Section 174 TCJA: What Startups Need to Know in 2025

TL;DR

The Internal Revenue Service (IRS) recently provided guidance on the treatment of Research and Experimental Development (R&D) costs under Section 174 of the Tax Cuts and Jobs Act, revealing significant changes that directly affect startups in the United States. This article explores the implications of these changes, focusing on the need for startups to capitalize and amortize R&D costs over specific periods. We also discuss the potential impact on cash flow and present strategies, such as Employer of Record (EOR) services, to help startups mitigate the financial challenges posed by these regulatory changes.

Changes Under Section 174

Under the amended regulations, startups can no longer immediately expense R&D costs. Instead, they are required to capitalize and amortize these costs over a 5-year period for domestic research and a 15-year period for foreign research. This marks a significant departure from the previous practice and particularly affects startups in their development stage, where a considerable portion of operational costs is attributed to labor expenses for research, development, testing, and product iteration. The cut-off date for this accounting attribution has been kept as 31 Dec 2021.

Ammortization Schedule

The amortization schedule is now set at 10% for the first year, 20% for years 2 through 5, and 10% for the sixth year. This structured approach to amortization poses financial challenges for startups, impacting their cash flow and overall financial health.

Comparative Analysis

To illustrate the impact of these changes, we present comparative tables outlining the tax implications for R&D costs over a 5-year period, both before and after the implementation of Section 174 amendments.

Illustrative Income Statement:

Before Section 174 Changes
	USD
Total Revenue (A)	1,000,000
Total R&D Costs (Labor costs only)¹ (B)	1,000,000
Total Profit/Loss (A-B)	0
Total Tax liability (calculated at marginal tax rate)²	0
Net cash change	0

After Section 174 Changes
	Year 0	Year 1	Year 2	Year 3
Total Revenue³		1,000,000	1,200,000	1,440,000
Total R&D Costs (Labor costs only)		1,000,000	1,000,000	1,000,000
Amortized R&D Costs⁴		100,000	300,000	500,000
Total Profit/Loss		900,000	900,000	940,000
Total Tax liability (calculated at marginal tax rate)		189,000	189,000	197,400
Net cash change		-189,000	11,000	242,600
Total Cash before Year Start	1,000,000	811,000	822,000	1,064,600

Assumptions:

Average cost of developer in the United States = USD 200,000; No. of developers = 5
Marginal Corporate tax rate = 21%
Revenue is assumed to increase at a CAGR of 20%
Ammortization schedule: 10% for Y1, 20% for Y2-Y5, 10% for Y6

Financial Analysis

The illustrative Income Statement highlights a need for founders to have USD 189,000 to cover tax obligations, creating pressure on capital. To address this, founders can adjust tech development costs by strategically hiring talent, offering a way to offset the tax burden and preserve capital for their ventures.

Conclusion

In light of these regulatory changes, startup founders are encouraged to explore innovative solutions, such as EOR services, to optimize their cash flow and minimize the impact on their financial stability. By strategically navigating these cash outflows, startups can maintain their focus on product development and long-term growth.

To learn more about how Wisemonk can assist in hiring global talent and navigating compliance amid these regulatory shifts, let’s initiate a conversation.

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Frequently asked questions

What are the key changes to Section 174 of the IRS Tax Code regarding R&D costs?

Startups can no longer immediately expense R&D costs; instead, they must capitalize and amortize domestic R&D expenses over 5 years and foreign R&D expenses over 15 years, following a structured amortization schedule.

How does the new amortization schedule work under Section 174?

The amortization is set at 10% in the first year, 20% annually for years two through five, and 10% in the sixth year, spreading the deduction over longer periods and impacting cash flow.

Why do these changes pose challenges for startups?

The delayed expense recognition reduces immediate tax deductions, increasing short-term tax liabilities and cash outflows, which can strain startups’ limited capital and financial resources.

Can Employer of Record (EOR) services help startups manage the financial impact of these changes?

Yes, EOR services can help optimize hiring costs and cash flow management by strategically managing labor expenses and compliance, helping startups preserve capital amid the new tax regulations.

What is the cut-off date for R&D cost accounting under the amended Section 174 rules?

The accounting changes apply to R&D costs incurred after December 31, 2021, with costs before that date subject to prior expensing rules.

How can startups plan proactively to minimize financial strain due to Section 174 changes?

Startups should explore cost-efficient hiring strategies, optimize operational expenses, possibly leverage EOR services, and work with tax advisors to align R&D activities with amortization benefits.

Are foreign R&D costs treated differently than domestic costs under Section 174?

Yes, foreign R&D costs must be capitalized and amortized over 15 years, a much longer period compared to the 5-year amortization for domestic R&D costs, potentially affecting multinational startups differently.