Section 174 R&D Tracking: Avoid Phantom Taxable Income That Shrinks Your Runway

R&D Expense Tracking for US Startups: Section 174 Explained

For an early-stage SaaS, Biotech, or Deeptech startup, every dollar of R&D spending is an investment in the future. Yet, a significant tax law change now directly impacts how that investment affects your runway. Since 2022, the rules for deducting research and development costs have fundamentally shifted, creating an unexpected cash flow challenge for many pre-revenue and high-growth companies. This is not a minor compliance update; it is a strategic financial issue that can lead to surprise tax bills, even for companies operating at a net loss. Understanding how to track R&D expenses for Section 174 compliance is now a critical part of managing your startup’s financial health.

The Foundational Shift: From Immediate Expensing to Mandatory Capitalization

Prior to 2022, the accounting for R&D was straightforward. US-based startups could deduct 100% of their qualified research expenses in the same year they were incurred, which aligned with the cash-outflow reality of building a product. However, this is no longer the case. A critical change in the tax code, originating from the Tax Cuts and Jobs Act of 2017, now mandates a different approach.

Effective from the 2022 tax year, companies can no longer immediately deduct all R&D expenses. Instead, you must now capitalize these costs and amortize them, which means spreading the deduction out over several years. The specific timelines are rigid and depend on where the research activities occur.

The amortization rules are as follows:

• U.S.-Based R&D: Costs must be capitalized and amortized over a 5-year period. You can find the original legislative language in the statute text.
• International R&D: Costs for any development work performed outside the United States must be capitalized and amortized over a much longer 15-year period.
• First-Year Deduction Rule: A half-year convention applies in the first year. This means you can only deduct a fraction of a full year's worth of amortization, regardless of when the costs were incurred during the year. For U.S. R&D, this results in a deduction of only 10% of total costs in Year 1 (half of the standard 20% annual deduction).

For detailed practical guidance on applying these timelines, it is helpful to review commentary from accounting practitioners, such as this analysis from KPMG on Section 174 guidance.

Part 1: The Cash Flow Surprise of Phantom Taxable Income

This brings us to a question many founders are asking: "How can my company owe taxes if it is not profitable?" The answer lies in the gap this new rule creates between your financial statements (book income) and your tax return (taxable income). The mandatory capitalization of R&D can create "phantom taxable income," a situation where a company with a book loss still has a tax liability. The impact on your runway is direct and can be substantial.

Let’s walk through an example of a US-based deeptech startup to see how this works in practice.

Illustrative Example: Calculating Phantom Income

Imagine a startup with the following financials for the year:

• Revenue: $800,000
• Non-R&D Expenses (G&A, Sales): $500,000
• U.S.-Based R&D Expenses (salaries, cloud services, materials): $1,000,000

Book Income (For Financial Statements)

• Revenue: $800,000
• Total Expenses: $500,000 (Non-R&D) + $1,000,000 (R&D) = $1,500,000
• Net Loss: ($700,000)

On paper, the company has a $700,000 loss. Before 2022, this would also be its taxable loss, resulting in zero tax owed.

Taxable Income (Under Section 174 Rules)

This is where book accounting and tax accounting diverge. For tax purposes, you can no longer deduct the full $1,000,000 in R&D expenses in the current year.

1. Start with Revenue: $800,000
2. Subtract Non-R&D Expenses: -$500,000
3. Subtract Allowable R&D Deduction for Year 1: You can only deduct 10% of your U.S. R&D spend ($1,000,000 x 10% = $100,000) because of the 5-year amortization and half-year convention. Your allowable deduction is -$100,000.
4. Calculate Taxable Income: $800,000 - $500,000 - $100,000 = $200,000

Despite a $700,000 book loss, the company has $200,000 in positive taxable income. With the U.S. federal corporate tax rate at 21%, this results in an unexpected federal tax bill of $42,000. This is cash that must be paid, directly reducing the company’s runway and impacting operational plans.

Part 2: What Actually Counts as an R&D Cost Under Section 174?

With the financial stakes clear, the next critical step is identifying which payroll, contractor, and cloud bills must be capitalized. The definition of R&D under Section 174 is intentionally broad, covering both direct and indirect expenses associated with research and experimentation.

Direct R&D Costs

Direct costs are expenses clearly and directly tied to the development process. These typically include:

• Salaries and Wages: Compensation for engineers, data scientists, product managers, and other employees directly involved in designing, developing, and testing your product.
• Contractor Fees: Payments to outside firms or individuals contracted for specific development, engineering, or research tasks.
• Supplies and Materials: For a biotech startup, this includes lab chemicals and consumables. For a deeptech company, it could be raw materials or components for building prototypes.

Indirect R&D Costs

Indirect costs are overhead expenses that support the R&D function. It is equally important to identify and allocate these properly.

• Supervisory Salaries: A reasonable portion of the salary for a manager or executive, like a CTO or even a CEO, who oversees the R&D team and strategy.
• Facility Costs: Rent, utilities, and insurance for the office or lab space occupied by the R&D team. This is typically allocated based on headcount or square footage.
• Cloud Computing: A key distinction is required here. Costs for development and staging environments (like AWS or Azure sandboxes used for coding and testing) are R&D. However, costs for production environments that host your live application for customers are generally considered Cost of Goods Sold (COGS).
• Tooling and Software: Subscriptions for software used by the development team, such as GitHub, Jira, or other specialized design and testing tools.

What matters most to the IRS is having a reasonable and defensible methodology for allocating these indirect costs. You must be able to explain how you arrived at your allocation percentages. It is also important to distinguish Section 174 capitalization from the R&D Tax Credit. While related, they are separate parts of the tax code with different rules and purposes. Section 174 is a requirement for timing your deductions, while the R&D Tax Credit is an incentive to reduce your tax liability.

Part 3: How to Track R&D Expenses for Section 174 Compliance

For lean teams, the immediate concern is how to track this properly in QuickBooks and spreadsheets to satisfy the IRS and investors. The good news is that you do not need an expensive ERP system. A structured approach using your existing tools is perfectly sufficient. The reality for most Pre-Seed to Series B startups is more pragmatic: good documentation and a well-organized Chart of Accounts (COA) are your best defense.

1. Enhance Your Chart of Accounts

Start by adding sub-accounts to your COA in your accounting software to segregate costs by function. This allows you to tag expenses as R&D, General & Administrative (G&A), or Sales & Marketing (S&M) at the point of entry. For more detail on structuring your COA, see this department code structure example.

An example of a structured COA in QuickBooks might look like this:

• 6000 · Payroll Expenses
  • 6010 · Salaries
    • 6011 · R&D Salaries
    • 6012 · G&A Salaries
    • 6013 · S&M Salaries
• 7000 · Cloud Services
  • 7010 · Hosting
    • 7011 · R&D (Dev/Staging)
    • 7012 · COGS (Production)
• 7100 · Contractors
  • 7110 · R&D Contractors
  • 7120 · G&A Contractors

For more specific help with projects and time tracking, you can consult vendor resources like this guide from QuickBooks on tracking job expenses.

2. Document Your Allocation Methodology

For shared costs like rent or a CEO's salary, you must allocate a portion to R&D. The key is to document how and why you chose your allocation percentages in a simple internal memo. This creates a clear, auditable trail that justifies your calculations.

Here is an example of what a simple allocation memo might include:

Subject: R&D Cost Allocation Methodology - FY2023

This document outlines the methodology for allocating indirect costs to R&D for Section 174 compliance.

• Rent & Utilities: Allocated based on headcount. As of Jan 1, 2023, 10 of our 15 employees (67%) are dedicated to R&D functions. Therefore, 67% of facility costs are allocated to R&D.
• Executive Salaries (CEO): Based on a time study and calendar review, an estimated 25% of the CEO's time is spent on product strategy and R&D oversight. This portion of the salary is allocated to R&D.

This methodology will be reviewed quarterly to reflect any changes in team structure or focus.

This simple document demonstrates a thoughtful and consistent process, which is what auditors and investors want to see. Consistency is key.

Final Recommendations for Your Startup

Navigating Section 174 is no longer optional; it is a core component of sound financial management for any R&D-intensive startup in the US. The shift from immediate expensing to mandatory capitalization has profound effects on tax liability and cash runway.

To manage this effectively, focus on these four actions:

1. Forecast Your Tax Liability: Rerun your financial models immediately. Incorporate the R&D amortization rules to project your potential taxable income and cash needs. Do not let a surprise tax bill derail your plans.
2. Organize Your Accounting System: Proactively update your Chart of Accounts in a tool like QuickBooks. Segregating R&D costs from other operational expenses from the start will save significant time and effort at year-end.
3. Document Everything: Create and maintain a simple allocation memo. A clear, documented methodology for how you treat shared costs is your best defense in an audit and provides clarity for investor due diligence.
4. Distinguish US vs. Foreign R&D: If you use international contractors or have a foreign subsidiary performing research, ensure those costs are tagged separately. The 15-year amortization period for foreign R&D has a much greater impact on your near-term taxable income. For help with this, see guidance on contractor vs employee expense classification.

Ultimately, while these rules add a layer of complexity, they are manageable with a pragmatic and organized approach. Start at our expense categorization hub for more guidance, and always consult with your tax advisor to ensure your tracking methods are compliant and optimized for your company’s situation.

Frequently Asked Questions

Q: Does Section 174 amortization replace the R&D Tax Credit?
A: No, they are separate. Section 174 dictates the timing of R&D expense deductions, which is a requirement. The R&D Tax Credit is an incentive that reduces your tax liability. You must comply with Section 174 amortization rules, but you may still be eligible to claim the R&D credit on your qualified expenses.

Q: How does this affect a pre-revenue startup with no income?
A: Even if you are pre-revenue, you may have other income from grants or interest. More importantly, the amortization creates a Net Operating Loss (NOL) that is smaller than your book loss. This reduces the size of the NOL you can carry forward to offset future profits, impacting long-term tax planning.

Q: How should we handle founder salaries in R&D cost allocation?
A: Founder salaries should be allocated based on the time they spend on different business functions. A technical founder might allocate 80-90% of their time to R&D, while a CEO might allocate 25%. A time study or a reasonable, documented estimate of their activities is the best way to support this allocation.