Understanding Section 174: Impact on Startups

In the realm of tax policy, very few provisions quietly reshape the financial profile of early-stage companies the way Section 174 has over the past two years. Long viewed as a backdrop to more prominent tax credits like R&D or 179 expensing, Section 174 has moved from footnote to headline—transforming what once felt like a deferrable technicality into an urgent CFO-level decision point.

For startup executives, especially in software, hardware, and technology-driven sectors, the implications are immediate and deeply strategic. Section 174 now governs how U.S. companies must capitalize and amortize research and development (R&D) costs for tax purposes. The shift, triggered by a statutory change that went into effect for tax years beginning after December 31, 2021, affects not only tax liabilities but also cash flow, runway, and earnings visibility.

In my three decades as an operational CFO guiding venture-backed companies through every stage from seed to M&A, I have rarely seen a tax rule create such widespread confusion. And yet, unlike Section 41 R&D credits or the Qualified Small Business Stock (QSBS) exemption, Section 174 carries less public awareness despite being embedded into the financial DNA of every innovation-driven startup.

This essay demystifies Section 174. It explores what the law requires, how and when to calculate affected expenses, and why founders, CFOs, and boards must actively plan around it—not reactively, but as part of their ongoing financial architecture.

What Changed—and Why It Matters

Prior to 2022, U.S. companies could immediately deduct research and experimental (R&E) expenditures under Section 174. This treatment aligned with economic reality: companies spend heavily in early years with no immediate return, and those investments are matched with contemporaneous tax deductions. This regime made intuitive and financial sense, especially in innovation economies.

But as part of the Tax Cuts and Jobs Act (TCJA) passed in 2017, a provision was included—initially overlooked in its impact—that would require companies, starting in 2022, to capitalize and amortize Section 174 expenses over five years (15 years for foreign R&D). That change, originally intended to raise revenue in outlying budget years, became effective by default when Congress failed to repeal or delay its implementation.

The result is that startups and growth-stage companies now find themselves with a dramatic reversal: rather than deducting all of their R&D expenses in the year incurred, they must spread the deduction over multiple years. The impact is significant: taxable income rises, current tax liability increases, and cash runway shortens—even if the business remains unprofitable under normal operating metrics.

What Qualifies Under Section 174

Section 174 applies to a broader set of costs than Section 41, the familiar R&D tax credit provision. While Section 41 is specific and somewhat narrow—focused on innovation, experimentation, and uncertainty—Section 174 covers all research and experimental expenditures incurred in connection with the development or improvement of a product.

This includes software development, hardware design, process improvements, and system architecture. More importantly, it applies regardless of whether the company claims an R&D tax credit. If you build software, design new tools, or engineer products, you’re likely incurring Section 174 costs, even if you’re not actively pursuing credits.

The scope includes both direct costs (engineer salaries, prototype materials, contractor fees) and certain indirect costs (allocated overhead, rent for R&D facilities, software licenses used in development). While Section 41 has more stringent qualification hurdles, Section 174 casts a wider net.

When the Amortization Hits—and How It Works

Under the new regime, domestic Section 174 costs must be capitalized and amortized over five years, using a mid-year convention. This means that in the first year, a company can only deduct one-tenth of its qualified R&D spend, then one-fifth in each of the next four years, and the final one-tenth in year six.

For foreign R&D, the amortization is stretched over 15 years, using the same mid-year convention. The distinction matters deeply for startups with offshore engineering teams or global product development centers.

Let’s say your U.S.-based startup incurs $1 million in qualified Section 174 costs in 2023. Under prior rules, that entire $1 million would have been deducted in 2023. Under the current rule, you deduct only $100,000 in 2023, and the remaining $900,000 over the next five years.

For startups that are pre-revenue or marginally profitable, this change can create taxable income out of thin air. If your book income is negative, but you’re carrying large Section 174 expenses, your tax return may now reflect positive taxable income, triggering federal and potentially state-level liabilities where none were expected.

How to Calculate 174 Costs: Practical Steps

For finance teams, the first challenge is identifying which costs fall under Section 174. This often requires coordination between finance, engineering, and legal—since many qualifying activities are not labeled “R&D” in the general ledger.

Here is a simplified approach to estimating 174 costs:

1. Identify Engineering and Technical Staff: Use payroll records to isolate employees involved in development. Allocate salaries based on time spent on qualifying activities.
2. Capture Third-Party Contractors: Include agencies, freelancers, or offshore partners who perform development or technical design work.
3. Include Supplies and Tools: Capture materials used in prototypes or testing, and software tools used exclusively for development.
4. Allocate Overhead: Apply a reasonable percentage of rent, utilities, and benefits to the R&D function based on headcount or square footage.
5. Exclude SG&A: Costs related to general administration, marketing, or customer service should not be included.

Once calculated, these totals should be tracked separately for U.S.-based and foreign-based activity. The finance team should create an amortization schedule to reflect the deduction timing and coordinate with tax preparers to ensure alignment between financial and tax reporting.

Why Startups Must Care—Even Without Profit

The most common misconception is that Section 174 only matters to profitable companies. This is false. Because certain tax adjustments can flip GAAP losses into taxable income, unprofitable startups may still owe taxes.

One of the more frustrating outcomes is when a startup generates an accounting loss—reported to investors as part of its standard operating metrics—but is forced to pay federal taxes anyway due to deferred R&D amortization. This causes confusion, impairs cash planning, and introduces governance strain if the board is unaware of the rule.

Additionally, many states conform to federal tax treatment and do not offer offsets. That means startups operating in high-tax jurisdictions like California or New York may face significant state tax bills even while burning cash.

I have advised startups where Section 174 changes created an unexpected six-figure tax liability—prompting urgent conversations with investors and tax counsel. The companies had not changed operations. Only the rules had changed. And no one had prepared.

Planning and Strategy in the 174 Era

The reality of Section 174 is now baked into the tax landscape. While legislation to reverse the rule has been introduced in Congress, it remains stalled. Until it is repealed or deferred, companies must plan as though it is permanent.

Here’s how to do that effectively:

• Model the Impact: Include 174 amortization effects in your tax provision models and cash planning. Do not assume losses equate to zero tax.
• Consider the R&D Credit: Although you must amortize R&D expenses, you can still claim Section 41 credits—providing a partial offset. Companies eligible for the startup payroll offset (up to $500,000/year as of 2023) should take full advantage.
• Enhance Documentation: Begin tracking qualifying costs with more precision. Use timesheets, project tracking software, and cost center accounting to support your position.
• Collaborate Across Teams: Tax doesn’t own this alone. Engineering, HR, and legal must contribute to the accuracy and defensibility of 174 calculations.
• Engage Early with Advisors: Do not wait until year-end to calculate 174 impact. Tax preparers need time to model amortization schedules and file properly.

174 Is a Financial Leadership Moment

The Section 174 shift is not just a compliance issue. It is a moment for financial leadership. It forces startup CFOs and founders to integrate tax awareness into their growth narrative, to bridge the distance between product development and tax planning, and to show investors that governance is not something added at exit—it is built from day one.

When startups model Section 174 accurately, prepare for the cash impact, and align their equity, compensation, and financial strategy accordingly, they de-risk their trajectory. They operate with clarity. And they demonstrate the kind of sophistication that venture capital and acquirers increasingly expect.

This is not the tax environment of 2019. This is a new regime. And those who plan accordingly will not only preserve capital—they will build trust.

Disclaimer: This blog is intended for informational purposes only and does not constitute legal, tax, or accounting advice. You should consult your own tax advisor or counsel for advice tailored to your specific situation.