Section 174 Changes for 2025: What Founders Must Know About Phantom Income

US R&D Credit Section 174 Changes: 2025 Impact on Startups

The rules that once allowed startups to deduct 100% of their research and development expenses in a single year are gone. For R&D-heavy SaaS, Biotech, and Deeptech companies, this is not just a minor tax update; it is a fundamental shift that directly impacts cash flow and runway. Effective since 2022, the changes to Section 174 of the tax code are now creating unexpected and significant tax liabilities for pre-revenue and unprofitable companies. As you plan for 2025, understanding these R&D expense capitalization rules is essential for accurate financial modeling and protecting your cash reserves. This is no longer a footnote for your accountant; it is a core strategic issue for founders.

The Core Change: Why Your R&D Spend Now Creates Taxable Income

Before 2022, the system was straightforward: if your startup spent $1 million on R&D, you could deduct the full $1 million from your income that year. This typically resulted in a Net Operating Loss (NOL), a valuable asset that could be carried forward to offset future profits. This simple approach supported innovation by reducing the immediate tax burden on companies investing heavily in future growth.

That has fundamentally changed. The new Section 174 amortization rules, which were part of the 2017 Tax Cuts and Jobs Act, now mandate that these same costs must be capitalized and spread out over time. According to the updated tax code, "Effective 2022, R&D costs must be amortized over five years for research conducted within the United States." For any work done abroad, the timeline is even longer, as "R&D costs for work conducted outside the US must be capitalized over 15 years." You can review the official guidance on these required accounting-method changes from major firms like KPMG: Rev. Proc. 2023-8 and Section 174.

This forced amortization creates a phenomenon known as 'phantom income.' Instead of a full, immediate deduction, your allowable write-off is severely limited in the first year. In most cases, "The first-year deduction for capitalized R&D spend is approximately 10%." This means the majority of your R&D investment no longer offsets revenue in the year it occurs, which can artificially inflate your taxable income.

Consider this simple scenario for a US-based startup with $1 million in R&D spend:

• Old Rule (Pre-2022): You could deduct the full $1,000,000 in Year 1. This would generate a $1,000,000 Net Operating Loss (NOL), resulting in zero taxable income.
• New Section 174 Rule (2022+): You can only deduct $100,000 in Year 1 (using the half-year convention). This leaves you with $900,000 in taxable 'phantom income'.

Even if your company is pre-revenue, you are now faced with $900,000 in taxable income that can rapidly erode your accumulated NOLs or trigger an actual tax payment. The impact of tax law changes on startups cannot be overstated, turning a key growth investment into a sudden tax liability.

Impact 1: The Cash-Flow Squeeze from Section 174 Amortization Rules

The abstract concept of 'phantom income' quickly becomes a real cash-flow problem. For founders managing every dollar of runway, an unexpected tax bill can be devastating. Because you can only deduct a small portion of your largest expense category (R&D), your company may show a profit for tax purposes while burning through cash in reality. This forces you to use precious capital, intended for hiring engineers or running experiments, to pay federal and state taxes.

This cash-flow squeeze is a primary challenge for startup tax compliance in 2025. Your financial models, which previously assumed R&D spend would generate tax losses, now need to account for a potential cash outlay for taxes, including quarterly estimated payments. This directly affects your runway calculations and could influence fundraising discussions with investors, who are also becoming more aware of this issue.

A scenario we repeatedly see is founders being caught off guard when their tax preparer delivers the news of a five or six-figure tax liability they never budgeted for. While some states like California have 'decoupled' from the federal Section 174 rule, allowing for full deductibility at the state level, the federal mandate is unavoidable. Planning for this cash requirement must become a standard part of your financial operations.

Impact 2: Meeting R&D Tax Documentation Requirements

To comply with the new rules, startups must first identify exactly what qualifies as a Section 174 R&D expense. The definition is broader than many founders assume and includes all costs associated with developing or improving a product or process. This covers direct costs like engineer salaries and benefits, but also indirect costs like the portion of rent for R&D office space, software licenses for developers, and all software development expenses, including related cloud hosting fees.

The reality for most Pre-seed to Series B startups is more pragmatic: you are likely using QuickBooks for your accounting, not a complex enterprise system. The key is to adapt your existing tools for better tracking without over-engineering a solution. The most practical first step is to modify your Chart of Accounts to isolate these costs systematically.

For US companies using QuickBooks, a simple and effective setup could look like this:

6000 - R&D Expenses (Sec 174)
6010 - Salaries & Wages - R&D (Sec 174)
6020 - Contractor Fees - R&D (Sec 174)
6030 - Cloud & Hosting - R&D (Sec 174)
6040 - Software & Tools - R&D (Sec 174)

By categorizing every relevant transaction into these accounts throughout the year, you create a clean record of your total Section 174 spend. This organized approach simplifies the R&D tax documentation requirements for your tax preparer and provides a clear basis for your amortization schedule. It significantly reduces the risk of costly and time-consuming year-end clean-up projects. For more on this, see our software development documentation guide.

Impact 3: How R&D Expense Capitalization Affects Your Tax Credit

The changes to Section 174 also have significant implications for the valuable R&D tax credit. It is critical to understand the difference between Section 174 costs and the expenses eligible for the credit. As noted in tax analysis, "Section 174 of the tax code governs the requirement to capitalize and amortize R&D expenses," and its definition of costs is very broad. In contrast, "Section 41 of the tax code defines the 'Qualified Research Expenses' (QREs) eligible for the R&D tax credit," which represent a narrower, more specific subset of your total R&D spend. You can find more detail in the IRS Form 6765 instructions.

Understanding the Section 41 Four-Part Test

To claim the R&D tax credit, your expenses must pass the IRS's rigorous four-part test for qualified research. This test acts as a filter, narrowing your broad Section 174 costs down to the specific activities Congress intends to incentivize.

1. Permitted Purpose: The research must aim to create a new or improved business component, such as a product, process, software, formula, or invention.
2. Technical Uncertainty: The research must intend to eliminate uncertainty concerning the capability, method, or appropriate design of that business component.
3. Process of Experimentation: The company must engage in a systematic process of evaluating one or more alternatives to eliminate that uncertainty, such as modeling, simulation, or systematic trial and error.
4. Technological in Nature: The process of experimentation must rely on principles of the physical or biological sciences, engineering, or computer science.

Here’s a practical distinction: The salary of a product manager involved in sprint planning for a new software feature is a Section 174 expense because it is an indirect cost of software development. However, that salary is likely not a Section 41 QRE because the product manager's work does not typically involve a 'process of experimentation' to resolve technical uncertainty. The work of your engineers writing and testing code to solve that uncertainty, on the other hand, would likely qualify. Meticulous tracking of your Section 174 costs provides the necessary foundation for a defensible R&D credit calculation.

Practical Next Steps: Adapting Your Process for Startup Tax Compliance in 2025

Compliance with the Section 174 R&D capitalization rules is not a one-size-fits-all process. What founders find actually works is tailoring their approach to their company’s stage and operational complexity.

For Pre-Seed and Seed Stage Startups

Your primary focus should be on foundational setup. The main job is to get your setup right in QuickBooks from day one. Use the sub-account structure detailed earlier to tag all developer salaries, contractor costs, and related cloud spend consistently. At this stage, you do not need complex project-level accounting. Your goal is to create a clean, aggregated pool of Section 174 costs that your tax advisor can easily work with. This simple discipline will save you significant time and potential errors down the line.

For Series A and Series B Startups

Your operations are more complex, and so are your documentation requirements. While you should start with a clean Chart of Accounts, you also need to build a process for project-level tracking. This is essential for defending your R&D tax credit and providing auditors with the necessary support. This tracking might still live in spreadsheets, but it should be robust. Connect engineering time from payroll or tools like Jira to specific R&D initiatives that meet the four-part test. Furthermore, if you employ international talent, remember the difference in amortization periods. A developer in Europe has their salary capitalized over 15 years, not five, which has a much smaller near-term tax benefit and requires careful segmentation in your financial records.

For Series C and Beyond

At this stage, spreadsheets may no longer be sufficient. Investors, auditors, and potential acquirers expect a higher level of financial rigor. You should consider implementing more robust cost accounting methodologies to allocate shared costs (like rent and utilities) to the R&D function. It may also be time to explore software solutions that integrate with your payroll and project management systems to automate the tracking of QREs. The goal is to produce contemporaneous, audit-ready documentation that fully supports both your Section 174 amortization schedule and your Section 41 credit claim.

Conclusion

The mandatory amortization of R&D expenses under Section 174 is a permanent shift in the financial landscape for US startups. It is a cash-flow and compliance issue that demands proactive management from founders. The first step is to acknowledge the new reality and model its impact on your cash reserves for 2025. Next, implement practical tracking systems within your existing tools, like QuickBooks, to accurately capture all relevant costs. Finally, work closely with your tax advisors to ensure your strategy is compliant and optimized. By taking these steps, you can navigate this challenge effectively. For more details on preparing claims, see the R&D tax credit process hub.

Frequently Asked Questions

Q: Can we still claim the R&D tax credit under the new Section 174 rules?
A: Yes. The R&D tax credit (under Section 41) and the requirement to capitalize R&D expenses (under Section 174) are separate parts of the tax code. You must first identify all your Section 174 costs and then determine which subset of those costs qualifies for the credit, providing the necessary foundation for the claim.

Q: Does Section 174 apply to software development costs?
A: Absolutely. The IRS considers nearly all software development costs to be R&D expenses under Section 174. This includes salaries for developers, related contractor fees, and allocated overhead. This makes the R&D expense capitalization rules especially impactful for SaaS and Deeptech companies.

Q: Is there any chance Congress will repeal these changes?
A: While there has been bipartisan support for repealing the Section 174 amortization requirement, legislative action has repeatedly stalled. As you plan for 2025, you should assume the current rules will remain in effect. Relying on potential future legislative changes is not a sound financial strategy.