For three years, software companies had to capitalize their domestic development costs and deduct them over five years. For a pre-profit SaaS company that often meant a tax bill despite losing money. Legislation enacted in July 2025 changed that, and the IRS issued procedures in Rev. Proc. 2025-28. Here is what changed and the decisions it creates.
The short history
- Through 2021: research and experimental (R&E) costs, including software development, could be deducted currently.
- Tax years beginning after December 31, 2021: Section 174 required capitalization, with amortization over 5 years for domestic research and 15 years for foreign research.
- Tax years beginning after December 31, 2024: new Section 174A restores a current deduction for domestic research and experimental expenditures. Foreign research stays on 15-year amortization.
The decisions it creates
1. Current deduction or capitalization going forward
Domestic R&E incurred in tax years beginning after 2024 can be deducted currently, or a taxpayer can elect to capitalize and amortize. Companies with net operating losses sometimes prefer amortization to preserve future deductions; the right answer depends on your projected taxable income.
2. Unamortized costs from 2022 to 2024
Costs capitalized under the old rules have amortization remaining. The new law provides ways to accelerate the remaining deductions, and the procedures in Rev. Proc. 2025-28 set out how and when to elect.
3. The small-business retroactive election
Taxpayers meeting the Section 448(c) gross receipts test may elect to apply Section 174A retroactively to tax years beginning after December 31, 2021, which means amending earlier returns. The procedures include a deadline, and timing matters: confirm the current date in Rev. Proc. 2025-28 against the statute of limitations for each year before deciding.
How it interacts with the R&D credit
The research credit under Section 41 and the deduction under 174A are coordinated: claiming the credit can reduce the amount deductible unless an election is made to take a reduced credit instead. Model both together.
What to gather
- Development payroll by year and location (domestic versus foreign).
- Contractor invoices for development work and where it was performed.
- Cloud and software costs used in development.
- Your 2022 to 2024 returns and the amortization schedules filed with them.
What we do
We model current deduction versus capitalization against your projected taxable income, evaluate the retroactive election and amended returns where they help, and coordinate the result with the R&D credit and your state returns, which do not always follow federal treatment.
A simple illustration
A company spent $1,000,000 on domestic software development in each of 2022, 2023 and 2024.
- Under the old rules, each year's costs were amortized over five years using a midpoint convention, so only a fraction was deductible in the year incurred. Much of the 2022 to 2024 spending was still unamortized entering 2025.
- Under Section 174A, domestic costs incurred in tax years beginning after 2024 can be deducted in the year incurred.
- For the remaining 2022 to 2024 balance, the new law allows the unamortized amount to be deducted on an accelerated schedule, subject to the elections in the IRS procedures; eligible small businesses may instead amend the earlier years.
The right path depends on whether the company is profitable now, expects to be, and how its state returns treat the change.
State conformity
States decide whether to follow federal changes. Some conform automatically, some conform as of a fixed date and some decouple from specific provisions. A company can deduct research costs federally while still amortizing them for a particular state, which changes state taxable income and estimated payments. Check each state where you file.
Documentation that supports both 174A and the credit
Track development cost by project and by location (domestic or foreign). The same records support the Section 41 credit's qualified research expenses and the 174A deduction, and they are the first thing an examiner asks for.
Sources
- IRS, Rev. Proc. 2025-28 (Section 174A procedures), via IRS Internal Revenue Bulletins
- IRS, Instructions for Form 6765
Questions founders ask
Do foreign research costs get the same treatment?
No. Research performed outside the United States remains subject to capitalization and amortization over 15 years.
Who can apply the change retroactively?
Taxpayers meeting the Section 448(c) gross receipts test ($31 million average annual gross receipts for the relevant period) may elect to apply the new rules to tax years beginning after December 31, 2021, under procedures in Rev. Proc. 2025-28.
