Navigating the Latest Section 174 R&D Capitalization Rules: What Founders Need to Know in 2025

For early-stage startups, research and development (R&D) is the lifeblood of innovation. Historically, small companies benefited from being able to immediately deduct R&D costs each year. However, legislative changes enacted under the Tax Cuts and Jobs Act (TCJA) of 2017 have altered the playing field.

This post explores Section 174 in its current form, common pitfalls for founders, and practical strategies to help you navigate these rules effectively—even as legislative uncertainty looms.

Section 174: A Fundamental Shift in R&D Cost Treatment

What Changed?

Prior to 2022, businesses could expense R&D costs under Section 174 immediately. But for tax years beginning after December 31, 2021, the TCJA now requires R&D expenses to be capitalized and amortized over:

• 5 years for domestic research, and
• 15 years for foreign research.

Mid-Year Convention

Crucially, the amortization period starts at the midpoint of the tax year in which the R&D expenditures are paid or incurred. This detail further delays the timing of deductions, which can significantly impact cash flow and tax liability for startups.

Example: How Amortization Actually Works

Consider AI Innovations Inc., a pre-seed startup that invests $1 million in domestic R&D during 2023. Under old rules, they would have deducted the full $1 million in 2023. With the new Section 174 rules and a 5-year amortization plus the mid-year convention:

1. Year 1 (2023): Deduct 10% (mid-year start)
   • $1,000,000×10%=$100,000\$1,000,000 \times 10\% = \$100,000$1,000,000×10%=$100,000
2. Years 2–5 (2024–2027): Deduct 20% each year
   • $200,000\$200,000$200,000 per year for four years
3. Year 6 (2028): Deduct the final 10%
   • $100,000\$100,000$100,000

In total, the startup still deducts $1 million but spread over approximately 5.5 calendar years. During the critical first year, they only deduct $100,000, inflating their taxable income (or reducing net operating losses) far more than before.

Legislative Attempts to Reverse or Delay Amortization

Since Section 174 capitalization took effect in 2022, both Democrats and Republicans have pushed for its repeal or delay, aiming to restore full or partial expensing.

• American Innovation and Jobs Act (2023)
  • Sought to reinstate immediate expensing and bolster the R&D tax credit for smaller companies.
  • Outcome: Proposed but not enacted.
• Tax Relief for American Families and Workers Act (January 2024)
  • Included a provision to defer amortization until 2026.
  • Outcome: Passed the House, stalled in the Senate.

Despite bipartisan support, no final solution has emerged as of 2025. Founders must plan for the current law while keeping an eye on potential future changes.

The New Administration and Republican-Controlled Congress: What Lies Ahead

In 2025, we have a new administration and a Republican majority in Congress. While this typically signals pro-business tax incentives, concerns about the federal budget deficit may delay any sweeping amendments to Section 174.

Key Considerations:

• Pro-Innovation Rhetoric vs. Revenue Concerns
  • Restoring immediate R&D expensing reduces government revenue, which lawmakers may offset with other tax hikes or spending cuts.
• Broader Tax Overhauls in 2026
  • As other TCJA provisions expire in 2026, Congress may bundle Section 174 changes into a larger tax reform bill, creating additional uncertainty for founders today.

Impact on SBIR/STTR Grant Recipients

Federal Grants: A Unique Tax Challenge

For startups relying on SBIR (Small Business Innovation Research) or STTR (Small Business Technology Transfer) grants, Section 174 amortization can be especially problematic:

1. Grant Income Is Taxable
   • SBIR/STTR grants are recognized as taxable income when earned (under accrual accounting).
   • At the same time, your R&D costs get capitalized and amortized over 5+ years.
2. Mismatch in Timing
   • You may recognize the entire grant in Year 1, but only 10% of the R&D costs are deductible that year due to the mid-year convention.

Example: SBIR Dilemma

• MedTech Innovations received a $1.5 million SBIR grant in 2024 and spent it entirely on R&D that same year.
• They must recognize $1.5 million in grant income in 2024 (accrual accounting).
• Under Section 174, only $150,000 (10%) of those costs is deductible in 2024, leaving them with $1.35 million in taxable income.
• This can create a significant, unexpected tax liability, even if the startup has no commercial revenue.

Potential Solutions for Grant-Funded Startups

• Choose the Appropriate Accounting Method

1. 1. • Accrual Method
        • Typically matches grant income recognition to the period in which R&D expenses are incurred, providing a more aligned view of revenue vs. expenses.
        • While Section 174 costs still must be capitalized, accrual accounting often reduces mismatches compared to the cash method for grant-funded research.
      • Cash Method (Less Commonly Useful)
        • Recognizes income only when received and expenses when paid, potentially exacerbating timing mismatches if grant income arrives at once but related R&D happens over multiple months.

• R&D Tax Credits: Proceed with Caution

1. 1. • A portion of R&D paid by Federal funds is ineligible for the R&D tax credit. If your startup’s R&D is entirely or partially funded by SBIR/STTR grants, you cannot claim credits on those federally funded expenses.
      • If you do have non-federally funded R&D, you may be eligible for the credit on that portion. Additionally, early-stage companies can opt to apply the credit against payroll taxes (up to $250,000 per year).
      • Always separate your federally funded research costs from privately funded R&D to accurately calculate any allowable credits.

• Maintain Robust Documentation

1. 1. • Keep detailed records showing how each dollar of grant money is spent versus privately raised funds.
      • Proper classification ensures you don’t capitalize ordinary expenses and helps determine what portion (if any) qualifies for R&D tax credits.

• Project Future Tax Liabilities

1. 1. • Conduct detailed tax forecasts under multiple scenarios, especially if additional grants are expected.
      • Consider working with a CPA or tax advisor who specializes in startup tax issues to avoid large, year-end tax surprises.

• Stay Alert for Legislative Changes

• • • Even if a short-term fix or delay occurs, it may only last until 2026. Keep tabs on Capitol Hill and monitor how any new bill could affect Section 174 requirements.

Practical Tips for All Founders (Not Just Grant Recipients)

• Accurately Separate R&D vs. Operating Expenses

1. 1. • Ensure that only true R&D costs are subject to Section 174 capitalization. Other operational expenses remain fully deductible under IRC Section 162.

• Adjust Financial Projections

1. 1. • Update your runway calculations to factor in the reduced first-year R&D deductions.
      • This will help you plan your fundraising strategy and cash burn.

• Monitor Investor Sentiment

1. 1. • With increased tax liability, some founders may seek alternative funding vehicles (SAFE notes, structured venture debt, etc.) to offset near-term cash constraints.

• Collaborate with Industry Groups

• • • Organizations like the National Venture Capital Association (NVCA) or BIO can provide updates on proposed legislation and best practices for compliance.

 

Next Steps for Startups

Section 174’s shift from immediate expensing to amortization poses real challenges for startups, especially those reliant on federal grants or operating on tight budgets. Although bipartisan support for change exists, the timeline for any permanent fix remains uncertain.

Action Items for Founders Right Now

• Plan for Higher Taxable Income

1. 1. • Especially in the first year due to the 10% amortization limit under the mid-year convention.

• Use the Accrual Method if Feasible

1. 1. • Better align grant revenue and R&D expenses, reducing adverse timing mismatches.

• Separate Federally Funded R&D

1. 1. • Remember that federally funded portions cannot generate R&D tax credits.

• • • Keep an eye on potential Section 174 fixes as part of broader tax legislation.

By proactively planning, tracking expenses meticulously, and staying informed, founders can limit the financial strain and continue to focus on growing their businesses and innovating in today’s rapidly evolving market. Contact our team to learn the latest on section 174 and how it may impact your company.