By Jessica I. Marschall, CPA, ISA AM
The One Big Beautiful Bill Act (OBBBA) enacted significant changes to the treatment of research and development (R&D) expenditures, including software development. For tax years beginning after December 31, 2024, domestic software development costs that qualify as R&D may be immediately expensed rather than capitalized. This represents a substantial shift from the previous rules under the Tax Cuts and Jobs Act (TCJA), which required taxpayers to capitalize and amortize these costs over multiple years.
Software Development as R&D
Under the OBBBA, software development is explicitly classified as R&D for purposes of Internal Revenue Code Section 174A. This means that software development activities, when conducted domestically, fall within the scope of expenditures eligible for immediate deduction. The new provision removes the requirement to capitalize these costs, allowing taxpayers to deduct them in the same year they are incurred.
Immediate Expensing or Capitalization Option
Although immediate expensing is now the default treatment for domestic software development costs, taxpayers retain the option to capitalize and amortize these expenditures. If elected, amortization must be over a period of not less than 60 months. This provides flexibility for businesses that may wish to match costs with anticipated revenue streams or manage taxable income levels strategically.
Foreign software development costs remain subject to the prior capitalization rules. These must be amortized over a 15-year period and are not eligible for immediate deduction under the OBBB.
Relief for Costs Capitalized in 2022 through 2024
For costs incurred in tax years 2022 through 2024 that were capitalized under the TCJA’s amortization requirement, the OBBB offers several relief options:
- Continue amortizing under the original five-year schedule.
- Elect to deduct the remaining unamortized amount in full in 2025.
- Split the remaining unamortized amount evenly between 2025 and 2026.
- For qualifying small businesses, defined as those with average annual gross receipts of $31 million or less over the prior three years, the option exists to amend prior-year returns to fully deduct those expenses in the earlier years.
Why a Near Break-Even Company May Still Choose Amortization
While immediate expensing may provide an up-front tax benefit, companies operating near zero net income should carefully consider the potential advantages of amortizing software development costs.
Preserving the Value of Deductions
If a company is close to break-even, expensing a large software development cost could generate a Net Operating Loss (NOL). Current law allows NOLs to offset only up to 80 percent of taxable income in a future year, which can diminish the full value of the deduction compared to using it in a year with sufficient taxable income to absorb it completely. Amortization spreads deductions into future years when income is higher, ensuring the deduction can be used more effectively.
Income Smoothing and Stakeholder Perception
Amortization produces a more predictable expense pattern, reducing fluctuations in net income from year to year. This consistency can improve how lenders, investors, and rating agencies view the company’s financial performance.
Matching Costs with Revenue
Capitalizing and amortizing costs aligns expense recognition with the revenue the software is expected to generate over multiple years. This alignment can better reflect the economic reality of the asset’s benefit.
Preserving EBITDA
Because amortization is excluded from EBITDA calculations, capitalizing software costs helps maintain higher EBITDA in the near term. This may be important for loan covenants, investor reporting, or valuation purposes.
Tax Rate Planning
If higher corporate tax rates are anticipated in the future, either from increased profitability or legislative changes, pushing deductions into those higher-rate years can increase the overall tax savings.
Numerical Example: Expensing vs. Amortizing in a Near Break-Even Year
Facts:
- 2025 projected taxable income before software costs: $100,000
- Software development costs: $2,000,000
- Corporate tax rate: 21 percent
- Projected taxable income for 2026–2029: $1,000,000 per year
| Year | Expensing – Taxable Income After Deduction | Taxable Income (Loss Carryforward Applied) | Tax Savings This Year | Amortizing Over 5 Years – Annual Deduction | Taxable Income After Deduction | Tax Savings This Year |
| 2025 | ($1,900,000) NOL created | 0 | $21,000 (saves only on $100,000) | $400,000 | ($300,000) NOL created | $21,000 (saves only on $100,000) |
| 2026 | NOL carryforward used (limited to 80% of $1M) | $200,000 taxable | $168,000 total from carryforward over multiple years | $400,000 | $600,000 taxable | $84,000 |
| 2027 | NOL carryforward used (limited) | $200,000 taxable | — | $400,000 | $600,000 taxable | $84,000 |
| 2028 | NOL carryforward used (limited) | $200,000 taxable | — | $400,000 | $600,000 taxable | $84,000 |
| 2029 | NOL carryforward used (limited) | $200,000 taxable | — | $400,000 | $600,000 taxable | $84,000 |
Key Takeaways from the Example:
- Expensing in a low-income year produces a large NOL that is restricted in how quickly it can be used, delaying the tax benefit.
- Amortizing spreads deductions into future profitable years, ensuring full use of each dollar of deduction and producing more predictable after-tax income over time.
Strategic Considerations
The change in treatment of domestic software development costs creates an opportunity for businesses to improve cash flow and reduce current-year taxable income. However, decisions regarding whether to expense or capitalize should be made in the context of broader tax planning objectives. Businesses should also evaluate whether it is advantageous to take a catch-up deduction for previously capitalized costs or to amend prior-year returns if eligible.
Beginning in 2025, domestic software development costs that qualify as R&D under Section 174A may be immediately expensed, eliminating the capitalization requirement that existed under the TCJA. While taxpayers may still elect capitalization, the new rules provide greater flexibility and potential tax savings. For companies near break-even or with strategic financial reporting considerations, amortization may remain a preferred option. Businesses should consult with their tax advisors to determine the optimal approach for both current and prior-year costs, particularly in light of the catch-up and amendment provisions for expenses capitalized from 2022 through 2024.
