A California software company pays developers in San Francisco and overseas to build the same product. Both teams do similar work, but their costs may receive very different federal tax treatment. Under Section 174A, software development tax deductions now depend heavily on where the work is performed.
For tax years beginning after December 31, 2024, qualifying domestic research expenses can generally be deducted immediately. Foreign research expenses remain subject to 15-year amortization.
For software founders and CFOs, the distinction affects taxable income, cash flow planning, and how development spending should be documented. Here’s what to review before closing the books for 2026.
Yes. Qualifying domestic software development expenses can generally be deducted in the year they are paid or incurred under Section 174A. The change applies to tax years beginning after December 31, 2024.
That reverses a costly timing rule introduced in 2022.
From 2022 through 2024, businesses generally had to capitalize research and experimental expenses, including software development costs. Instead of deducting the full amount immediately, they spread deductions over five years for domestic research or 15 years for foreign research.
Capitalization means recording an expense for tax purposes and recovering its cost over time. Amortization is that gradual recovery.
Section 174A restores immediate deductions for qualifying domestic expenses. Companies may alternatively elect to capitalize and amortize those costs over at least 60 months, beginning when they first realize benefits.
The IRS explanation of domestic research deductions confirms these options.
For software companies investing heavily in development, the change can significantly affect when expenses reduce taxable income. It does not mean every development dollar automatically qualifies.
Software development costs generally fall within the research expenditure rules when they relate to qualifying development activities. The key is identifying what the company actually paid for, rather than relying on how an expense was labeled in its accounting system.
Potentially qualifying costs include:
Not every technology expense belongs in the same category.
Routine software maintenance, general administrative work, employee training, and activities outside the applicable development definitions may require different treatment.
Consider a SaaS company that employs engineers to build a new analytics feature while another team handles customer support and routine system maintenance.
Both teams may be recorded under technology expenses. But their work serves different purposes, and the costs may need to be separated for tax reporting.
This is where documentation matters. Payroll records, contractor invoices, project descriptions, and development timelines can help establish which activities generated the expenses.
A general ledger account labeled “R&D” is not, by itself, proof that every expense qualifies. Maintaining clean financial records makes it easier to identify development costs, support deductions, and distinguish qualifying activities from routine operating expenses.
Qualifying domestic research expenditures generally receive immediate deduction treatment under Section 174A. Foreign research expenditures remain subject to capitalization and 15-year amortization under Section 174.
Consider a California SaaS company with the following development spending in 2026:
Development activity | Annual spending | General federal tax treatment |
Software engineering performed in California | $600,000 | Potential current deduction |
Software engineering performed in India | $400,000 | Generally amortized over 15 years |
Total | $1,000,000 | Different treatment based on location |
Illustrative amounts – Actual treatment depends on the nature of the activities and applicable tax rules.
The company may pay both teams from its California headquarters. That does not make all $1 million domestic research spending.
The location where the research or development work is performed is central to determining whether expenditures are domestic or foreign.
For foreign research costs, the 15-year amortization period generally begins at the midpoint of the tax year in which the costs are paid or incurred.
For software companies with overseas teams, payroll and contractor costs are often grouped by department rather than work location. Before filing, companies should review these expenses by location, activity, and entity to ensure the correct tax treatment.
Location also matters beyond R&D deductions. Companies with developers working across U.S. states should consider multi-state tax nexus for software companies, since employee locations can create separate state tax obligations.
Companies may have options to recover remaining domestic research costs capitalized under the earlier Section 174 rules. However, the appropriate treatment depends on eligibility, prior filings, and the applicable transition provisions.
Between 2022 and 2024, businesses generally had to capitalize domestic software development expenditures and recover them over five years.
The 2025 legislation introduced transition options for previously capitalized domestic expenses.
Under Revenue Procedure 2025-28, eligible taxpayers received options to deduct remaining unamortized domestic research costs in their first tax year beginning after December 31, 2024, or spread the recovery over that year and the following year. Certain eligible small businesses also received options to apply the new rules retroactively to earlier tax years.
For a calendar-year company, these transition decisions generally began with 2025, not 2026. By October 2026, the priority is to review which elections or methods were adopted, whether earlier returns require attention, and how any remaining deductions affect the 2026 tax position.
Foreign research costs remain subject to separate rules and generally do not receive the same accelerated recovery treatment.
A Section 174A deduction reduces taxable income. An R&D tax credit generally reduces tax liability, subject to applicable limitations. The two benefits operate differently and have separate eligibility requirements.
Suppose a software company has $500,000 in qualifying domestic research expenditures.
If the entire amount is deductible, the deduction reduces taxable income by $500,000. The actual tax benefit depends on the company’s tax circumstances and applicable rates.
The R&D tax credit under Section 41 has a narrower eligibility test. A software company may deduct qualifying development expenses under Section 174A without meeting the additional requirements for a credit, such as demonstrating technological uncertainty and a process of experimentation. Routine development work may therefore receive different treatment under the two provisions.
Companies claiming both benefits must also coordinate the deduction and credit calculations under Section 280C. Depending on the applicable election, claiming a research credit can require a reduction in the related deduction. That is why the two benefits should be evaluated together, not calculated independently.
The IRS instructions for Form 6765 explain the research credit requirements and related coordination rules.
September 2026 IRS guidance updated how businesses can obtain automatic approval for certain accounting-method changes involving research expenses. It did not create the Section 174A deduction, which became law in 2025.
Under Revenue Procedure 2026-32, the IRS revised procedures for companies changing how they account for research expenditures under Sections 174 and 174A.
For software companies, this matters when reviewing the transition from mandatory capitalization to the newer domestic deduction rules. Depending on their prior filings and chosen tax treatment, businesses may need to evaluate Form 3115 or another applicable procedure.
Changing an expense category in accounting software is not the same as changing a federal tax accounting method. Companies should confirm the correct procedure before preparing their returns.
Before finalizing 2026 development expenses, software companies should work through five questions.
For companies with development teams in multiple countries, the review should also consider intercompany arrangements and how development expenses are allocated.
The objective is not simply to maximize deductions. It is to apply the correct treatment, support the amounts claimed, and avoid unexpected adjustments during tax preparation.
Software development tax deductions become more complicated when engineering teams operate across countries or earlier research costs remain on the books. Getting the treatment right requires understanding both the development activity and the company’s broader tax position.
ASAM LLP has served U.S. and international businesses since 1986, including more than 13 years supporting a dual-listed international software and IT consulting group with U.S. accounting, tax, and intercompany matters. Our partner-led team helps software and technology companies coordinate development expense treatment with broader tax planning.
Have questions about your company’s U.S. or offshore development costs? Contact Vivian Ni, CPA, at vivian.ni@asamllp.cpa or +1 (415) 788-2371.
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