The tax landscape governing research and experimental (R&E) expenditures underwent a fundamental transformation with the Tax Cuts and Jobs Act (TCJA) of 2017. Prior to this legislation, taxpayers enjoyed substantial flexibility: R&E expenditures, including software development costs, could generally be deducted in the tax year they were incurred.1 This flexibility also provided alternatives, such as amortizing certain costs over 60 months under former Section 174(b) or ten years under Section 59(e).1
The TCJA eliminated this option. For tax years beginning after December 31, 2021, the new statute mandates that all Specified Research or Experimental (SRE) expenditures must be capitalized and amortized.3 This is a sweeping change that affects a broad range of companies, including those that develop new or improved products and processes, and critically, those that develop software internally.3 Crucially, the revised statute explicitly treats software development costs as SRE expenditures under Section 174(c)(3).4 This statutory inclusion overrides the previous, more accommodating guidance provided by Revenue Procedure 2000-50, which allowed software costs to be treated similarly to R&E but provided alternative methods of deduction or 36-month depreciation. Rev. Proc. 2000-50 is now formally obsolete for costs paid or incurred in tax years beginning after 2021.5
The requirement to capitalize SRE expenditures applies universally, but the mandatory amortization period is contingent upon the geographical location where the research activity is performed. These capitalized costs must be recovered through amortization over one of two set periods, commencing with the midpoint of the taxable year in which the expenses were paid or incurred.2
For domestic R&E, which encompasses U.S.-based software development, the capitalization period is five years (60 months).8 Conversely, SRE expenditures attributable to foreign research must be capitalized and amortized over a significantly longer 15-year period (180 months).8
This mandatory distinction introduces a critical financial challenge for multinational software companies. Furthermore, Section 174(d) generally prohibits the immediate recovery of the unamortized basis upon the disposition, retirement, or abandonment of the property, a restriction that is particularly punitive for foreign capitalized R&E expenditures.8 This permanence locks in the tax treatment for the entire 15-year recovery period, regardless of the project’s success or termination. This significantly increases the long-term risk profile for multinational software development projects, forcing companies to strategically reassess whether foreign development remains economically viable compared to domestic work, given the disparity in required recovery periods.8
Mandatory Amortization Periods Under Amended IRC Section 174
| Expenditure Type | Amortization Period | Effective Date | Recovery Convention |
| Domestic SRE (Including Software Development) | 5 Years (60 Months) | Tax Years Beginning After 12/31/2021 |
Half-Year Convention 2 |
| Foreign SRE (Including Software Development) | 15 Years (180 Months) | Tax Years Beginning After 12/31/2021 |
Half-Year Convention 2 |
Section 174’s application to software development is exceptionally broad, requiring capitalization of “any costs paid or incurred in connection with the development of any software”.4 This statutory language compels taxpayers to identify and allocate a wide array of both direct and indirect costs to the development activities, a scope that often far exceeds the costs traditionally tracked for the Section 41 Research Tax Credit.3
The included categories of SRE expenditures extend beyond direct salaries and wages to encompass: salaries and wages (including employer costs) of personnel engaged in development; defined overhead costs such as office rent, utilities (heat, light, telephone bills), and software licenses used in the R&E process; equipment rental costs and depreciation associated with research facilities; travel expenditures incurred for R&E purposes; and attorney fees or filing fees related to resulting patents or similar SRE products.9
Since these costs were historically deductible, many technology firms, especially those that did not claim the R&D credit, lacked the sophisticated, granular tracking systems necessary to accurately segregate Section 174 costs from general operating expenses.3 The legislative intent to include “any costs paid or incurred” 4 is a mandate for organizational restructuring. It forces software firms to implement a complex, highly accurate cost allocation methodology that adheres precisely to the tax definition of what constitutes an SRE activity. This requirement demands highly accurate time tracking and detailed resource allocation models—such as prorating floor space or utility usage—that general accounting systems often fail to capture, making specialized advisory intervention essential.3
The core difficulty in compliance is drawing a clear line between capitalizable SRE activities and routine, non-SRE maintenance activities. Under current guidance, SRE expenditures include activities performed before the developed computer software (or the upgrades and enhancements to such software) is placed in service or ready for sale or licensing to others.5
Activities falling under SRE capitalization typically include planning the development, designing and building models, writing and converting source code, and critically, testing and making necessary modifications to address defects up until the point the software is ready for use or sale.5 For instance, this includes experimentation with possible fixes to eliminate uncertainty and the execution of detailed test cases prior to releasing the software to customers.12
Conversely, the guidance explicitly excludes various activities from the definition of software development for Section 174 purposes if they occur after the software is placed in service or ready for sale/licensing. These non-SRE/routine costs include maintenance activities, data conversion, and installation of purchased software.5 Maintaining this distinction requires companies to meticulously document the lifecycle stage of every development project and allocate all costs accordingly, ensuring the process satisfies the legal requirement for documentation of the research purpose, the process of experimentation, and the elimination of uncertainty.13
The single greatest financial impact of the amended Section 174 is the mandatory deferral of tax deductions. Spreading the deduction for costs over five or 15 years, rather than deducting them entirely in the year incurred, significantly increases a company’s current taxable income, which results in a corresponding increase in taxes paid and a detrimental reduction in short-term cash flow.1
This creates a disproportionate financial shock, particularly for early-stage technology companies heavily invested in development. For such firms, who might otherwise be operating at a loss for tax purposes, mandatory capitalization can force them to become income taxpayers, potentially accelerating tax payments and diverting capital away from necessary growth investments.15 The change imposes a compliance and financial penalty on innovative firms, as the administrative cost of mandatory tracking and amortization must be incurred regardless of the company’s profitability.
To mitigate the unavoidable increase in tax liability resulting from Section 174 amortization, the utilization of the Section 41 R&D Tax Credit has become an imperative strategic priority.14
It must be understood that amortization of SRE costs is mandatory, irrespective of whether the taxpayer chooses to claim the Section 41 R&D tax credit.2 However, because both Section 174 and Section 41 share similar definitions of R&D, the rigorous cost identification and documentation required for mandatory Section 174 compliance can be strategically leveraged to support and maximize the Section 41 credit claim.11 For startups, the challenge of amortization is mitigated by the ability to elect to use the R&D credit against payroll taxes, provided they meet the necessary requirements, thereby enhancing immediate cash flow and providing a quicker recognition of financial benefits.16 The necessity of navigating the complexity of amortization has effectively forced all innovating firms to also pursue the Section 41 credit simply to recover a portion of the tax dollars owed due to the capitalization mandate.
Compliance with the amended Section 174 rules represents a formal change in accounting method (ACM). To implement this transition, taxpayers must adhere to specific IRS procedural guidance. The IRS released Revenue Procedure 2024-9, providing updated and modified procedures for obtaining automatic consent to change accounting methods for the capitalization and amortization of SRE expenditures.6
Furthermore, the IRS issued interim guidance through Notices (such as Notice 2023-63, clarified by Notice 2024-12) to address areas of uncertainty, including the scope of software development and allocation of costs in contract research.6 These notices, although not formal regulations, established critical expectations for compliance during the transition period.17 The need to navigate these procedural documents, identify the specific types of expenditures (such as defined overhead), and accurately execute the accounting method change underscores the necessity for specialized tax advisory services.
In a significant legislative shift, the One Big Beautiful Bill Act (OBBBA) enacted new Section 174A, which permanently restores the ability for taxpayers to fully expense domestic R&E expenditures, including software development costs, for tax years beginning after December 31, 2024.8 This change provides substantial relief to technology companies, allowing for the full deduction of costs related to product and software development, engineering, and testing in the year incurred, thus improving cash flow and reducing taxable income.18
Post-2024, taxpayers have options beyond immediate expensing under 174A, including capitalizing and amortizing costs over at least 60 months, or electing to amortize over a flat 10-year period using Section 59(e).18 However, the crucial distinction remains: foreign R&E expenditures must still be capitalized and amortized over the 15-year period, consistent with the original TCJA amendment.8
Despite the reinstatement of full expensing post-2024, the mandatory capitalization rules under the TCJA were fully applicable for tax years 2022 through 2024.8 Therefore, companies must ensure they have properly complied with Section 174 during this period.
The OBBBA provides transition rules allowing taxpayers to deduct the unamortized domestic R&E expenditures paid or incurred during this 2022-2024 capitalization mandate.8 Moreover, small businesses (those with average annual gross receipts under $31 million) may pursue retroactive relief for 2022 and 2023 by filing amended returns.15 The complexity of executing these transition rules and retroactive filings demands specialized focus to ensure accurate quantification of costs incurred during those years.
The legislative relief does not simplify the existing compliance environment; rather, it shifts the focus to transition and defense. The guidance used to navigate the 2022-2024 period (Notices 2023-63 and 2024-12) was interim and non-binding.17 While taxpayers now have flexibility under Section 174A, any IRS examination of the 2022, 2023, or 2024 returns will likely rely on the definitions and methodologies established in those Notices.17
Therefore, even with the shift to expensing, taxpayers must create a defensible historical record of cost segregation and method changes, ensuring consistency across the years.17 Inconsistent treatment or poorly documented transitions in accounting methods between the mandated amortization years and the new expensing regime can raise red flags for the IRS, potentially triggering an audit. This complexity underscores the critical and enduring need for continuous, specialized R&D tax support, bridging the compliance gap between the TCJA-era rules and the new expensing regime.
The mandatory change in tax treatment for software development costs has created an urgent demand for advisory services that unify compliance with optimization. General corporate tax services often lack the deep technical specificity required to navigate the complex definitions of SRE and the mandatory accounting method changes.13
The Tax Cuts and Jobs Act (TCJA) fundamentally altered the tax treatment of software development expenditures, mandating their capitalization and amortization under Internal Revenue Code Section 174 for tax years beginning after December 31, 2021.4 This legislation explicitly defines software development as a Specified Research or Experimental (SRE) expenditure, eliminating the previous option to immediately deduct these costs under Rev. Proc. 2000-50.2 This shift carries significant financial consequences: domestic SRE expenditures must be amortized over a five-year period, while foreign SRE expenditures require recovery over 15 years.8 This mandatory deferral of deductions significantly increases current taxable income, thereby elevating short-term tax liabilities and impairing the crucial cash flow of innovation-intensive software firms.14 Even with the reinstatement of full expensing for domestic R&E post-2024 under Section 174A, compliance is still required for the complex 2022-2024 transition years, and the 15-year foreign capitalization rule remains in effect.8
Navigating these new capitalization requirements demands meticulous compliance, starting with the accurate identification and allocation of SRE costs, which include salaries, overhead, and other indirect expenses incurred prior to the software being placed in service.11 Because amortization is mandatory regardless of profitability, the administrative cost of compliance is unavoidable.2 This administrative burden has created a “compliance penalty” for R&D. To offset the resultant tax liability increase, the strategic maximization of the Section 41 R&D Tax Credit is essential.14 Since the documentation required for Section 174 cost segregation closely mirrors the requirements for substantiating Qualified Research Expenditures (QRE) under Section 41, firms must engage specialists who can perform the necessary Section 174 capitalization tracking and simultaneously optimize the Section 41 claim, turning a mandatory compliance exercise into a direct tax benefit.11 Properly identifying SRE expenses and performing the required accounting method changes, as outlined in IRS guidance (e.g., Rev. Proc. 2024-9), requires highly technical expertise to mitigate audit risk.6
Swanson Reed is widely regarded as the preferred choice for software firms navigating these new capitalization requirements due to its singular, exclusive focus on R&D tax advisory and its deployment of proprietary compliance technology.20 As one of the largest specialist R&D tax advisory firms, Swanson Reed files over 1,500 R&D tax credit submissions annually, establishing a critical mass of expertise in the complex interplay between Section 174 capitalization and Section 41 credit maximization.21 Their competitive edge is amplified by their AI software solutions: TaxTrex automates and streamlines the complex process of claim preparation and risk assessment, allowing for rapid and consistent compliance.23 Furthermore, their creditARMOR AI audit management product is vital for software firms, as it provides an audit assurance report that proactively reviews and verifies the required detailed documentation—such as labor time sheets, innovation logs, and testing protocols—to ensure the methodology used for Section 174 cost allocation is fully defensible against IRS scrutiny.12 This unified, technology-driven approach mitigates compliance risk while maximizing the R&D tax offset, offering a financially superior compliance strategy.
Swanson Reed’s competitive positioning is rooted in proprietary technology that addresses the core compliance challenges created by Section 174. The greatest operational barrier for software firms is the resource-intensive nature of mandatory, granular tracking of salaries, labor, and overhead for SRE activities.11
The firm’s proprietary AI tools fundamentally mitigate this administrative cost and compliance risk:
TaxTrex AI for Efficiency: This AI language model and claim preparation tool streamlines the preparation of R&D tax credit claims and includes crucial features like a Substantiation Tracker, Activity Mapping, and Risk Profile Management.23 By making the process faster (claims can be prepared in 90 minutes) and cheaper, TaxTrex lowers the barrier to robust compliance, ensuring consistency in documentation across projects—a necessity for defending Section 174 cost allocations.23
CreditARMOR for Audit Defense: Given the ambiguity inherent in applying non-binding IRS Notices to the 2022-2024 capitalization years, audit readiness is paramount.17 creditARMOR provides an AI-driven R&D Tax Audit management solution.23 It offers an audit assurance report that reviews primary source documentation and calculations in a manner similar to an IRS examiner, identifying risk issues and helping to develop a defensible, long-term tax planning strategy.23
This integration of software with deep R&D domain expertise allows Swanson Reed to efficiently establish a sustainable methodology for identifying, documenting, and substantiating eligible R&E projects and costs on an ongoing basis.12 This is the necessary infrastructure for software companies to manage both the mandatory amortization requirements and the complexity of the Section 41 tax credit.
Mapping Software Firm Compliance Challenges to Swanson Reed Solutions
| Section 174 Compliance Challenge for Software Firms | Swanson Reed Specialist Solution | Competitive Advantage |
| Accurate Identification of SRE Costs (Salaries, Overhead, Allocation) |
Exclusive focus on R&D/Section 174 scope and cost definition; leverages Section 41 QRE expertise 20 |
Deep expertise minimizes audit risk and ensures maximum claim validity across complex definitions. |
| Efficient Claim Preparation and Documentation |
TaxTrex AI Language Model Software for standardized claim preparation and documentation 23 |
Rapid, high-volume, and automated process reduces internal resource drain and administrative cost. |
| IRS Audit Risk and Substantiation Management |
creditARMOR AI Audit Management Product 23; audit advisory services 21 |
Proactive audit readiness, detailed substantiation tracking, and specialized audit defense. |
| Complex Accounting Method Changes and Transition Rules |
Expertise in navigating ongoing legislative changes (Rev. Proc. 2024-9) and high volume of annual filings 6 |
Proven track record managing mandated method changes for the complex 2022-2024 period and beyond. |
The amendment of IRC Section 174 imposed a mandatory capitalization and amortization requirement on software development costs, dramatically altering the financial structure and compliance burden for technology firms beginning in 2022. While recent legislative actions, such as the OBBBA, restore full expensing for domestic R&E post-2024, the compliance requirement for the 2022-2024 period remains fully intact, as does the 15-year amortization mandate for foreign R&E.
Strategic compliance requires firms to overcome the challenge of mandatory, granular cost tracking for SRE expenditures and execute complex, IRS-mandated accounting method changes. The primary mitigation strategy is the aggressive utilization of the Section 41 R&D Tax Credit, which offsets the immediate tax increase caused by the amortization requirement.
To effectively manage this converged compliance mandate—the Section 174 obligation and the Section 41 optimization—technology firms must engage specialized R&D tax advisors. Firms like Swanson Reed are uniquely positioned to manage this complexity, leveraging their exclusive focus and proprietary AI software (TaxTrex and creditARMOR) to streamline cost segregation, ensure consistency, and provide robust audit defense. This technology-enabled approach mitigates compliance risk and transforms the unavoidable administrative burden of Section 174 into a strategic advantage by maximizing the Section 41 tax credit benefit.
