Section 174 R&D Capitalization: Tax Reform's Impact on Startup Taxable Income and Runway

Foundational Understanding: Why Your Taxable Income Just Went Up

The core of the issue is a change from immediate expensing to mandatory long-term amortization. For US-based companies, mandatory capitalization and amortization of R&D expenses began for tax years starting in 2022. According to Section 174 of the tax code, you can no longer write off these costs as they occur. Previously, if you spent $500,000 on engineering salaries and software, you could deduct the full $500,000 from your revenue in that same year. For a pre-profit company, this typically resulted in a net operating loss (NOL), which meant no tax liability.

Under the new rules, those same costs must be capitalized as an asset and spread out over time. The amortization period for R&D costs for research conducted within the U.S. is 5 years. To complicate matters further, the law applies a half-year convention in the first year. This convention means that regardless of when you incurred the costs during the year, you can only deduct half of a single year's amortization amount. This mechanism significantly defers the tax benefit of your R&D spending.

This creates what is often called 'phantom income'. Even if your company is pre-revenue and burning cash, your tax calculations show a higher taxable income because you can no longer deduct all your R&D costs. A higher taxable income can trigger a federal tax bill, creating a direct and often unexpected drain on your cash flow.

Consider this simple comparison for a US-based startup with $500,000 in R&D spending within a single tax year:

Old Rule (Pre-2022): With a $500,000 R&D spend, you could claim a $500,000 deduction in Year 1. This would reduce your taxable income by the full amount, likely resulting in a loss for tax purposes and no federal income tax due.

New Rule (Post-2022): With the same $500,000 R&D spend, you must amortize it over five years. The first-year deduction is limited by the half-year convention, so you can only deduct $50,000 ($500,000 divided by 5 years, then multiplied by 0.5). Your taxable income is now $450,000 higher than it would have been under the old rules.

This $450,000 difference in deductible expenses answers the key question we hear from founders: "We're not profitable, so how can we owe taxes?" It is a direct result of the R&D tax changes in 2022 and underscores the need for proactive startup tax planning R&D.

The Founder's Checklist: What Actually Counts as a Section 174 Cost?

One of the first challenges in achieving Section 174 compliance is identifying which expenses fall under these rules. The scope is broader than you think, extending far beyond your core engineering team. For US research expense rules, Section 174 costs include all direct and indirect expenses related to the elimination of uncertainty concerning the development or improvement of a product.

This includes several key categories:

• Direct Labor: This is the most straightforward category. It includes gross salaries and wages for employees directly engaged in R&D activities, such as software developers, scientists, product managers, and UX researchers involved in new feature development.
• Direct Materials and Supplies: This includes the cost of tangible materials for building prototypes, lab supplies for experiments, and even cloud computing services like AWS or Google Cloud used specifically for development and testing environments.
• Contractor and Third-Party Costs: Any payments to external firms or individuals conducting R&D on your behalf are included. This covers everything from freelance software developers to specialized contract research organizations (CROs).
• Indirect Costs (Allocated Portion): You must also capitalize a reasonable portion of overhead that supports R&D. This includes salaries for support staff (like a CTO's direct reports or an R&D operations manager) and facility expenses like rent, utilities, and insurance for the office or lab space used by the R&D team.

For example, consider a preclinical Biotech startup developing a new therapeutic platform. Its Section 174 costs for capitalizing research costs would not just be the lead scientist's salary. They would also include:

• Salaries for the lab technicians running experiments.
• The cost of all reagents, cell cultures, and other consumables.
• Fees paid to a CRO for conducting specific assays or toxicology studies.
• An allocated portion of the facility's rent, calculated based on the lab's square footage relative to the total office space.

Critically, you must also differentiate where the work occurs. The amortization period for R&D costs conducted outside the U.S. is 15 years, not 5. This makes the cost of a foreign-based contractor or an offshore development team significantly less tax-efficient in the short term compared to a domestic one, a factor that now needs to be part of strategic hiring decisions.

A Pragmatic System for Tracking R&D Costs

Founders often worry they need a new, expensive enterprise system for Section 174 compliance. The reality for most startups is more pragmatic: you can build a sufficient tracking system using tools you already have, like QuickBooks and your payroll provider.

First, start with your chart of accounts. A scenario we repeatedly see is founders being unable to separate R&D from other costs at year-end, which leads to difficult and expensive cleanup work by their accountants. Instead of using a single 'Salaries' or 'Contractors' line item, create more granular sub-accounts. A well-structured chart of accounts in QuickBooks might look like this:

• 6000 R&D Expenses (Parent Account)
  • 6010 R&D Salaries - US
  • 6015 R&D Salaries - Foreign
  • 6020 R&D Contractors - US
  • 6025 R&D Contractors - Foreign
  • 6030 R&D Software & Tools (e.g., AWS, Jira, GitHub)
  • 6040 R&D Lab Supplies & Materials

Next, for indirect costs, you must create and document a reasonable allocation methodology. This does not need to be complex; it just needs to be logical and consistently applied from period to period. Your goal is documentation and consistency. You can formalize this in a simple, one-paragraph memo saved with your financial records.

For example, here is a simple methodology memo:

Our methodology for allocating indirect costs to Section 174 involves a headcount-based approach. We calculate the percentage of total employees directly involved in R&D activities each quarter. This percentage is then applied to shared costs, including rent, utilities, and administrative support salaries, to determine the portion for capitalizing research costs. This method is reviewed annually for reasonableness.

When you document this, you can refer to an internal policy for consistency. A practical template is available in the R&D Capitalization Policy Template for Startups to help formalize your approach.

Section 174 and the R&D Tax Credit: They're Related, But Different

Many founders understandably ask, "Does this change mean I lose my R&D tax credit?" The answer is no, but the relationship between the deduction rules and the credit is now more important than ever. They're related, but different. The key is understanding that Section 174 and Section 41 are distinct parts of the tax code.

• Section 174 dictates the timing of your expense deduction. It is a rule about when you can subtract R&D costs to calculate your taxable income.
• Section 41 governs the R&D Tax Credit. This is a separate, dollar-for-dollar credit that reduces your actual tax liability after it has been calculated. The R&D Tax Credit is governed by a separate regulation, Section 41.

The expenses you identify and capitalize under Section 174 are generally the same pool of costs used to calculate your credit under Section 41. Therefore, meticulous Section 174 tracking has a dual benefit. It ensures you meet the R&D amortization requirements and simultaneously creates the necessary documentation to substantiate your R&D tax credit claim. Following IRS R&D guidelines is critical. Misclassifying these costs or failing to track them properly not only creates compliance issues but also puts this valuable credit at risk during scrutiny. You cannot claim a credit for expenses you cannot properly identify and document.

Practical Takeaways: Your Stage-Specific Playbook

Your approach to how to handle R&D capitalization under section 174 should evolve as your company grows. You do not need a perfect, enterprise-grade system from day one. In practice, a staged approach works best to ensure compliance without overburdening a small team.

For Pre-Seed and Seed Stage Startups:

Keep it simple. Your immediate goal is to avoid a surprise tax liability that consumes your runway. Work with your accountant to set up a basic R&D-specific chart of accounts in QuickBooks, like the example provided earlier. Focus on rigorously tagging direct costs. This includes engineer and scientist salaries (using data from Gusto or Rippling to identify roles), contractor invoices, and major R&D-specific software subscriptions. At this stage, a simple, consistent process for direct costs is 80% of the battle.

For Series A Startups:

Refine your process. You now have more resources and a more complex organization. This is the time to formally document your allocation methodology for indirect costs like rent and support staff salaries. Begin using features like Class or Location tracking in your accounting software to separate US and foreign R&D spending. This is critical given the different amortization periods (5 vs. 15 years). Your process should be clean enough that a new finance hire could understand it within a day.

For Series B Startups and Beyond:

Systematize and review. By this stage, you likely have a controller or head of finance, even if fractional. Your tracking system should be robust and subject to regular review as part of your quarterly financial close. The R&D cost analysis becomes a standard report, not a year-end scramble. The documentation you produce is not just for tax compliance; it becomes a key part of financial diligence for future funding rounds or an acquisition. Your systems must provide clear answers about the capitalized R&D assets on your balance sheet.

Conclusion

The shift to mandatory R&D capitalization under Section 174 represents a significant change for innovative startups, especially in the Biotech, Deeptech, and SaaS industries. It has transformed R&D spending from a simple annual deduction into a capitalized asset that must be tracked and amortized over many years. This directly impacts your taxable income and, most importantly, your company's cash runway.

This isn't just an accounting exercise; it is a core component of modern financial management for technology companies. By implementing a pragmatic tracking system using your existing tools, developing a consistent allocation methodology, and understanding the interplay with the R&D Tax Credit, you can manage your Section 174 compliance effectively. The key is to start now. Establishing a clear and simple process today will prevent significant costs and complexity as your company grows. For further resources, see the R&D Project Accounting & Capitalisation hub.

Frequently Asked Questions

Q: Can I still deduct any R&D expenses in the first year?
A: Yes, but only a small portion. Due to the five-year amortization schedule for US-based R&D and the half-year convention, you can only deduct 10% of your total qualified R&D expenditures in the first year ($100k spend / 5 years * 0.5 = $10k deduction). The remaining 90% is deducted over the next several years.

Q: What happens if I misclassify my R&D expenses?
A: Misclassifying expenses can lead to an incorrect calculation of your taxable income, potentially resulting in underpayment of taxes, penalties, and interest upon an IRS review. It also undermines the documentation needed to claim the Section 41 R&D Tax Credit, putting that valuable credit at risk during scrutiny under IRS R&D guidelines.

Q: Does the Section 174 change affect state taxes?
A: It depends on the state. Many states conform to the federal tax code, meaning this change will also impact your state tax liability. However, some states have "decoupled" from this specific provision, allowing for immediate expensing at the state level. It is crucial to check the rules for each state where you operate.

Q: Is there any chance Congress will repeal or change this law?
A: There has been bipartisan support for repealing the Section 174 capitalization requirement and returning to immediate expensing, but legislation has not yet passed. While a future change is possible, companies must comply with the current law. Founders should plan for the current rules to remain in effect for the foreseeable future.