Tax Planning Startups Compliance

Section 174 Capitalization Explainer: What Domestic R&E Treatment Looks Like in 2026

Published June 5, 2026 by Invisible LLC Team · 9 min read

The short version

The Tax Cuts and Jobs Act broke a rule that had held for 70 years: that you got to deduct research costs in the year you incurred them. From 2022 through 2024, you had to capitalize domestic research and experimental (R&E) expenditures and amortize them over five years, and foreign R&E over fifteen. That hit early-stage software companies hardest, because their largest expense — engineering payroll — was suddenly a balance-sheet item, not an income-statement deduction.

The One Big Beautiful Bill Act (OBBBA) fixed that for domestic R&E permanently. New §174A, effective for tax years beginning after December 31, 2024, restores immediate expensing of domestic R&E. Foreign R&E is still on the 15-year amortization track. The §280C(c)(2) election is now annual homework you should actually do, not a default-on autopilot. And if you capitalized R&E from 2022 to 2024 and you're a small business, the retroactive recovery election is open through the week of July 6, 2026.

You're a founder, not a tax accountant. The rest of this post is what you actually need to know.

What Section 174 used to be, and why TCJA broke it

Section 174 of the Internal Revenue Code governs the tax treatment of research and experimental expenditures. From 1954 through 2021, §174 let taxpayers do one of two things with R&E costs: deduct them in the year paid or incurred, or elect to capitalize and amortize them. Almost everyone deducted. The rule was simple and aligned with how research actually works: you spend money on people and equipment to figure out whether a thing can be built, and the cost goes against the year you spent it.

The Tax Cuts and Jobs Act of 2017 changed that, effective for tax years beginning after December 31, 2021. Under the TCJA version of §174, all R&E expenditures had to be capitalized and amortized:

Domestic R&E: five-year amortization, with a half-year convention (10% deduction in year one, 20% in years two through five, 10% in year six)
Foreign R&E: fifteen-year amortization with the same half-year convention

The change was a revenue raiser baked into TCJA's scoring. The policy implications were ugly. A software startup with $400,000 of engineering payroll in 2022 could only deduct $40,000 of it that year. The other $360,000 became a balance-sheet asset to amortize across the next five years — even though the cash was gone. Companies that had been profitable became taxably profitable for the first time. Companies that were burning cash burned faster.

Most practitioners assumed Congress would walk it back before it took effect. Congress did not.

What OBBBA actually did

The One Big Beautiful Bill Act, signed into law in mid-2025, created new IRC §174A and modified §174. The substantive changes:

Domestic R&E (§174A): Permanent immediate expensing restored, effective for tax years beginning after December 31, 2024. Taxpayers can deduct domestic R&E in the year paid or incurred, the way the rule worked through 2021. An election to capitalize and amortize over 60 months (under §174A) is also available for taxpayers who want it — but it's no longer mandatory.

Foreign R&E (§174): Still must be capitalized and amortized over 15 years (180 months). OBBBA did not restore expensing for foreign-jurisdiction research. This matters for any company using foreign contractors, foreign subsidiaries, or foreign engineering teams.

Small-business retroactive election: Eligible small business taxpayers (under $31M average gross receipts, tested against 2025) can retroactively apply §174A to 2022, 2023, and 2024 — recovering the capitalized R&E from those years through amended returns. The filing window closes the week of July 6, 2026, per Rev. Proc. 2025-28. The mechanics, deadlines, and pitfalls of the retroactive election are covered in our Section 174 small-business retroactive election piece.

§280C(c)(2) election: Modified to interact with the new §174A regime. Taxpayers must affirmatively decide each year whether to take the full §174A deduction with a reduced §41 R&D credit, or the full credit with a corresponding deduction reduction.

That's the headline. The rest of this post is what each of those means in practice for a 2026 filing.

Domestic vs. foreign R&E: the line that costs the most money

The single most important distinction in 2026 §174 work is whether R&E is "domestic" or "foreign." OBBBA didn't simplify the test; it just made it matter more.

Domestic R&E is research conducted within the United States. The location of the research activity is what matters — not the location of the company, the location of the customer, or where the IP is held. A U.S.-incorporated company with a U.S.-based engineering team is the easy case: everything is domestic. A U.S.-incorporated company with a development team in Bulgaria is doing foreign R&E, even though the company files U.S. taxes.

The harder cases:

Remote U.S. contractors paid through a U.S. payroll system: Domestic, even if the contractor sometimes travels abroad.
Foreign contractors who deliver code to a U.S. team: Foreign. The work was done abroad.
U.S. employees who work remotely from Portugal for six months: Likely foreign for the portion of work performed abroad. Travel and remote-work patterns are now a 15-year-amortization risk if not tracked.
Cloud compute used for development, hosted in U.S. data centers: Domestic. Hosted in EU data centers: arguably foreign, though the IRS has not given crisp guidance.
Open-source contributions you sponsor with grants to foreign maintainers: Foreign.

The economic consequence is large. A $200,000 contractor invoice from a Bulgarian dev shop is fully deductible only on a 15-year amortization schedule under §174 — meaning roughly $6,700 in deductible expense in year one, with the remaining $193,300 sitting on the balance sheet for 14 more years. That's a meaningful cash-tax drag if foreign R&E is more than a token line item in your budget.

Most software founders we onboard mid-year did not realize the distinction was binding until we walked through it. If your engineering budget has a meaningful foreign component, the §174 capitalization conversation is annual, not one-time.

What "research and experimental expenditures" includes (and doesn't)

§174A and §174 cover R&E expenditures, which is a broader category than "qualified research expenses" (QREs) under §41 — the R&D credit. The two definitions are related but not identical, and conflating them is the most common 2026 §174 mistake.

R&E under §174A includes costs of research in the experimental or laboratory sense — work to discover information that would eliminate uncertainty about the development or improvement of a product. Software development costs are explicitly treated as R&E by statute. R&E includes:

Engineering wages and benefits for work on developing or improving software
Cloud compute, server costs, and software-development tools used in R&E
Contractor R&D costs (100% of cost, in contrast to the 65% rule under §41)
Supplies consumed in research
Patent legal costs to obtain patents
Some software-license costs used in development

QREs under §41 (the R&D credit) are a tighter category: only certain wage costs (must be for qualified services — direct research, direct supervision of research, or direct support of research), 65% of domestic contractor R&D, certain supplies, and rental or lease cost of computers. Foreign contractor R&D is not a QRE. Pure overhead is not a QRE.

The practical consequence: your §174A deduction in 2026 is usually larger than your §41 credit base. Some costs are R&E but not QREs (patent legal, certain overhead allocations), and some treatment differences (the 100% vs. 65% contractor rule) widen the §174A category. Your tax preparer should be running these as two separate calculations, not one.

§280C(c)(2): the election that became annual homework

The §280C(c)(2) election has been around for decades, but it just became more interesting. Here's the mechanics in plain English.

The §41 R&D credit is a tax credit on a percentage of QREs. The natural double-dip you'd expect: deduct the QRE under §174A, and also take the credit. Tax law has historically prevented that double-dip by reducing one of the two — either reducing the deduction by the credit amount (the default rule), or reducing the credit (the §280C(c)(2) election).

Pre-TCJA, the §280C(c)(2) election was a one-decision-and-forget choice for most taxpayers; it reduced the credit by 21%, which lined up with the corporate tax rate, making the two paths economically equivalent for most filers. Most preparers defaulted to electing.

Under §174A and the modified §280C, the math is no longer that clean. The right election varies by:

Your effective tax rate (corporate vs. flow-through, federal-only vs. with state stacking)
Whether you have an NOL position
Whether you're taking the QSB payroll offset under §41(h)
State conformity to §174A and §280C in your filing jurisdictions

For Pillar C2 founders running their first §174A return in 2026, the right answer changes year-over-year. Running both paths annually is what good R&D tax practitioners do; defaulting to last year's election is a common mistake that quietly costs money.

Grant Thornton's analysis and BDO's procedural guidance both walk through the §280C interaction in detail; either is a good starting point for the technical layer.

State conformity: federal isn't the whole answer

Federal §174A is one thing. State conformity is another, and state tax treatment of R&E is genuinely inconsistent in 2026:

Rolling conformity states (Illinois, Michigan, several others): Generally pick up §174A automatically, but watch for state-specific decoupling on the small-business retroactive election.
Static conformity states (California, Texas, New York for some purposes): Conform to the federal code as of a specific date. California has not adopted §174A as of 2026; California taxpayers still amortize R&E for state purposes per the pre-OBBBA rules.
Selective conformity states: Some states (Massachusetts, others) pick and choose which federal provisions apply.

For a software startup with engineering teams in California and a Delaware parent, the federal §174A deduction is full expensing — but the California return still capitalizes R&E. The result is a state-level deferred tax position that doesn't exist federally. It's not a problem; it just has to be tracked.

If you're filing in three or more states, the §174 state question is annual homework. A good preparer or a bookkeeper who keeps the GL clean enough to feed the state returns is the difference between "we caught the California decoupling in March" and "we caught it in October during the extended-return scramble."

What this means for 2026 filers

If you're a software founder or a software company controller running a 2025 return in 2026, three concrete pieces of homework:

Confirm your domestic vs. foreign R&E split for 2025. Pull the engineering payroll, contractor invoices, and any foreign-related R&E costs. The domestic piece is expensable under §174A. The foreign piece capitalizes over 15 years. Track the split now, not at year-end.
Run the §280C(c)(2) analysis both ways. Don't default to last year's election. The math changed.
If you capitalized R&E in 2022, 2023, or 2024 and you qualify as a small business taxpayer for 2025, decide on the retroactive election before mid-June. The amended-return window closes the week of July 6, 2026. The mechanics live in our retroactive election piece; the math is usually worth the work for any company with more than ~$100K of capitalized R&E in the 2022–2024 window.

If any of the above feels like it's outside your zone, that's expected. The §174A regime is not a thing founders should be tracking on the side of building product. Our team does this work for seed-stage and post-seed software clients as part of standard monthly bookkeeping and annual tax-prep coordination. We are not an R&D study factory; we are the people who keep the underlying books clean enough that the §174A deduction, the §41 credit, and the §280C election all get filed correctly the first time.

You're a founder. You want to ship product. The §174A regime should be a clean line on a clean return, not a thing you have to learn.

Publishing Brief

Hero image

Description: Stylized illustration of a balance-sheet-to-income-statement flow, with R&E costs visualized as a stack of dollar bills moving from one side to the other — a visual metaphor for the "capitalize vs. expense" question.
Filename: section-174-capitalization-explainer-hero.jpg
Dimensions: 1200×630
Alt text: "Conceptual illustration of R&E expenditures moving from balance sheet capitalization to income statement expensing under Section 174A."

In-body images

 — Decision tree: "Is the R&E performed in the U.S.?" → Yes branch (§174A immediate expensing); No branch (§174 15-year amortization). Include common fact patterns (U.S. contractor, foreign contractor, remote employee working abroad) as decision nodes. Filename: section-174-domestic-vs-foreign-flowchart.png. Alt: "Decision flowchart distinguishing domestic R&E (immediate expense under Section 174A) from foreign R&E (15-year amortization)."
 — U.S. map with states color-coded by §174A conformity: green for rolling-conformity states that picked up §174A automatically, yellow for selective conformity, red for static-conformity states that have not adopted §174A. Filename: section-174a-state-conformity-map.png. Alt: "U.S. state map showing rolling, selective, and static conformity to federal Section 174A in 2026."

Internal links checklist

Anchor text	Destination	Body section
Section 174 small-business retroactive election piece	/blog/section-174-small-business-retroactive-election	OBBBA section + closing CTA
bookkeeper who keeps the GL clean enough to feed the state returns	/services/bookkeeping	State conformity section
Our team	/quote	Closing CTA

Refresh checkpoints

30-day check (early July 2026): Update the post once the July 6, 2026 §174A small-business retroactive election deadline has passed; rewrite the closing CTA to remove the time-sensitive framing.
90-day check (early September 2026): Refresh state conformity map if any states (especially California, New York) have adopted §174A through legislative action or regulatory guidance.
180-day check (early December 2026): Confirm the $31M small-business gross-receipts threshold is unchanged for tax years beginning in 2027 (it indexes to inflation). Update if Treasury publishes a new figure.
Time-sensitive expiry: The closing "What this means for 2026 filers" section references the July 6, 2026 retroactive election window. Update that section by July 7, 2026.