Section 174 Changes for Startups: Payroll Credit, 280C, Form 3115

The One Big Beautiful Bill Act restored immediate expensing of domestic research and experimental costs for tax years beginning after December 31, 2024, which means the Section 174 changes for startups filing 2025 returns reverse the five-year amortization regime that squeezed cash flow from 2022 through 2024.¹ Smaller startups can also amend 2022 and 2023 returns to recover deductions they were forced to spread out. Foreign research spending is a different story: it still has to be amortized over 15 years.

What the New Law Does for 2025 Returns

From 2022 through 2024, every business had to capitalize domestic research costs over five years and foreign research costs over fifteen, with a mid-year convention that allowed only about 10% of a domestic expense to be deducted in the first year. That reversed roughly 70 years of policy that let companies deduct research costs immediately.

The One Big Beautiful Bill Act (Pub. L. 119-21), signed July 4, 2025, created new Section 174A, which restores immediate expensing for domestic research and experimental spending starting with the 2025 tax year.¹ If your startup spends $500,000 on domestic product development in 2025, you deduct $500,000 that year instead of spreading it across six calendar years.

Retroactive Relief for 2022 and 2023

The new law includes a retroactive window aimed at smaller companies. Businesses with average annual gross receipts under $31 million can amend their 2022 and 2023 returns to claim full immediate expensing of domestic R&E costs that were originally amortized. The statutory deadline for filing those amended returns runs through July 4, 2026, though earlier cutoffs may apply in certain election scenarios.

Larger startups that don’t qualify for the amended-return path have a different mechanism. Prior amortized Section 174 expenses from 2022 through 2024 can be accelerated in 2025 to line up with the restored expensing treatment. If your startup capitalized meaningful development costs over those years, model both paths before filing. The one that produces the largest refund or current-year deduction depends on your historical spending pattern and your projected 2025 taxable income.

Foreign Research Is Still Amortized Over 15 Years

The restoration applies only to domestic research. If your startup pays engineers overseas, contracts with a foreign development shop, or runs experiments outside the United States, those costs still fall under Section 174’s amortization rules. Foreign research expenditures must be capitalized and recovered ratably over 15 years, starting at the midpoint of the tax year.¹

The mid-year convention gives you a half-year of amortization in year one regardless of when the expense was paid. For foreign spending, that works out to roughly 3.33% of the cost in the first year, with the remainder spread evenly over the next fourteen and a half years. The same $200,000 is fully deductible in 2025 if spent domestically and produces a first-year deduction of about $6,667 if spent abroad.

One more trap on the foreign side: if you abandon a foreign research project mid-amortization, Section 174(d) prohibits any deduction or loss on the unrecovered balance. The schedule continues as if the project were still alive.¹ Factor that into any decision about keeping offshore work going on a product line you’re thinking about killing.

What Qualifies as Research and Experimental Spending

Section 174 reaches wages for employees doing research work, supplies consumed during development, fees paid to outside contractors for technical services, and a reasonable share of overhead like rent and utilities allocated to the research function. For most startups, employee compensation is the largest category by a wide margin.

Software Development, Before and After Launch

IRS guidance treats software development as a research activity, so every phase of building or upgrading software falls under these rules.² Covered activities include planning and documenting software requirements, designing the architecture, building prototypes or models, writing and converting source code, and testing to fix defects identified during development. This applies whether the software is built for internal use or for sale.

The line moves once the product ships. After software is placed in service (for internal tools) or ready for sale or licensing (for commercial products), routine maintenance and bug fixes, employee training, data conversion, and installation are no longer Section 174 costs.² A bug fix during development is a research expense; the same fix after launch is not. Engineering teams need time-tracking granular enough to draw that line, because the tax treatment of the same person doing the same work changes depending on where the product sits in its lifecycle.

What Doesn’t Count

Treasury regulations exclude several categories from Section 174:³

Quality control testing of individual units to see whether they meet specifications. Testing whether the product design itself works does qualify.
Market research and consumer surveys.
Efficiency surveys and management studies.
Acquiring someone else’s patent or process.
Research funded by another party when you don’t retain substantial rights to the results.

Over-capitalizing ordinary business costs as research delays deductions you could have taken immediately. Under-capitalizing is worse: it creates an underpayment, and the IRS applies a 20% accuracy-related penalty for negligence or a substantial understatement.⁴

The Payroll Tax Credit Most Startups Miss

For pre-revenue startups, the single most valuable R&D incentive is also the one most often overlooked. Under Section 41(h), a qualified small business can elect to apply up to $500,000 of its R&D tax credit against the employer portion of Social Security tax instead of against income tax.⁵ A startup with no income tax liability can’t use an income tax credit in the near term. The payroll election converts it into cash savings on deposits you’re already making.

Two tests have to be met:

Gross receipts for the tax year must be under $5 million.
You cannot have had gross receipts in any tax year before the five-year period ending with the current year. A startup founded in 2022 that first earned revenue in 2023 could qualify through 2027.

The $500,000 cap reflects a $250,000 increase enacted by the Inflation Reduction Act for tax years beginning after 2022.⁵ The election must be made on the original return by the filing deadline, including extensions. Payroll tax savings begin in the quarter after the return is filed.

The 280C Election: Easy to Miss, Impossible to Fix

Section 174 governs how you deduct research costs. Section 41 gives you a credit against tax owed. Federal law doesn’t let you benefit twice from the same dollar, so Section 280C makes you choose. Under the default rule, your deductible research expenses are reduced by the full amount of the credit you claim. The alternative is a reduced credit election: keep the full deduction, take a credit reduced by the credit amount multiplied by the corporate tax rate (currently 21%).⁶ For a startup expecting to sit in a low bracket for years, the reduced credit election often wins, because it preserves the full deduction and sacrifices only a fraction of the credit.

The election must be made on your original, timely filed return (including extensions) for the year you claim the credit. Once made, it’s irrevocable, and the IRS will not accept it on an amended return.⁷ If your startup has any R&D credit activity, put this on the pre-filing checklist every year.

How You Actually Change Your Method: Form 3115

Startups changing their accounting method for research expenditures (whether catching up on prior amortization or claiming retroactive expensing under the new law) use Form 3115, Application for Change in Accounting Method. The IRS treats this as an automatic consent change under designated change number (DCN) 265, so there’s no prior approval needed and no user fee.⁸

You file two copies. The original goes with your timely filed federal return (including extensions) for the year of change. A signed duplicate is mailed to the IRS Ogden, UT address no later than the date you file the return.⁹

The change produces a Section 481(a) adjustment to keep income from being counted twice or missed in the transition. A negative adjustment (you’re catching up on deductions you should have taken) is claimed in full in the year of change. A positive adjustment (you deducted too much in prior years) is spread over four years.¹⁰ Startups moving from forced amortization to restored expensing will usually see a negative adjustment, which means a single-year catch-up deduction for the unamortized balance.

One state-level caution worth flagging: not every state follows federal Section 174 automatically. States with fixed-date conformity or their own R&E rules may still require amortization even after the federal restoration. If your startup operates in multiple states or employs people outside your home state, confirm each state’s treatment before filing rather than during an audit.

1
Office of the Law Revision Counsel. 26 USC 174 – Amortization of Research and Experimental Expenditures
2
Internal Revenue Service. Notice 2023-63 – Guidance on Amortization of Specified Research or Experimental Expenditures
3
eCFR. 26 CFR 1.174-2 – Definition of Research and Experimental Expenditures
4
Internal Revenue Service. Accuracy-Related Penalty
5
Office of the Law Revision Counsel. 26 USC 41 – Credit for Increasing Research Activities
6
Office of the Law Revision Counsel. 26 USC 280C – Certain Expenses for Which Credits Are Allowable
7
Internal Revenue Service. Amended Returns/Refund Claims Containing Invalid IRC 280C(c)(3) Elections
8
Internal Revenue Service. Instructions for Form 3115
9
Internal Revenue Service. Where to File Form 3115
10
Internal Revenue Service. 4.11.6 Changes in Accounting Methods