In 2022, a five-person software startup with $1.2 million in engineering payroll and zero profit suddenly owed federal income tax on $960,000 of "phantom income." Nothing about its bank account had changed. What changed was that a long-delayed provision of the Tax Cuts and Jobs Act finally took effect, forcing every business in the country to capitalize and amortize its research and experimental expenditures instead of deducting them in the year incurred. Founders who had never paid attention to a tax code section number suddenly knew Section 174 by heart, and most of them hated it.
Four years and one piece of legislation later, the worst of that trap is gone — but only for domestic spending, only if you know how to claim it, and only on a deadline. The new Section 174A, enacted by the One Big Beautiful Bill Act (OBBBA), permanently restores immediate expensing for domestic research costs for tax years beginning after December 31, 2024. It also opens a one-time retroactive election for small businesses to amend their 2022, 2023, and 2024 returns and claim back the cash they overpaid — but only until July 6, 2026.
If you run a startup, a software company, or any business with engineers on payroll, the next few months are the most consequential R&D tax window of the decade. Here is what changed, what stayed the same, and what to do about it before the door closes.
A Short History of Section 174: From Friend to Foe and Back Again
For nearly seven decades, Section 174 of the Internal Revenue Code was one of the most founder-friendly provisions in the tax law. Enacted in 1954, it let businesses deduct research and experimental (R&E) expenditures in the year they were paid or incurred. If you spent $500,000 on engineers building a new product, your taxable income dropped by $500,000 that year. Cash out, deduction in, simple.
The TCJA changed that in 2017, but with a five-year delay. Beginning with tax years starting after December 31, 2021, the deduction disappeared. Taxpayers were required to capitalize R&E costs and amortize them — over five years for domestic research and fifteen years for foreign research, both using a midyear convention that meant only a half-year of amortization in year one.
The math was brutal. A company that spent $1 million on domestic engineering wages in 2022 could only deduct $100,000 that year (one-tenth, thanks to the half-year convention). The other $900,000 sat on the balance sheet as a deferred tax asset, dripping into income over the next five years. For unprofitable startups burning venture capital, the change created tax bills they had never modeled. For companies with offshore development teams, the fifteen-year period was even more punishing.
Then came OBBBA in 2025. Lawmakers added a brand-new Code section — Section 174A — that permanently restores full expensing for domestic R&E costs incurred in tax years beginning after December 31, 2024. They left the original Section 174 in place for foreign research, which still amortizes over fifteen years. And they added transition rules and a retroactive election for small businesses to recover the cash they had locked up since 2022.
What Counts as a Research or Experimental Expenditure
Before you celebrate or panic, you need to know what falls inside the Section 174 fence. The definition is broader than most founders assume, and a single misclassification can swing tens of thousands of dollars in deductions.
R&E expenditures generally include costs incurred in connection with the taxpayer's trade or business that represent research and development costs in the experimental or laboratory sense. That covers activities undertaken to discover information that would eliminate uncertainty about the development or improvement of a product. Two categories deserve special attention because they snare the most companies:
- Software development. The code explicitly treats any amount paid or incurred in connection with the development of software as an R&E expenditure. That includes wages of engineers writing new code, contractor payments for custom development, cloud compute costs allocated to development environments, and a share of payroll taxes and benefits. It does not include software that is purchased off the shelf, routine bug fixes after a product is released, data conversion, training, or maintenance.
- Wages of supporting employees. R&E is not just engineers. Product managers writing specifications, designers prototyping user interfaces, QA testers running pre-release scripts, and first-line engineering managers all generate Section 174 costs if their work is directly tied to qualified development activity.
What is not an R&E expenditure: land acquisition, exploration for ore or minerals, market research, advertising, quality control testing of finished products, and routine data collection. Misclassifying any of these as R&E can artificially inflate your capitalized amounts and create messy adjustments later.
The 2026 Landscape: Three Regimes Operating in Parallel
Here is the part that confuses every controller and outside accountant. As of 2026, three Section 174 regimes are running simultaneously:
Regime 1: Domestic R&E in 2025 and Later (Section 174A)
For tax years beginning after December 31, 2024, domestic R&E expenditures are fully deductible in the year paid or incurred. This is the new normal, and it applies automatically — no election required.
You also have the option to elect to capitalize and amortize domestic costs over a period of not less than 60 months, beginning with the month you first realize benefits from the expenditures. Most companies will skip this and take the immediate deduction. The amortization election exists mainly for entities that want to push deductions forward into more profitable years.
Regime 2: Foreign R&E (Original Section 174, Unchanged)
Foreign research is still subject to mandatory capitalization and 15-year amortization with a half-year convention. There is no election, no shortcut, and no immediate deduction. If your engineering team includes contractors in Buenos Aires, Krakow, Bangalore, or Manila, the wages and contractor payments tied to their work continue to be capitalized for fifteen years.
This bifurcation creates a real planning question for companies that have flexibility over where work is performed. Bringing a software engineering function onshore is now meaningfully more tax-efficient than keeping it offshore, and that delta can drive decisions about where to grow headcount.
Regime 3: Unamortized 2022–2024 Costs
Costs you capitalized in 2022, 2023, and 2024 still have unamortized balances sitting on your books. OBBBA gives you three choices for how to handle them:
- Continue amortizing the remaining balances over the original five-year (domestic) or fifteen-year (foreign) periods. This is the default if you do nothing.
- Deduct the entire unamortized balance in your first tax year beginning after December 31, 2024 (typically 2025). This is the most cash-positive option for most companies.
- Deduct the unamortized balance ratably over your 2025 and 2026 tax years. This option helps companies that expect 2026 to be more profitable than 2025 and want to spread the benefit.
You make this election on the tax return for your first taxable year beginning after December 31, 2024. Once chosen, the method applies to all of your remaining unamortized 2022–2024 R&E.
The Small Business Retroactive Election: Why the July 6, 2026 Deadline Matters
If your business qualifies as a small business taxpayer, OBBBA gives you something more valuable than the prospective fix: a chance to go back and amend your 2022, 2023, and 2024 returns and apply Section 174A retroactively. That means treating your domestic R&E in those years as if it had been immediately deductible. Cash refunds, not just deferred deductions.
Who Qualifies
To make the small business retroactivity election, you must qualify as a small business taxpayer for your first tax year beginning after December 31, 2024 (typically 2025). The test is the Section 448(c) gross receipts test: combined average annual gross receipts of the taxpayer and its aggregated group must not exceed $31 million for 2025, calculated as the three-year rolling average ending with the prior tax year.
Notice that the aggregation rules pull in commonly controlled entities, so a serial founder with three small entities under common ownership has to add them together. Tax-exempts and certain trusts also have special rules.
The Filing Mechanics
To claim the retroactive election by amending returns, eligible small businesses must file amended returns for each affected year by the earlier of:
- July 6, 2026, or
- The normal statute of limitations for refund claims (three years from the original filing date for that year).
For most calendar-year small businesses that filed their 2022 returns on extension in October 2023, the July 6, 2026 date will be the binding deadline. That is roughly eight weeks of runway for any small business reading this in mid-May 2026.
The amended returns must follow Rev. Proc. 2025-28, the IRS procedural guidance issued in August 2025. Among the practical requirements: you must consistently apply the new method across all affected years, you must true-up your Section 41 research credit calculations to reflect the changed deductions, and you must coordinate the election with any state-level conformity rules where your state has decoupled from the federal treatment.
Coordinating Section 174 With the Section 41 Research Credit
This is where many companies leave money on the table. The R&D tax credit under Section 41 and the R&E deduction under Section 174 are siblings, not strangers — and they have to be reconciled.
The Section 280C(c) Add-Back
Under Section 280C(c), if you claim the Section 41 research credit, you must either:
- Reduce your Section 174A deduction by the amount of the gross research credit, or
- Elect the reduced credit (currently 79% of the gross credit at the 21% corporate rate) and keep the full deduction.
Most C corporations elect the reduced credit because the math is simpler and the after-tax economics are usually similar. Pass-through entities and individuals taxed at higher marginal rates often benefit from running the comparison both ways.
The Foreign Research Carve-Out
Foreign research is excluded from the Section 41 research credit base entirely. Costs incurred outside the United States, Puerto Rico, or U.S. possessions do not generate a credit, even though they are capitalized under Section 174. So foreign R&E hits you twice: no immediate deduction and no credit. This is the strongest argument for keeping qualifying work onshore.
Why a Clean Mapping Matters
To claim the Section 41 credit, you need to identify Qualified Research Expenses (QREs) — wages of employees performing or supporting qualified research, supplies consumed in research, and 65% of contract research payments. Your Section 174 capitalization schedule should map directly to your QRE schedule, with only documented adjustments between them. If the two schedules look unrelated, the IRS notices, and so do most state tax authorities.
The Accounting Method Change: Statement in Lieu of Form 3115
In the original TCJA-era Section 174 rules, taxpayers had to file Form 3115, Application for Change in Accounting Method, to convert from immediate deduction to capitalization. The IRS later simplified this by allowing a statement in lieu of Form 3115 for the first year of capitalization.
For the OBBBA Section 174A change, Rev. Proc. 2025-28 again allows a statement in lieu of Form 3115 rather than a full method change application. The statement must include the taxpayer's name and identification number, the year of change, a description of the method being adopted, and the Section 481(a) adjustment if any. For most small businesses with clean books, this is a single-page attachment to the 2025 federal return.
That said, do not let the simplified filing fool you into thinking the underlying analysis is trivial. You still need:
- A documented schedule of R&E costs by year and by domestic/foreign category
- A reconciliation of book-to-tax differences between your GAAP R&D expense and your Section 174 capitalized amount
- A clear treatment of mixed-use compensation (engineers who split time between qualified development and non-qualified maintenance)
- A coordinated approach with any state filings, since not all states conform to Section 174A automatically
The Bookkeeping Reality: Why Your Chart of Accounts Decides Your Tax Bill
The reason so many founders got blindsided in 2022 was simple: their bookkeeping did not separate the data they needed. R&D wages were lumped into "Salaries and Wages." Contractor payments to engineers sat next to contractor payments to marketing freelancers. Cloud compute costs for development environments were not distinguished from production. When tax time arrived, untangling all of this took weeks of forensic work that nobody had budgeted for.
The companies that survived Section 174 best were the ones that built the right categorization into their books from day one. A practical starting structure for any business with meaningful engineering spend:
- Separate expense accounts for R&D wages, R&D contractors, and R&D cloud/tooling, broken out by domestic vs. foreign cost center
- Time-tracking discipline for engineers and engineering managers who split time between qualified development and other activities
- A monthly close process that reconciles capitalized R&E to the underlying source transactions, not to a year-end estimate
- Documentation supporting the technical qualification of each project under the Section 41 four-part test (permitted purpose, elimination of uncertainty, process of experimentation, technological in nature)
You do not need a tax engine to do this. You need a chart of accounts that asks the right questions, a bookkeeping practice that answers them every month, and audit trails that survive an IRS information document request three years after the fact.
A 2026 Checklist for Founders and Controllers
If you are reading this in May 2026, here is the practical sequence:
- Confirm your 2025 small business status under Section 448(c). If you might be under the $31 million combined gross receipts threshold, you have a retroactive election available.
- Pull your 2022, 2023, and 2024 capitalization schedules. Separate domestic from foreign. Identify how much is still unamortized.
- Run the cash math on the retroactive election. For most small businesses, the refund opportunity dwarfs the amendment cost.
- File amended 2022, 2023, and 2024 returns by July 6, 2026 if you qualify and the math works. Coordinate with your state returns.
- Choose your transition method for unamortized 2022–2024 costs on your 2025 return: continue amortizing, deduct all in 2025, or split between 2025 and 2026.
- Attach the statement in lieu of Form 3115 to your 2025 federal return adopting the Section 174A method.
- Reconcile your Section 41 research credit for 2025 and any amended years using either the gross credit with deduction add-back or the Section 280C(c) reduced credit election.
- Audit your foreign R&E classification. Wages and contractor payments tied to non-U.S. development continue to capitalize over fifteen years. Make sure you are pulling them out cleanly.
- Update your bookkeeping going forward so that domestic vs. foreign R&E, qualified vs. non-qualified, and R&D vs. other engineering work are all distinguishable in real time, not at year-end.
Keep Your Engineering Spend Tax-Ready From Day One
Section 174 turned what used to be a straightforward "expense and forget" line item into a multi-year accounting exercise with real cash consequences. The OBBBA relief is real, but it only reaches the companies whose books can actually answer the questions: how much is domestic, how much is foreign, how much qualifies, and how much was already amortized. Beancount.io provides plain-text accounting that keeps every transaction, every account split, and every cost-center tag in version-controlled files you fully own — exactly the audit-ready structure the IRS expects when it sees an R&D claim. Get started for free and turn the messy Section 174 paper trail into a clean ledger your CPA will actually thank you for.