Startups and investing

Section 174 is fixed: the R&D tax credit and expensing for a small US software company in 2026

October 25, 2026

What the July 2025 law changed for software development costs (deductible again from 2025, the 2022-2024 balance written off over one or two years), who qualifies for the research credit, how a startup takes up to $500,000 a year of it against payroll taxes, a six-person company worked through ($699,000 of research costs, a $73,360 credit used over five quarters), the records courts ask for, what specialists charge and nine questions for your accountant.

A hand holding a pen points at a printed table of percentages and dollar figures beside a calculator and a laptop on a wooden desk

From 2022 to 2024, a small US software company that paid its developers $700,000 could deduct only $70,000 of it in the first year. The rest had to be spread over five years under Section 174, which counts every dollar spent developing software as research. Profitable small firms paid tax on money they had already spent, and many only found out when their accountant sent the bill.

The One Big Beautiful Bill Act, signed on 4 July 2025, fixed that for US research. For a small software company the change brings three things: an immediate deduction again from 2025, a way to write off what is left of the 2022-2024 costs, and the research credit, which a young company can take as a cut in its payroll taxes even before it makes a profit. Here is how each works, with the numbers for a six-person company, the records to keep and the questions to ask your accountant. Dates and rules as of 24 October 2026.

What changed, in one table

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                                 Tax years 2022-2024 (old Section 174)   Tax years from 2025 (new Section 174A)
-------------------------------  --------------------------------------  -------------------------------------------
US research, including software  Capitalised, amortised over 5 years     Deducted in the year paid (or elect to
development                      (10% in year one)                       amortise over 60+ months)
Research done outside the US     15 years                                Still 15 years
Is software development          Yes (174(c)(3))                         Yes: "any amount paid or incurred in
"research"?                                                              connection with the development of any
                                                                         software" (174A(d)(3))
Unamortised 2022-2024 balance    Kept amortising                         Any company may deduct it all in 2025, or
                                                                         half in 2025 and half in 2026
Small business (average gross    -                                       Could amend 2022-2024 returns to expense
receipts up to $31M)                                                     them; deadline was 6 July 2026, now passed
Research credit (Section 41)     Unchanged                               Unchanged; deduction reduced by the credit
                                                                         unless you elect a 79% credit (280C(c))

The IRS set out the mechanics in Revenue Procedure 2025-28 (August 2025): the elections are made with statements attached to the return, the switch to expensing is an automatic accounting method change, and companies that had already filed 2024 got an extension to file superseding returns. Revenue Procedure 2026-32 (4 September 2026) widened the automatic method changes further for years beginning before 2028. If your 2024 or 2025 return was prepared before your accountant read these, ask whether it used them.

What it means in cash: two examples

The first-year deduction. A profitable software company spends $699,000 on US development in 2026: developer salaries, part of a technical founder's pay, and development cloud costs.

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                                         Old rule (2022-2024)      New rule (2026)
---------------------------------------  ------------------------  ----------------------
Deduction for the $699,000 in year one   $69,900 (10%)             $699,000
Extra deduction in year one                                        $629,100
Tax saved in year one at 21%                                       $132,111
(C corporation)

The total deduction over five years is the same; what changes is when you get it. For a small company, $132,000 of tax not paid this year is the difference between hiring and not.

The leftover balance. The same company capitalised $400,000 in 2022, $500,000 in 2023 and $600,000 in 2024, and amortised them on the old schedule (10% in the first year, then 20% a year).

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Year capitalised   Amount      Amortised by end of 2024   Left at 1 Jan 2025
-----------------  ----------  -------------------------  ------------------
2022               $400,000    50%                        $200,000
2023               $500,000    30%                        $350,000
2024               $600,000    10%                        $540,000
                                                          ------------------
                                                          $1,090,000

Choice: deduct $1,090,000 on the 2025 return, or $545,000 in 2025 and $545,000 in 2026.

Which is better depends on profit: a company with a 2025 loss may prefer to spread it into 2026, or into a net operating loss it can use later. Your accountant should model both. Calendar-year corporations on extension had to file 2025 by 15 October 2026, so this is mostly a check that it was done.

Who qualifies for the research credit

The deduction is about timing. The research credit under Section 41 is money: a credit against tax of roughly 5% to 10% of qualifying research costs. To count, the work has to pass a four-part test for each "business component" (a product, feature or piece of software):

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1. Section 174/174A cost      It is research and experimental spending (software development is).
2. Technological in nature    It relies on computer science, engineering or a physical science.
3. Permitted purpose          It aims at a new or improved function, performance, reliability or
                              quality of the component.
4. Process of experimentation "Substantially all" (80% or more) of the activity is evaluating
                              alternatives to resolve an uncertainty about capability, method or
                              design: prototypes, tests, benchmarks, rejected approaches.

What qualifies as cost (qualified research expenses, QREs): taxable wages of people doing, directly supervising or directly supporting the research (if 80% or more of someone's time qualifies, all of their wages count); supplies; 65% of what you pay contractors for research done on your behalf, if you bear the risk and keep rights to the results; and payments for computers rented off-site. Practitioners treat development and test cloud environments as qualifying and production hosting as not, but the IRS hasn't ruled on cloud costs; tag your cloud bills so the split can be shown.

Software sold to or used by customers, including SaaS, is generally not "internal use software", which matters because internal-use software (built for your own accounting, HR or admin) must also pass a much harder "high threshold of innovation" test. Tools that serve both customers and your back office are presumed internal use unless they fit a 25% safe harbour.

The payroll tax offset for startups

A credit against income tax is no use to a company with no profit. Section 41(h) lets a qualified small business use up to $500,000 of the credit a year against its payroll taxes instead: first against the employer's 6.2% Social Security, then the employer's 1.45% Medicare.

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Who        Gross receipts under $5 million in the credit year, and no gross receipts in any year
           before the 5-year period ending with that year (in practice: receipts started 2022 or
           later for the 2026 tax year). Corporations, S corporations and partnerships qualify.
Limit      $500,000 a year (raised from $250,000 for years beginning after 2022); at most 5 years.
How        Elected on Form 6765 with a timely filed original income tax return (extensions count).
           Not on an amended return.
When       From the first calendar quarter after the income tax return is filed, claimed on the
           quarterly Form 941 with Form 8974. Unused amounts roll to the next quarter.

Worked through: a six-person software company

A C corporation founded in 2023 sells a SaaS product, had $1.4 million of revenue in 2026 and a small loss. Six people: four developers at $150,000, a technical founder at $150,000 who spends half their time on development, and an operations person at $90,000. Development cloud costs are $24,000 a year. Research costs in earlier years were $200,000 (2023), $350,000 (2024) and $500,000 (2025).

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Qualified research expenses, 2026
  4 developers, 80%+ of time on qualifying work: 100% x $600,000    $600,000
  Founder, 50% of time: 50% x $150,000                                $75,000
  Development and test cloud (tagged)                                 $24,000
                                                                     --------
  Total QREs                                                          $699,000

Credit by the alternative simplified method (ASC)
  Average QREs of the 3 prior years: ($200k + $350k + $500k) / 3      $350,000
  Half of that                                                        $175,000
  14% x ($699,000 - $175,000)                                          $73,360
  (If any of the 3 prior years had no QREs: 6% x $699,000 = $41,940)

Reduced-credit election (280C(c)(2)): 79% x $73,360 = $57,954, and no cut to the
  deduction. A company with a loss usually does NOT elect it: the default cuts the
  174A deduction by $73,360, which only shrinks a loss, and keeps the full credit.

Payroll offset (qualified small business: $1.4M receipts, receipts began 2023)
  Total wages $840,000; each salary under the 2026 Social Security wage base
  Employer Social Security per quarter: $840,000 x 6.2% / 4           $13,020
  Employer Medicare per quarter: $840,000 x 1.45% / 4                  $3,045
  Offset per quarter                                                  $16,065
  2026 return filed 15 March 2027 -> offset starts in Q2 2027
  $73,360 / $16,065 = about 4.6 quarters: Q2 2027 to Q3 2028

So a company with no taxable profit gets about $73,000 back through payroll over five quarters, starting about three months after it files. That is real money for a six-person firm, and the reason to file on time: the payroll election can't be added on an amended return.

Form 6765 and the new Section G

From tax years beginning after 2025, Form 6765 asks for detail by business component in Section G: what each component is, the information you were trying to discover, and the wages, supplies and contract costs for each, covering at least 80% of QREs (up to 50 components). Two groups are exempt: a qualified small business taking the payroll offset, and companies with QREs of $1.5 million or less and gross receipts of $50 million or less claiming on an original return. Our example company is exempt twice, but the IRS can still ask for the same detail in an exam, so keep it anyway.

Records to keep, and why the courts care

Research credit cases are usually lost on paperwork, not on whether the work was clever. In Siemer Milling (Tax Court, 2019) the whole credit was denied because the company couldn't show its process of experimentation; saying it used "trial and error" wasn't enough. In Little Sandy Coal (7th Circuit, March 2023) the taxpayer couldn't show that 80% of the activity was experimentation, measured on a principled basis. In Moore (Tax Court, 2023) an executive's wages, allocated 65% to research, were thrown out for lack of time records, while the engineers' wages stood.

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Keep, per business component (feature, service, product), for each year:

[ ] What was uncertain at the start: capability, method or design, in a sentence
[ ] The alternatives tried: design docs, spikes, benchmarks, failed branches, test results
[ ] Tickets and commits linked to the component (Jira/Linear epics, Git history)
[ ] Who worked on it and roughly what share of their time: monthly estimates
    written at the time beat reconstructions a year later
[ ] Payroll by person; contractor agreements showing you bear the risk and keep
    the rights
[ ] Cloud bills with development and test environments tagged separately from
    production
[ ] Gross receipts history from the first sale (for the payroll offset)

If you claim on an amended return (for example a missed 2024 or 2025 credit), the IRS requires the business components, the research activities and the total wages, supplies and contract costs with the claim; since 18 June 2024 it no longer requires the names of individuals and the information each sought, though it can ask in an exam. Claims missing the required items can be fixed within 45 days, under a transition rule that runs to 10 January 2027.

What specialist firms charge

Research credit studies are often sold on contingency: 15% to 25% of the credit is the range one specialist calls competitive, with 30% or more at the high end, and Pilot's example shows a $6,000 fee on a $30,000 credit (20%). On our example's $73,360 that would be $11,000 to $18,000. For a company with clean records and a few components, a CPA billing by the hour may cost less; ask for both quotes.

Questions to ask your accountant this year

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1. Did our 2025 return deduct the unamortised 2022-2024 research balance, in one
   year or two? Which is better given our 2025 and 2026 profit?
2. Did we qualify for the small-business retroactive election (deadline 6 July
   2026), and was it made? If not, what is left to use?
3. Is our 2026 research deducted under 174A, and did we elect to amortise
   anything instead? Why?
4. Do we qualify for the payroll offset (receipts under $5M, first receipts in
   the last 5 years)? How many of our 5 years have we used?
5. Should we elect the reduced 280C credit, given we have a loss/profit?
6. Which costs are we counting as QREs: whose wages and what share, contractors,
   cloud? What do we need to keep to support each?
7. Does Section G apply to us, and is any of our software internal-use?
8. Any state credit? (California, for example, kept its 15% credit and replaced
   its alternative incremental credit with a 3% simplified one from 2025.)
9. For an S corporation or LLC: how does the credit flow to the owners, and can
   they use it?

Cash freed by the deduction and the credit is often what a small software company uses to grow without raising money; our comparison of revenue-based financing and a seed round covers the other ways to fund the next hire, and the cost of AI coding tools covers one of the newer costs that may count as development spending.

Comparing a tax-funded hire with outside money? The revenue-based financing calculator shows what an advance really costs (months to repay, effective annual rate) against a bank loan for the same money. Runs in your browser.

Open the revenue-based financing calculator

Sources

Law and IRS guidance: 26 U.S.C. 174A and 280C; Rev. Proc. 2025-28 (Aug 2025); Form 6765 instructions (Dec 2025); IRS on the qualified small business payroll credit (reviewed Jun 2026); IRS FAQ on research credit refund claims (updated Oct 2026); Chief Counsel memo 20214101F; IRS research credit audit techniques guide.

Analysis: PwC on domestic R&E options (Sep 2025); Grant Thornton on Rev. Proc. 2026-32 and EY (Sep 2026); Journal of Accountancy on the AICPA's 174A(c) questions (Feb 2026); Cherry Bekaert on the final Form 6765 instructions (Feb 2026); The Tax Adviser on computer rental and cloud costs (Jun 2026); StrikeTax on 280C after OBBBA; California FTB on SB 711 (Dec 2025).

Cases and fees: RSM on Little Sandy Coal (2023); Baker Tilly on Siemer Milling (2019); Grant Thornton on Moore (2023); Swanson Reed on contingency fees; Pilot R&D credit. The examples are ours and simplified (federal only, C corporation, 21%); this is not tax advice, and your accountant decides what applies to your company.