Prototype & Software Development Tax: Sections 174 and 174A

Building a prototype creates expenses before a startup knows whether the product will succeed. The tax treatment depends on the type of cost, the year, where research occurs, and the applicable elections. Philip Falco, Attorney & CPA, helps connect development contracts and accounting records with tax planning and return preparation.

Domestic Research Rules Changed for Years Beginning After 2024

IRC §174A generally permits a current deduction for qualifying domestic research or experimental expenditures paid or incurred in tax years beginning after December 31, 2024. It also provides an elective capitalization-and-amortization approach. Software development is expressly addressed. Read §174A before assuming that older five-year domestic capitalization guidance still controls current spending.

The statute does not make every startup payment an immediate research deduction. Equipment, acquired assets, ordinary operations, and other expenditures can require different treatment. Review the actual activity and costs, including whether the taxpayer is entitled to use the provision.

Foreign Research Requires Separate Treatment

Under §174, qualifying foreign research expenditures generally remain subject to 15-year amortization beginning at the midpoint of the tax year. Do not determine location solely from the vendor’s mailing address or the currency on the invoice. Establish where the underlying work was performed and retain support for mixed-location projects.

Earlier Capitalized Costs Need Their Own Schedule

Costs capitalized under the rules applicable to 2022–2024 tax years should not simply disappear from the ledger when current-year treatment changes. Transition provisions, elections, and accounting-method procedures may affect remaining balances. Some small-business relief involved specific eligibility conditions and filing deadlines. At a September 2026 review, do not assume that an earlier election window remains open.

The IRS guidance in Revenue Procedure 2025-28 addresses implementation and transition procedures. Review the taxpayer’s year-end, filing history, elections, extensions, and any later guidance before selecting a correction or recovery approach.

Keep Project-Level Support

• Describe the development objective and the work actually performed.
• Separate domestic and foreign activity using reliable records.
• Retain vendor agreements, statements of work, invoices, and payment evidence.
• Track payroll and contractor costs consistently with project activity.
• Identify equipment, licenses, purchased technology, and other costs requiring separate analysis.
• Maintain beginning balances, additions, amortization, deductions, and elections by tax year.

A label such as “engineering” or “R&D” in the accounting system is a starting point, not a tax conclusion. Review the substance of the work and allocation method. Agreements about IP rights and financial risk may matter to the broader analysis.

A Research Deduction Is Different From a Research Credit

Qualification under the research-credit rules requires a separate analysis. A deduction for development costs does not establish credit eligibility. Review the activities, documentation, funding arrangements, applicable limitations, and coordination rules before claiming a credit. See IRS research-credit information.

Payroll-tax credit opportunities for eligible small businesses also require separate qualification and timely elections. Do not include an anticipated credit as available cash in the budget before the claim and timing have been evaluated.

Connect Tax Treatment to Runway

A tax deduction does not refund the full cost of a prototype. Losses, entity classification, limitations, and the timing of actual tax payments affect the cash result. Maintain separate book and tax schedules and reflect realistic tax assumptions in cash forecasts and financial reports.

Bring the Development History

For review, provide prior returns, capitalization schedules, project descriptions, developer locations, contracts, payroll reports, accounting exports, and filed elections. Identify foreign activity and any costs already deducted or amortized. Coordinate the result with business tax preparation and the financial information used in investor diligence.