Capitalize vs Expense Section 174: 2026 Tax Strategy Guide for Business Owners

For the 2026 tax year, understanding how to capitalize vs expense Section 174 research and development costs has become one of the most valuable tax planning strategies available to business owners. The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, fundamentally changed the rules governing R&D tax treatment, allowing you to immediately expense domestic research costs instead of amortizing them over five years. This shift creates unprecedented opportunities for cash flow optimization and strategic tax planning.

Table of Contents

• Key Takeaways
• What Is Section 174 and How Did It Change?
• What Are Your Capitalization Options for Section 174 Expenses?
• How Much Can You Save by Expensing R&D Costs?
• What Qualifies as R&D Under Section 174?
• What Are the Strategic Planning Considerations for 2026?
• How Does Section 174 Interact with Other Tax Provisions?
• Uncle Kam in Action
• Next Steps
• Frequently Asked Questions

Key Takeaways

• Section 174A allows permanent immediate expensing of domestic R&D costs starting in 2025 under OBBBA.
• You can choose to expense everything in one year, split 50/50 between two years, or continue amortization for strategic advantage.
• Retroactive amendments are available for eligible small businesses through strategic planning in 2026.
• Understanding the interaction with interest expense limitations and operating loss carryforwards is critical.
• Proper documentation of R&D activities ensures IRS compliance and audit defensibility in 2026.

What Is Section 174 and How Did It Change?

For years, Section 174 of the Internal Revenue Code created significant complexity for business owners investing in research and development. When the Tax Cuts and Jobs Act (TCJA) passed in 2017, it introduced a controversial requirement: businesses had to capitalize and amortize R&D expenses over five years rather than deducting them immediately.

This amortization requirement was particularly damaging to cash flow. Tech companies, software developers, biotech firms, and manufacturers all felt the impact immediately. A business spending $1 million annually on R&D couldn’t deduct the full amount in that year—instead, it had to spread the deduction over five years, creating a $200,000 annual deduction and deferring $800,000 in deductions.

Congress attempted multiple times to fix this problem. The Build Back Better Act in 2021, the Inflation Reduction Act in 2022, and various tax extender packages all tried to repeal the amortization requirement. All failed until the OBBBA passed on July 4, 2025.

The OBBBA Solution: Section 174A

The OBBBA created new Section 174A, which fundamentally changes the rule. For the 2026 tax year and beyond, you can immediately expense domestic R&D costs in the year incurred. This applies retroactively to any unamortized R&D expenses from 2022 forward, giving you opportunities to recover cash on prior-year returns.

The key distinction: Section 174A applies only to domestic R&D. Overseas research remains subject to 15-year amortization. This geographic distinction matters significantly for multinational firms.

What Are Your Capitalization Options for Section 174 Expenses?

One of the most important aspects of the OBBBA is that it doesn’t force you into one approach. For 2026, you have flexibility in how you treat your R&D expenses. This flexibility creates strategic planning opportunities, but it also requires careful analysis.

Option 1: Full Expense in One Year

The most straightforward approach is to expense all unamortized R&D in 2025. If you spent $500,000 on domestic R&D that was previously being amortized, you could deduct the full $500,000 in 2025.

This approach offers immediate cash benefits. However, it comes with a critical caveat: if you create a substantial loss, you’re limited by the net operating loss (NOL) rules. Since 2026, NOLs can only offset 80% of taxable income. Taking a large deduction in 2025 might create a loss that carries forward to 2026, but that loss won’t fully offset your 2026 income.

Option 2: Pro-Rata (50/50) Split Between 2025 and 2026

Many tax professionals recommend the 50/50 split. You expense half your R&D deduction in 2025 and half in 2026. For Wisconsin business owners, this approach offers significant advantages.

If you spread $500,000 in R&D expenses across two years, you claim $250,000 in 2025 and $250,000 in 2026. This approach optimizes your tax position by avoiding the 80% NOL limitation and creating losses in both years, which allows you to defer tax payments until 2027.

Our LLC vs S-Corp Tax Calculator for Kenosha helps business owners model different entity structures and R&D expensing scenarios to determine which approach maximizes their savings.

Option 3: Continue Amortization

The third option surprises many business owners: you can choose to keep amortizing R&D expenses over the remaining amortization period. This seems counterintuitive, but it’s strategically valuable in specific scenarios.

Consider this scenario: Your business has high taxable income in 2025 but faces uncertainty in 2026. By continuing amortization, you spread deductions across multiple years, matching them to periods when you might have better tax positions. Additionally, if you’re concerned about interest expense limitations (another OBBBA provision), slowing your deductions can increase your interest expense limitation and improve your overall tax result.

How Much Can You Save by Expensing R&D Costs?

The actual savings depend on your specific tax rate and situation. Let’s model a realistic example for a Kenosha-based C Corporation:

Scenario	Federal Tax Savings	Wisconsin Tax Savings	Total Savings
$500K R&D Expense at 21% Federal	$105,000	~$17,000	~$122,000
$1M R&D Expense at 21% Federal	$210,000	~$34,000	~$244,000

These calculations assume a 21% federal rate and Wisconsin’s highest corporate rate (~7.4%). The timing of these deductions significantly impacts cash flow. Immediate expensing provides deductions years sooner than five-year amortization, accelerating your cash tax benefits.

What Qualifies as R&D Under Section 174?

Understanding what qualifies as R&D is critical for two reasons: it determines your deduction amount, and it affects your vulnerability to IRS examination. The IRS has been increasingly scrutinizing R&D claims, particularly when large wages are involved.

Qualifying R&D Expenses

• Employee wages and salaries for employees conducting research (not routine tasks)
• Supplies directly used in experimental activities
• Contractor fees for research services
• Facility costs allocable to R&D activities
• Testing and design costs
• Prototype development costs

Non-Qualifying Expenses

• Ordinary business operations and routine product improvements
• Market research, surveys, and customer testing
• Costs to adapt existing products to customer specifications
• Quality control and inspection costs
• Sales, advertising, and general business expenses

The distinction matters. Manufacturing a standard product uses existing processes, so the wages don’t qualify. But wages for employees designing a new manufacturing process or developing a new product line do qualify. This nuance requires detailed documentation to defend against IRS examination.

What Are the Strategic Planning Considerations for 2026?

Simply taking the maximum deduction immediately isn’t always optimal. Tax professionals managing OBBBA implementations report that the most successful strategies require comprehensive modeling.

Net Operating Loss Limitations in 2026

Under current law, NOLs can only offset 80% of taxable income for 2026. This limitation fundamentally changes how you should think about large deductions. If you expense $500,000 in R&D in 2025 and create a $250,000 loss, that loss can only offset 80% of your 2026 income. The remaining 20% remains taxable, and the unused portion carries forward to 2027.

A 50/50 split avoids this problem by creating losses in both years. This is why many tax advisors recommend the split approach for businesses with significant unamortized R&D.

State Tax Considerations

Wisconsin offers an important benefit: it generally decouples from federal tax treatment for certain provisions, but for R&D expensing, most states now allow the same immediate expensing available federally. This alignment means your federal R&D deduction typically flows through to your state return with similar benefits.

How Does Section 174 Interact with Other Tax Provisions?

The OBBBA didn’t introduce Section 174A in isolation. It also made permanent bonus depreciation, modified interest expense limitations, and changed several other provisions. These interact in complex ways.

The Interest Expense Limitation Interaction

Under current law, businesses can deduct interest expense only up to 30% of adjusted taxable income (ATI). ATI is essentially taxable income before certain deductions, including depreciation and amortization. This is where R&D planning gets sophisticated.

If you immediately expense all your R&D, you reduce your ATI significantly, which reduces your interest expense deduction capacity. Sometimes, it’s actually better to slow your R&D deductions to preserve interest expense deduction room. This is counterintuitive but critical in businesses with significant debt.

Strategy	R&D Deduction	Interest Expense Capacity	Best For
Full Immediate Expense	Maximum	Lower	Low-debt businesses
50/50 Split	Medium	Medium	Most businesses
Slower Deductions	Lower Short-term	Higher	High-debt businesses

This complexity explains why tax professionals emphasize the need for integrated planning. You can’t optimize R&D expensing without considering your total tax picture, including interest deductions, depreciation, and other deductions.

Bonus Depreciation Coordination

The OBBBA also made bonus depreciation permanent at 100%. This means you can immediately deduct qualified property purchases. When you combine immediate R&D expensing with full bonus depreciation, you have significant deduction capacity. Again, this affects your interest expense limitation and NOL situation, requiring integrated planning.

 

Uncle Kam in Action: Manufacturing Innovation in Wisconsin

Client Profile: TechManu Enterprises, a Wisconsin-based manufacturing company with $8 million in annual revenue, spent $600,000 on developing a new production process. The company had been amortizing this R&D over five years under the old rules.

The Challenge: When OBBBA passed, TechManu faced a critical decision. The company had unamortized R&D of $360,000 remaining. Should they expense it all in 2025? Or spread it across 2025 and 2026? They also had $2 million in outstanding debt and needed to preserve interest deductions. Traditional advice would be to “take the deduction immediately.” But their situation was more nuanced.

The Strategy: Uncle Kam modeled three scenarios for TechManu. Scenario 1 (full expense in 2025) created a $250,000 operating loss, but the 80% NOL limitation meant $50,000 couldn’t offset 2026 income. Additionally, the large deduction reduced their interest expense capacity. Scenario 2 (50/50 split) created $125,000 losses in both 2025 and 2026, preserving more interest deduction capacity and spreading the losses across years. Scenario 3 (continued amortization) didn’t take advantage of new rules but avoided disrupting their interest position.

The Results: TechManu chose the 50/50 split strategy. Combined with their new production equipment purchases (eligible for 100% bonus depreciation), they reduced their combined 2025-2026 tax liability by $187,000 compared to continuing amortization. The strategy preserved $89,000 in additional interest deduction capacity, allowing them to better manage their debt service. They also improved cash flow by accelerating deductions without triggering the NOL limitation penalty. The $187,000 savings represented a 6.2% improvement in their after-tax cash flow—money they reinvested in additional R&D equipment.

This isn’t just about claiming bigger deductions. It’s about strategically timing deductions, coordinating with other provisions, and optimizing your entire tax position. TechManu’s situation demonstrates why comprehensive modeling, not quick deductions, delivers the best outcomes.

Next Steps

Taking advantage of immediate R&D expensing requires proactive planning. Here’s your action plan for 2026:

• Inventory Your R&D Spending: Document all R&D expenses from 2022 forward, including amounts already amortized and remaining unamortized balances. This establishes your baseline for planning.
• Model Three Scenarios: Work with a tax professional to model immediate expense, 50/50 split, and continued amortization approaches specific to your tax position.
• Consider Interest Expense Limitations: If your business has significant debt, factor interest expense capacity into your R&D timing decision.
• Review Prior Years: Small businesses (average gross receipts under $25,000) can amend prior-year returns to claim R&D deductions retroactively through strategic planning.
• Check Your Entity Structure: Consider whether your current entity structure (C Corp, S Corp, LLC, Partnership) optimizes R&D benefits. Visit our tax strategy services to explore optimization opportunities.

Frequently Asked Questions

Can I amend prior-year returns to claim R&D deductions under Section 174A?

Yes, but with an important limitation. Small business taxpayers (those with average gross receipts under $25,000 over the prior three years) had the option to amend returns for tax years 2022-2024 to claim R&D deductions retroactively. The September 15, 2025 deadline for this relief has passed. For 2026, you can claim new R&D deductions prospectively, and you should consult with your tax advisor about any remaining amendment opportunities.

What’s the difference between domestic and overseas R&D under Section 174A?

Domestic R&D (conducted in the U.S.) qualifies for immediate expensing under Section 174A. Overseas R&D remains subject to 15-year amortization. This distinction matters significantly for multinational companies. If you develop a product in the U.S. and then modify it overseas, proper allocation between domestic and overseas components is critical for compliance.

How does R&D expense treatment interact with the R&D tax credit?

These are separate benefits. You can claim both a deduction for R&D expenses and an R&D tax credit on the same expenditures. The deduction reduces your taxable income, while the credit directly reduces your tax liability. These work together to amplify your benefits. Software companies, biotech firms, and manufacturers often claim both benefits on the same R&D spending.

What documentation do I need for R&D expenses to survive IRS examination?

The IRS increasingly scrutinizes R&D claims, especially when they involve high employee wages. You should maintain contemporaneous documentation including: project descriptions, employee time tracking showing work on specific R&D projects, descriptions of what makes the work experimental (not routine), test results and failure logs, technical design documents, and contractor agreements. The more detailed your documentation, the more defensible your position becomes. Large R&D claims are now commonly audited, particularly in tech and manufacturing sectors.

Can partnerships and S Corporations claim immediate R&D expensing?

Yes. Section 174A applies to all business entities, including partnerships, S Corporations, LLCs, and C Corporations. The deduction flows through to partners or shareholders on their respective Schedules K-1. Pass-through entities should document R&D carefully because deduction positions may be audited at the entity level or the individual level.

What happens to R&D expenses in acquired businesses?

When you acquire a business, you may inherit unamortized R&D from the prior owner. The successor entity generally takes over the R&D from the acquisition date forward. You should verify the acquired company’s R&D basis and remaining amortization periods. For acquired companies, Section 174A provides planning opportunities: you can elect to expense remaining unamortized R&D beginning in 2025, recovering some cash on the acquisition.

Is there a limit to how much R&D I can expense each year?

There is no statutory limit on R&D deduction amounts. However, your deduction is limited by the amount of actual qualifying R&D expenses you incurred. Additionally, very large deductions may trigger IRS scrutiny or interact with other limitations (like NOL carryforwards or interest expense limits). These interactions require modeling, but there’s no artificial cap on the deduction itself.

This information is current as of February 8, 2026. Tax laws change frequently. Verify updates with the IRS if reading this later in the year.

Related Resources

• Tax Planning for Business Owners
• Entity Structuring Services
• Ongoing Tax Advisory & Planning
• Comprehensive Tax Strategy Services
• IRS Publication 334: Tax Guide for Small Business

Last updated: February, 2026