Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 8 MIN READ

Section 174 is still a cash-flow tax, and Congress could not fix it in 2024

The TCJA amortization rule has survived two attempts at repeal, and software startups are paying tax on money they have not earned

The Editors
Staff, Incorporator.org
8 min read Updated
Contents 7 sections
  1. What section 174 does now, in operational terms
  2. Notice 2023-63 and the software question
  3. H.R. 7024 and the 2024 attempt
  4. The accounting mechanics taxpayers still have to execute
  5. Who is actually paying
  6. What to do in the 2024 filing cycle
  7. Sources

our years after the Tax Cuts and Jobs Act rewrote Internal Revenue Code section 174, a bipartisan bill that would have unwound the damage cleared the House 357 to 70 and then died in the Senate on a 48 to 44 cloture vote on August 1, 2024. The section 174 R&D capitalization rule remains in force for tax year 2024, and every software company in the country is still paying federal income tax on engineering salaries it has not yet deducted.

This is the story of a tax provision nobody defended on the merits and nobody managed to repeal.

What section 174 does now, in operational terms

Before 2022, a company could deduct research and experimental expenditures under IRC section 174 in the year incurred, the default treatment the Code had carried since 1954. The Tax Cuts and Jobs Act, section 13206, amended section 174 effective for amounts paid or incurred in taxable years beginning after December 31, 2021. Under the amended statute, codified at 26 U.S.C. section 174(a)(2), a taxpayer must charge specified research or experimental expenditures to a capital account and amortize them ratably over five years for domestic research or fifteen years for foreign research, beginning with the midpoint of the taxable year in which the expenditures are paid or incurred. The half-year convention in the first year means only ten percent of domestic R&D is deductible in year one.

The statute explicitly pulls software development into section 174. Section 174(c)(3), added by the 2017 Act, provides that "any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure." That sentence is the operational heart of the problem. Every engineering salary at a software company, every contractor invoice, every AWS bill allocable to product development, every share of rent and utilities allocated to an engineering floor, is now a capital expenditure for tax purposes.

The deduction does not disappear. It stretches. A $1 million domestic engineering payroll in 2024 produces a $100,000 deduction in 2024, $200,000 in 2025, 2026, 2027, and 2028, and the final $100,000 in 2029. The company paid the cash in 2024 and pays federal income tax in 2024 on the $900,000 it cannot yet deduct. For a venture-funded startup at pre-revenue or early-revenue scale, the mismatch between cash spent and cash deductible is the whole problem.

Notice 2023-63 and the software question

The Treasury Department and the IRS published Notice 2023-63 on September 8, 2023, providing interim guidance on the amended section 174. The notice runs to 56 pages in the Internal Revenue Bulletin and answers, provisionally, the questions tax directors had been asking each other since January 2022.

The notice clarifies that specified research or experimental expenditures include labor costs of employees performing or directly supervising software development, materials and supplies consumed, cost recovery allowances on depreciable property used in the development, and patent costs. It addresses cloud computing: amounts paid to use cloud services to develop software are section 174 costs to the extent the cloud use supports development rather than production operation. It addresses prototype materials, long a grey area, and treats their cost as section 174 when the prototype's purpose is the resolution of uncertainty.

The notice also walks through the boundary between software development (capitalizable) and post-implementation activities (deductible), and between internally developed software and software acquired from a third party. Licensing fees for off-the-shelf software the company uses in its own business are not section 174 amounts. A company's own engineering labor spent integrating that software into its product is.

Notice 2023-63 is proposed guidance. Treasury said it intends to publish regulations and that taxpayers may rely on the notice for tax years beginning after December 31, 2021. That reliance is load-bearing. Without it, CFOs were filing returns against a statute that did not define its own most important terms.

H.R. 7024 and the 2024 attempt

On January 16, 2024, the Tax Relief for American Families and Workers Act of 2024, H.R. 7024, was introduced by House Ways and Means chair Jason Smith and Senate Finance chair Ron Wyden. The House passed it 357 to 70 on January 31, 2024, with 169 Democrats and 188 Republicans voting yes.

The bill had three pillars relevant to business taxation. Section 201 would have amended section 174A to restore immediate expensing for domestic research or experimental expenditures for taxable years beginning after December 31, 2021, and before January 1, 2026, with catch-up mechanics for 2022 and 2023 returns already filed. Foreign research would have remained on the fifteen-year schedule. Section 202 would have restored 100 percent bonus depreciation under section 168(k) for qualified property placed in service after December 31, 2022, and before January 1, 2026. Section 203 would have reinstated the EBITDA-based calculation of adjusted taxable income for purposes of the section 163(j) business interest limitation, again through 2025. The package also expanded the child tax credit, financed by an acceleration of the employee retention credit filing deadline.

The bill sat in the Senate for six months. Senator Mike Crapo, ranking member on Finance, signaled early that he wanted changes, chiefly on the child-credit lookback provision and on the bill's duration. A cloture vote on the motion to proceed failed on August 1, 2024, 48 to 44, short of the 60 required under Senate Rule XXII. Eighty percent of Senate Republicans voted against cloture.

The bill is not formally dead. Senate Majority Leader Charles Schumer filed the motion to reconsider, a procedural placeholder that keeps the bill technically alive through the end of the 118th Congress on January 3, 2025. In practice, with the election resolved and a new Congress arriving with different priorities and different committee arithmetic, any 2025 fix will start from a new bill.

The accounting mechanics taxpayers still have to execute

Every affected taxpayer had to file a change in method of accounting. Under Revenue Procedure 2015-13 and the designated automatic change number assigned by subsequent revenue procedures, the shift to section 174 capitalization is an automatic method change, not a non-automatic one requiring advance consent. The taxpayer files Form 3115, Application for Change in Accounting Method, with the original return for the year of change. The section 481(a) adjustment for section 174 amounts is computed on a cutoff basis, which is to say there is no cumulative catch-up; the new rule applies only to amounts paid or incurred in taxable years beginning after December 31, 2021.

For 2022 returns, the IRS granted transition relief in Revenue Procedure 2023-8 and Revenue Procedure 2023-11, clarifying the automatic-change procedure and waiving certain scope limitations that would otherwise block the change. For 2023 and later years, taxpayers who failed to capitalize in 2022 are in the awkward position of needing to amend or relying on a second method change, neither painless.

The state tax picture is its own mess. States with rolling Code conformity picked up the amended section 174 automatically. States with static or selective conformity did not, or did so selectively, producing a separate set of state-only deductions and additions the taxpayer has to track. Georgia, Indiana, Tennessee, and a handful of other rolling-conformity states tax the federal inflated income directly. California decoupled from much of the TCJA already and computes its own section 174 adjacent rules. The compliance cost of the misalignment is substantial, and falls hardest on multi-state small companies without in-house tax departments.

Who is actually paying

The pattern is clearest in venture-funded software. A pre-profit startup with $3 million in 2024 engineering payroll and $500,000 in other deductions, funded by $5 million of equity, reports, under pre-2022 rules, roughly a $3.5 million net operating loss and zero federal tax. Under amended section 174, the same company deducts $300,000 of engineering payroll (ten percent, first-year convention), $500,000 of other costs, and has taxable income of roughly $2.2 million. At the 21 percent corporate rate, it owes $462,000 in federal tax on money investors just gave it. The deduction eventually arrives across years two through six, but the cash is out the door now, and startups run on cash.

Larger software companies with revenue absorb the timing mismatch more easily but not cleanly. The National Association of Manufacturers and trade groups for the software industry have documented laid-off research staff and paused projects traceable to the rule. It is difficult to prove a counterfactual in tax policy, but the direction of the effect is not contested by anyone, including the provision's original drafters, who treated it as a pay-for rather than a policy.

What to do in the 2024 filing cycle

Assume section 174 capitalization for tax year 2024. Run the Form 3115 if you have not already, confirm that your 2022 and 2023 returns applied the rule, and budget cash for the resulting federal liability even if your GAAP income statement shows a loss. Rely on Notice 2023-63 for the definitional questions, particularly around cloud spend and prototype materials, and document the allocations.

If a fix passes in 2025, it will almost certainly be retroactive to 2022 or 2023, as H.R. 7024 was, with amended-return mechanics. Keep records assuming the fix will eventually arrive and assuming it will not; the work is the same either way, and the tax posture you take this April will be the one you reconcile against whichever version of section 174 is ultimately in force.

For founders choosing an entity form with 174 exposure in mind, the calculus has not changed the basic answer: a C-corp still makes sense for venture-funded software, not because the tax is good but because the other pieces of the stack (QSBS, institutional investors, option grants) assume it. The timing tax is real and worth planning for. It is not large enough to reorganize around, yet.

The bill number for the 2025 attempt does not exist yet. The mechanics will rhyme with H.R. 7024, because there are only so many ways to write a section 174 fix, and because the people who drafted it are still in their seats.

Sources

Keep reading

More from the journal.