises founders who expect 20% per year. For costs incurred late in the year, the same midpoint applies — there is no short-year proration to improve it.
Foreign research at $90,000 would be $90,000 × (6/180) = $3,000 in year 1, then $6,000 per year — a materially worse recovery profile that has pushed some teams to keep research domestic where feasible.
Interaction with other capitalization: If you also capitalize inventory under §263A or depreciable property, Section 174 applies first to the research portion. Track it separately or you will double-capitalize or miss the required amortization schedule.
Section 174 vs. Section 41 — Two Rules, Two Purposes
Confusing the two is the most expensive mistake in this area.
- Section 174 — Deduction timing for all research or experimental expenditures fitting the experimental-or-laboratory definition. Mandatory capitalization since 2022. No credit, just when you recover the cost.
- Section 41 — Research credit (R&D credit) for qualified research — a narrower subset that must meet four tests (permitted purpose, technological in nature, elimination of uncertainty, process of experimentation) and be tied to qualified research expenses (QREs: in-house wages for qualified services, supplies consumed in research, and 65% of contract research). The credit is elective and claimed on Form 6765; many small businesses qualify for payroll-offset or ASC 730 nuances.
In plain terms: far more costs are Section 174 than are Section 41 QREs. Software wages that must be capitalized over five years under Section 174 may or may not count toward the credit. Budget for both — capitalize broadly for 174, and document narrowly for 41. Amending to claim a missed Section 41 credit is common; missing a required Section 174 capitalization draws an adjustment.
Why Software Is Caught — And What to Tag in the Ledger
IRS interim guidance (Notice 2023-63 and subsequent notices) confirms that software development costs — whether for sale, lease, or internal use — are specified research or experimental expenditures under Section 174 when they represent costs to develop or improve software and meet the research definition. That includes agile sprints that solve technical uncertainty, not just waterfall R&D.
Tag these as Section 174 in the chart of accounts or project codes:
- Engineer, designer, and product-manager time spent on development/improvement (including the research portion of founder time — track hours)
- Contractors who write, test, or architect product code
- Directly allocable cloud, DevOps, and tooling costs for the research environment where required
- Prototype materials and testing costs for physical products
Do not commingle Section 174 research costs with routine maintenance, bug-fix-only sprints with no uncertainty, customer support, data-entry operations, hosting for delivered product, or sales/marketing. The auditor's first request is a project listing that ties labor and contractor invoices to activities — if everything is in Engineering, the answer is "all of it is 174" by default.
OBBBA's Retroactive Fix — What "Back to Expensing" Would Actually Require
OBBBA — shorthand for the One Big Beautiful Bill Act tax package debated through 2025–2026 — proposes to restore immediate expensing under Section 174 for domestic research or experimental expenditures, retroactively to amounts paid or incurred in taxable years beginning after December 31, 2021. If enacted as drafted in its Section 174 provisions:
- Domestic Section 174 costs would be deductible in the year paid or incurred again, rather than amortized over five years.
- Foreign research would remain on the 15-year schedule in most drafts — domestic relief only.
- Taxpayers who already capitalized and amortized for 2022, 2023, 2024, and 2025 would need to recover the remaining unamortized basis. The mechanism under discussion includes amended returns for open years and/or an accounting method change (Form 3115, automatic consent where provided) with a Section 481(a) adjustment to catch up the unamortized balance in the year of change. IRS procedural guidance would be needed to specify which path — or combination — is permitted and whether a single 481(a) catch-up can sweep all remaining basis.
What that means for books in 2026 before enactment:
- Do not stop capitalizing on the expectation that OBBBA passes. File correctly under current law — capitalize and amortize. If you stop and the bill fails, you have under-capitalized and owe interest.
- Do build the schedule now so a retroactive fix is a filing exercise, not a forensic reconstruction. You will need, by year: domestic vs. foreign split, midpoint amortization already taken, and unamortized balance. Without it, the amended-return or Form 3115 package stalls.
- Model the cash. For a shop that amortized $540,000 over 2022–2025 and has $380,000 of unamortized domestic basis on January 1, 2026, a full 481(a) catch-up in 2026 would be a $380,000 additional deduction in 2026 (plus current-year expensing for 2026 costs) — often a five- or six-figure refund on 2022–2025 when carried back through amended returns. The spread between "we kept project-level 174 records" and "we didn't" is the spread between filing in weeks and filing in quarters.
State conformity warning: Even if OBBBA restores federal expensing, many states decouple from Section 174 or conform as of a fixed date. Some states already decoupled and require addback of the federal amortization or disallow immediate expensing. A federal refund does not imply a state refund — check each filing state's conformity date and its 174/41 addback schedule.
A Month-End Close That Handles Section 174 Correctly
At project setup: Create a Section 174 project code hierarchy — product × project × activity — distinct from the Section 41 QRE tracker. Every engineer timesheet and contractor invoice must hit one or the other (or neither) at entry, not at year-end by recollection.
Monthly:
- Post wages, contractor costs, and allocable overhead to the Section 174 project codes. Reconcile contractor 1099-NEC totals to the research project register — gaps are usually contractors whose work was not coded.
- Roll the Section 174 amortization schedule: beginning unamortized + current-year additions − current-period amortization = ending unamortized, split domestic/foreign. Reconcile the schedule to the GL capitalized-asset account — the tax amortization and the book expense (if books expense research under ASC 730) will differ, and that difference is a deferred-tax item.
- For book purposes, most small businesses expense R&D as incurred (ASC 730) while capitalizing for tax — track the book-tax difference explicitly. At year-end, this is an M-1/M-3 adjustment and — where material — a deferred-tax asset.
Quarterly: Pay estimates on actual taxable income after Section 174 capitalization, not on book income. True-up the schedule before each 1040-ES — the 6/60 first-year fraction is the reason Q1 estimates based on book profit are wrong in a research-heavy year.
Year-end: Lock the Section 174 addition total by year, the domestic/foreign split, the midpoint amortization, and the carryforward schedule. Produce the statements your preparer will ask for: a one-page Section 174 summary (additions, amortization, ending unamortized) and a Section 41 QRE summary (qualified wages, supplies, contract research) — two schedules, two purposes, one data source.
The Bookkeeping Connection
Section 174 rewards the habit that makes plain-text accounting powerful: every research hour, contractor invoice, and tooling charge is a dated, project-coded event — not a year-end allocation from a single engineering bucket. When Section 174 costs, Section 41 QREs, and the amortization schedule live in the same version-controlled ledger, the story from "$280,000 of engineering in 2025" to "$28,000 deductible, $252,000 capitalized, $224,000 unamortized domestic" is traceable and explainable to a preparer who must file under current law and — if OBBBA passes — unwind three prior years from your records, not your memory.
Simplify Your Financial Management
Mandatory R&D capitalization is a timing problem and a tracking problem before it is a tax-return problem. Beancount.io gives you plain-text, version-controlled accounting where research projects, Section 174 schedules domestic and foreign, Section 41 QREs, and book-tax differences stay explicitly linked — no hidden spreadsheets, no vendor lock-in, and AI-ready when you want help turning last sprint's timesheets into next quarter's estimate. Get started for free and keep the research that builds the product from breaking the tax return.