Section 174 explained

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One topic that has recently generated significant attention among startup founders is Section 174 of the IRS tax code.

At a high level, this tax code governs the tax treatment of expenditures related to specified research, experimentation, and software development activities (also known as specified research or experimental (“SRE”) expenditures).

Historically, Section 174 provided significant flexibility in how companies defined and identified SRE expenditures, but the legislation that has recently gone into effect has removed this flexibility while also introducing new, less favorable requirements. 

Significant changes were introduced in 2017 and took effect in 2022, drastically impacting how research-related expenditures can be taxed and influencing how founders should spend capital to grow their businesses.

Before these changes went into effect, businesses had multiple options for research expenditures: they could fully deduct these expenses in the year they were incurred or capitalize and amortize them over different periods.  

Having multiple options was an incredibly convenient method for tax planning.

Now, all SRE expenditures must be capitalized and amortized, with no option to fully deduct them in the year the costs were incurred.

To get more context behind the changes and their implications for startup founders, we sat with Dave Hanson, a Partner at Aprio, a top-25 CPA firm.

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What happened in 2017?

The 2017 Tax Cuts and Jobs Act (“TCJA”) removed the ability for companies to fully deduct R&D costs in the year they occur. This provision was included in the 2017 TCJA to offset the large tax cuts that were included in the first five years of the same tax act. 

As a result, for tax years that begin after December 2021, companies must capitalize and amortize SRE expenditures over five years if the related activities take place within the U.S. or over 15 years if they occur outside the U.S.

As a point of clarification, capitalization is usually viewed in a beneficial light for U.S. financial accounting purposes because it allows companies to spread the cost of new capital assets over multiple accounting periods, allowing companies to report higher levels of profit than they would if they had to recognize the entire expenditure in the year they paid it. 

To help illustrate the concept of capitalization for financial accounting purposes, Dave provided the following example: "… if you purchase a machine that you're using in your business that has a useful life of several years, [financial accounting principles allow] you [to] spread the cost of that machine out over those years, so you don't take a big hit to your net income in the year that you purchased the machine.".

However, for U.S. tax purposes (which are governed by a different set of rules than financial accounting standards), capitalization and amortization of expenditures is generally viewed unfavorably because it spreads the related tax deduction over multiple periods often resulting in higher taxable income, increased tax payments, and worse cashflow in the earlier years of the amortization period. 

Now that the new 174 law requires businesses to capitalize and amortize research expenditures, many are seeing significantly higher tax payments as a result.

This shift has been a major sore spot for companies, especially startups heavily invested in R&D.

What types of Section 174 expenses qualify for the R&D credit?

It should be noted that SRE expenditures under Section 174 are not the same as qualified research expenditures (“QRE”) that are eligible for the R&D Tax Credit under Section 41 of the tax code. 

Only a handful of eligible cost types qualify for the R&D tax credit. Generally speaking, credit-eligible costs include certain types of the following:

First, internal and external labor costs if the labor occurs in the U.S. "It would be W2 payments or a portion of the W2 payments that you would pay software developers or anybody in your business who is working on creating something new or improving upon an existing product or process," said Dave.

Supplies, like materials and prototype costs used and consumed during the development process, are also eligible, as well as applicable costs for computer rentals and pre-production cloud hosting fees used in the development process.

In addition to the credit-eligible costs listed above, costs required for capitalization under Section 174 also encompass costs related to foreign development activities as well as all costs "incident" to R&D, which is broadly defined as any effort to develop or improve products, processes, algorithms, and patents, including all software development costs (new development, upgrades, and enhancements). 

How have founders reacted to Section 174?

While founders knew that Section 174 was coming down the pike, many were still surprised when the changes took effect.

"In Congress, publicly, both sides of the aisle were saying, 'Hey, this has to get fixed. This was only included in the tax bill to help show that the budget would be balanced over the 10-year scoring process that Congress has to do every time they create tax law," said Dave.

But that fix never happened, and many founders were left scrambling to figure out how to adjust to this new reality.

"For a lot of our founder clients…it felt like they were hearing it for the first time. First and foremost, I think a lot of them couldn't believe that this was actually a real tax law," said Dave. He echoed the common question: why would the government want to disincentivize companies from doing R&D?

As a result of this new law, a startup founder could find themselves in a profitable, taxable position when they expected to be, or previously were, in losses.

"If they had $100,000 in revenue but $400,000 of software development costs… on paper and in reality, they had a loss of $300,000," said Dave. "But since they can't fully deduct that entire amount of $400,000 software development costs under this new law, all of a sudden it looks like they've got all this taxable income."

The current state of Section 174

In January of 2024, a bipartisan bill was drafted and passed in the House of Representatives to address much of the blowback from Section 174.

This bill remained stuck in the Senate until August 1, when it was ultimately voted down.

"It's an election year, and what we've heard is that neither side wants to give the other a win before the election. So, this could theoretically be unresolved, maybe going into 2025," said Dave.

How to navigate Section 174 as a founder

While Section 174 may be a friction point for many startup founders, especially those with high R&D costs, Dave suggests there are a few ways businesses might reduce the impact.

Structuring future contracts to avoid unnecessary inclusion under Section 174

If you're hiring contractors to help develop an application or platform, specific stipulations in the contract could preclude those costs from being included. 

For example, only the costs related to projects for which a founder has economic risk OR owns the intellectual property rights require capitalization. However, as Dave highlights, it is highly unlikely a founder would willingly forfeit intellectual property rights for a tax break related to a timing difference. To illustrate, Dave elaborates that “if it's a fixed-fee contract where the third-party contractor has to deliver this app that works for you, and… they keep the IP, they have the financial risk. It's not your 174 cost."

Categorizing costs into R&D and non-R&D buckets

Another tactic is to review your previous expenses and properly categorize them into different buckets to ensure you aren't overcapitalizing.

"You've got a bucket that is pure R&D; it's pure software development. If it aligns with all of the 174 requirements, obviously, you have to capitalize that," said Dave.

"And then on the other side of the spectrum, if you have activities and costs that align with the statutory exclusions...things like maintenance activities that don't give rise to enhancements…aligning those costs and keeping them there" is a strategy that could help minimize the impact, he explains.

It should also be noted that there are aspects of Section 174 that many consider unsettled – such as “incidental” R&D costs mentioned above. Recent IRS guidance provides several examples but also caveats that the guidance is not an exhaustive list. For these “gray area” types of costs and activities, it is recommended that founders consult with an expert who can help optimize their cashflow position while helping them stay in compliance with the new law. 

Claiming an R&D credit for the eligible portion of Section 174 costs 

If you are having to capitalize R&D costs as part of the new 174 requirements, make sure that you are also claiming an R&D credit for the credit-eligible portion of those costs. Federal and State R&D credits can be used to offset income tax and, in many cases, payroll taxes. 

Aprio is here to help

It’s fair to say that, unless Congress takes action on Section 174, the state of R&D tax deductions creates quite a few challenges for founders. 

Understanding and adjusting to these changes can make a big difference as founders try to mitigate their impacts. Making informed decisions and strategic planning play a big part in how well founders adjust. 

“There are lots of things to consider. At the end of the day, we'd recommend at least talking to a professional,” said Dave.

Aprio is a CPA-led business advisory firm with offices all over the U.S. that can help founders with any Section 174 or R&D tax credit questions. With a tailored approach to each of their clients, Aprio works to understand which approach to tax planning and prep would work the best and most efficiently for you.

Book a consultation with Dave to discuss R&D Tax Credits and Section 174 here.

Learn more about Aprio here. 

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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

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