Thousands of small businesses are struggling because of R&D amortization
A recent change in U.S. tax law now forces most software development costs to be treated as research and development that must be amortized over 5–15 years, rather than deducted as expenses in the year they occur. Commenters warn this effectively taxes “phantom profits,” hitting small and early-stage software companies hardest by requiring them to pay income tax even when they are cash‑flow break‑even or losing money, while leaving more traditional businesses largely unaffected. There is broad concern about reduced incentives for innovation and domestic R&D, some political blame over how the rule was created in the 2017 tax reforms, and cautious optimism around current bipartisan efforts to roll back or delay the change.
What Changed in Section 174
- 2017 tax law now in effect requires “specified research or experimental” costs to be capitalized and amortized instead of expensed.
- IRS guidance interprets essentially all software development and related activities as Section 174 costs.
- Domestic R&D is amortized over 5 years (effectively 6 tax years: 10% year 1, 20% years 2–5, 10% year 6); foreign R&D over 15 years.
- Bug-fixing and some non-functional UI changes can still be expensed; new features and performance improvements generally cannot.
- This is separate from traditional R&D tax credits, which have narrower scope.
Impact on Small Software Businesses and Startups
- Many examples: a company with $100k revenue and $100k dev salary is now taxed as if it had ~$80–90k profit, despite having no cash left.
- This especially harms:
- Bootstrapped and pre-profit startups.
- SBIR-style deep-tech firms with heavy R&D.
- Small consultancies whose clients must amortize contracted dev work.
- Effectively front-loads tax on “paper profits” and forces some to borrow, seek VC, or shut down before ever reaching later-year deductions.
- Long amortization for foreign work (15 years) strongly discourages outsourcing and non-US R&D.
Fairness, Accounting, and Policy Debate
- One side: this merely removes a subsidy/“loophole”; treating long-lived software like other capital assets is conceptually consistent.
- Opposing view: salaries are normally operating expenses; forcing capitalization of all dev is an accounting distortion that taxes unrealized future gains and uniquely targets software.
- Some argue most software work is ordinary product development, not the kind of high-risk R&D policymakers meant to favor; others reply that “development” is literally the D in R&D and strongly correlated with economic growth.
- Comparison to other sectors (restaurants, plumbers, construction, journalists) raises questions about why software is singled out.
Workarounds, Compliance, and Uncertainties
- Ideas floated: reclassify work as maintenance/support, push more into bug-fixing, use agencies or foreign entities, or simply “do not comply.”
- Others note IRS language is broad (“all costs incident to development or improvement”), making aggressive reclassification risky.
- There is confusion over cash vs accrual, one-person LLCs, contractors vs employees, and internal vs customer-facing software; thread flags likely litigation and further guidance needs.
Politics and Prospects for Change
- Change was included in the 2017 tax cuts as a delayed offset to make deficit projections look better.
- Widely viewed as unintentionally destructive but politically gridlocked.
- A new bipartisan bill (Tax Relief for American Families and Workers Act of 2024) would temporarily restore immediate expensing for domestic R&D through 2025 but leave foreign amortization in place; its passage is uncertain.
- Some see this as part of a broader pattern of US policy disincentivizing R&D compared to countries that offer enhanced deductions or credits.