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Many startup and tech company owners struggle to understand the value of R&D Capitalization. For some, it’s just another financial term that doesn’t apply to their business. For others, it sounds promising, but they can’t quite grasp how it works. If these descriptions sound familiar, you’re not alone. Getting a grasp on R&D Capitalization is vital to your business’s bottom line to get through the dreaded startup phase and reach stability as soon as possible. This article will break down the ins and outs of R&D Capitalization, especially as it relates to startups and tech companies.
As you read, you’ll uncover how R&D Capitalization can help improve your business’s financial health and boost your chances of attracting investors. At Haven, our accounting services for small businesses can help you achieve your goals by keeping you organized and compliant so you can focus on what matters, growing your business.
Table of Contents
What is R&D Capitalization?
R&D Capitalization is the process of turning research and development (R&D) expenses into assets on your balance sheet, rather than deducting them as immediate costs on your profit and loss (P&L) statement. This accounting treatment reflects the concept that investments in innovation, such as developing new products or technologies, can have long-term value and future income potential.
Why Capitalize R&D?
The basic idea is simple: if your company is building something that will deliver value down the line, those development costs aren’t just short-term expenses, they’re investments. So, instead of hitting your bottom line all at once, they’re amortized over time, allowing you to match the cost of development with the revenue it generates in future years. This is especially useful for startups and tech companies that are investing heavily in innovation and may not yet be profitable.
GAAP vs IFRS: Two Views on R&D
Under GAAP (Generally Accepted Accounting Principles)
In the U.S., companies usually expense R&D costs as they occur. This leads to volatile earnings, especially in early-stage companies, and can distort return metrics like ROA (Return on Assets) and ROIC (Return on Invested Capital). Capitalization is only allowed in minimal scenarios, such as software development during specific project phases.
Under IFRS (International Financial Reporting Standards)
The rules are more flexible. Once a project meets specific criteria (such as technical feasibility and future economic benefits), companies can capitalize on development costs. That means part of the R&D spend can appear as an asset, improving profitability metrics and reflecting the longer-term nature of innovation investments.
Tax Perspective: Post-2021 Capitalization Rules in the U.S.
Things changed drastically with the 2017 Tax Cuts and Jobs Act (TCJA). Beginning in 2022, businesses are no longer allowed to deduct 100% of R&D costs upfront for tax purposes.
How It Works Now
U.S.-based R&D must be capitalized and amortized over a period of 5 years. Foreign-based R&D must be capitalized and amortized over a 15-year period. So instead of deducting $1M in R&D this year, you deduct only $100K (or $200K in later years). This creates what’s known as "phantom income"; you show a profit for tax purposes, even though you're operating at a loss.
Capitalized vs. Non-Capitalized Costs
Capitalized R&D costs include: software development (in production phase), product engineering after feasibility is proven, and patent application costs. Non-capitalized R&D includes:
Early-stage research
Market testing
Consumer surveys
Admin
General overhead
What Might Change in 2025?
There’s a possible reprieve on the horizon. The Tax Relief for American Families and Workers Act, introduced in 2024, would retroactively allow full R&D expensing through 2025 for U.S.-based expenses. This means you could amend 2022–2024 tax returns to deduct all qualified R&D. Foreign R&D would still require 15-year amortization. This bill has not yet passed into law (as of December 2024).
Innovation Meets Accounting
R&D capitalization reflects the idea that innovation is an investment, but depending on your accounting standards and where you operate, it can seriously impact profitability, taxes, and funding runway. Whether you're a founder mapping out your budget or a CFO preparing financials, understanding how capitalization works can help you align your tax strategy with your innovation goals and avoid surprise tax bills along the way.
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How Does R&D Capitalization Work?
R&D capitalization refers to how companies treat research and development expenses for tax purposes. Historically, businesses could deduct R&D expenses immediately. Starting with the 2022 tax season, companies must capitalize research and development (R&D) costs and amortize them over five years. This change can significantly impact innovation-driven startups, software companies, and tech firms by creating a mismatch between a company’s financial reality and its taxable income.
How Does R&D Capitalization Work?
When a company incurs research and development (R&D) expenses, it must capitalize the costs and amortize them over five years. This means the firm can only deduct a fraction of the costs in the year they are incurred. R&D expenses incurred in foreign countries must be amortized over a 15-year period. This new treatment can significantly impact a company’s cash flow and taxes, even if the firm is operating at a loss.
Real-World Example of R&D Capitalization
To understand how R&D capitalization affects businesses, it is helpful to examine an example. Let’s say your startup has a revenue of $1 million and incurs $1.5 million in R&D expenses to develop a new software product. Under the old rules, you could deduct the entire $1.5 million upfront, resulting in a net taxable income of -$500,000 and no taxes owed. Under the new rules, you can only deduct $300,000 (1/5 of $1.5 million) in the first year, resulting in a taxable income of $700,000 and tax liability of $147,000. Even though your company is operating at a $500,000 loss, you still owe nearly $150,000 in taxes. This creates a mismatch between economic reality and taxable income, often referred to as “phantom income.”
The Impacts of R&D Capitalization
R&D capitalization rules don’t just change your tax form, they change how you budget, plan, and fund your growth. Even companies operating at a loss can face unexpected tax liabilities, forcing founders to rethink how much they invest in product development, and where. As Congress continues to debate potential reversals or revisions to these rules, it’s smart to work with a tax professional who understands the implications for your specific business model. If you’re planning heavy R&D investments in the coming year, now’s the time to run the numbers, not just on product ROI, but on tax impact too.
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Benefits of R&D Capitalization for Startups & Tech Companies
Research and development (R&D) can be a significant expense for startups and tech companies, especially those creating software products. The costs incurred can significantly impact a business’s bottom line, especially if the company has no meaningful revenue to offset the losses. Fortunately, accounting rules permit certain research and development (R&D) costs to be capitalized rather than expensed.
This means that instead of immediately impacting a business’s net income, the costs can be recorded as an asset and amortized over time. This is a more accurate representation of how the costs will impact the business financially. Capitalizing on R&D can help startups and tech companies show investors and other stakeholders a clearer picture of their profitability.
More Accurate Profitability Assessment
Revenues should be recognised in the same period as the expenses incurred to generate them. But here’s the challenge. Software R&D is front-loaded. You might spend hundreds of thousands (or millions) developing a product today that won’t start generating meaningful revenue for a year or more. If you expense all that development cost immediately, your financials will show steep losses in the build phase, even if your company is healthy and future-facing. Capitalizing R&D solves this by aligning costs with the income they help generate.
A Clearer Path to Profitability
Instead of expensing everything upfront, you record those development costs as an intangible asset on your balance sheet. Then you amortise them over a period of time (typically 5 years), spreading out the cost to better reflect how the asset delivers value. This provides stakeholders with a more accurate understanding of your profitability trajectory.
Boosted Net Income and EBITDA
Because capitalized R&D is moved off your income statement (at least initially), your operating expenses are lower, which translates into:
Higher net income
Higher EBITDA
More substantial gross and operating margins
This can make a big difference when you're seeking investment, applying for credit, or positioning your startup for acquisition. Investors and acquirers often use profitability metrics, such as EBITDA, to assess valuation, and a capitalized approach can significantly improve those optics.
Enhanced Financial Ratios
Capitalization can also positively impact key ratios such as:
Return on Assets (ROA): Since R&D is now an asset, the ratio may appear firmer due to improved net income.
Return on Equity (ROE): Better profitability leads to higher returns for shareholders.
Asset Turnover Ratios: With R&D sitting on the balance sheet, you show a larger asset base that’s contributing to revenue over time.
These metrics are vital to institutional investors, who often compare your startup to industry benchmarks or assess operational efficiency.
Smoother Cash Flow Planning
While R&D capitalization doesn't change how much you're spending in real cash terms, it helps make internal budgeting and forecasting more predictable. By deferring some expense recognition, you're better able to model future margins, cash runway, and return on investment, critical for early-stage startups managing finite funding.
Credibility with Investors and Auditors
When done correctly and in compliance with GAAP (ASC 350 or ASC 985), R&D capitalization signals that:
You’re taking financial reporting seriously
You understand long-term value creation
You’re managing your intangible assets strategically
This builds trust with sophisticated investors who want to see that you’re investing in R&D intelligently, not recklessly.
GAAP Requirements for R&D Capitalization
Research and development (R&D) capitalization under Generally Accepted Accounting Principles (GAAP) is a key financial concept that can shape how your company reports profits, calculates return on investment (ROI), and attracts investors. But it's not always straightforward, especially when it comes to software development. Let's break it down.
Capitalizing R&D: The Basics
GAAP generally requires companies to expense most R&D costs as incurred, meaning they hit your P&L right away. But there's an essential exception for software development, and it depends heavily on what kind of software you're building and where you are in the development lifecycle. There are two paths:
Internal-use software (used by your team, like admin dashboards or internal tools)
External (marketed) software (sold or licensed to customers)
The type of software determines when you can start capitalizing costs, and when you can’t.
Internal-Use Software: ASC Topic 350
Applies to: Tools your team uses (think CRM dashboards, admin portals, or internal data pipelines) Under ASC Topic 350, GAAP divides internal software development into three stages:
1. Preliminary Project Stage – Expense It
This is your “planning and prototyping” phase. Any brainstorming, tech evaluation, or concept sketching must be expensed; no capitalization allowed.
2. Application Development Stage – Capitalize It
Once you begin coding, testing, and configuration, you can start capitalizing on qualifying costs. That includes:
Engineers’ salaries are directly tied to the project
Third-party developer costs
Software licenses used in development
Necessary materials and tools
3. Post-Implementation Stage – Expense It Again
Once the tool is ready for use internally, all maintenance, updates, or bug fixes must be expensed. Even if you’re improving it later, those post-implementation costs generally don’t qualify for capitalization.
External (Marketed) Software: ASC Topic 985
Applies to: Software you plan to sell or offer as a SaaS product. Here, the capitalization rules follow a similar lifecycle, but with one big difference: “Technological feasibility” is the pivot point.
1. Planning Stage: Expense It
Design, research, and prototyping? That’s still too early. These are considered upfront R&D costs and must be expensed immediately.
2. Development Stage: Capitalize After Feasibility
You can only capitalize development costs after the software is deemed technologically feasible. That means you’ve proven that:
The concept works (usually via a working prototype or proof of concept)
There’s reasonable certainty that the product can be completed and used
From this point until the product is ready for general release, eligible costs (coding, testing, dev tools, labour) can be capitalized.
3. Post-Release Stage: Expense It
Once the product is available for sale, all ongoing work, such as bug fixes, routine upgrades, or adding new features, is expensed as incurred again. Yes, even if you're launching new modules in your SaaS platform.
Note: GAAP is strict, capitalization windows are narrow, and anything that doesn’t directly contribute to the finished, shippable version likely won’t qualify.
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Should a Startup or Tech Company Capitalize Its R&D Costs?
It depends mainly on project size and timing. If you're working on a big product with clear development phases, capitalizing costs can boost your reported profits by spreading expenses over time instead of hitting your P&L all at once. That’s great if you care about net income, EBITDA, or impressing investors.
But it’s not cash savings. You’re still spending the money, just showing it differently on your financials. And if you build fast (like most startups), the capitalization window is tiny. You can only capitalize after hitting "technological feasibility" and before launch. That may be just a few weeks. If tracking isn’t worth the hassle, just expense it. Only capitalize when it’s a big project, and you’re ready to track it properly. Otherwise, keep it simple and focus on building something people want.
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R&D Tax Credits for Architects
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Let your business take flight while Haven manages your financial runway. Built by founders for founders, we handle everything from daily bookkeeping to complex tax filings and R&D credits that put cash back in your pocket, as well as fractional CFO services. Join 400+ startups who've saved millions in tax credits, countless hours of administrative work, and never missed a filing deadline - all while accessing 24/7 Slack support from CPAs who understand the unique challenges of growing businesses. Book a call today to learn how our dedicated team can help you focus on building rather than bookkeeping.