Section 174 R&D capitalisation for small software companies

This is the most consequential tax rule for software businesses that most founders have never heard of, and the part of it that still bites is the part about geography.

What happened

Research and experimental expenditure — which for software includes a great deal of ordinary development work — was for several years required to be capitalised and amortised rather than deducted when incurred. The effect on a bootstrapped company was severe: real cash spent on salaries, only a fraction deductible, and a tax bill on profit that did not exist in the bank.

P.L. 119-21 added Section 174A, which reinstates current deduction of domestic research and experimental expenditure for tax years beginning after 2024.

Domestic and foreign are treated differently

What counts, and documenting it

The scope of what constitutes research and experimental expenditure for software is broader than most founders assume and narrower than treating every engineering cost as qualifying. The allocation between domestic and foreign is a factual question about where the work happened.

• Track development cost by location in your books from the start, not reconstructed at year end.
• Contractor location matters as much as employee location. An offshore contractor's work is foreign R&E.
• Keep something contemporaneous — timesheets, project allocations, contracts stating where work is performed.
• A hybrid team needs an allocation method you can explain and apply consistently.

The adjacent credit

Separately from the deduction question, a research credit exists and small companies can in some circumstances apply a portion of it against payroll tax rather than income tax — which matters for a company with no taxable income. It has its own eligibility rules and its own documentation burden. Worth asking your accountant about specifically, because it is frequently missed.

None of this changes the entity choice. It changes what your engineering actually costs after tax, and where.