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DevFinOps Strategy & Planning


HOW COMPANIES CAN USE JELLYFISH TO SEIZE THE NEW SECTION 174 SOFTWARE
CAPITALIZATION OPPORTUNITY



Ryan Kuchova
May 03, 2024

Section 174 of the United States Internal Revenue Code plays a crucial role in
shaping the strategies of software companies engaged in research and
development, impacting their ability to innovate as well as their bottom line. 

The passage of Section 174 in 1954 allowed for the immediate deduction of
research and experimental expenditures. The policy, intended to encourage
innovation, stood for more than sixty years before being sharply altered by the
2017 Tax Cuts and Jobs Act. The amendment’s changes — requiring companies to
amortize these expenses over five years for domestic and 15 years for foreign
expenditures — proved unpopular among businesses, but bipartisan legislation
that promised to roll back the revisions has stalled in Congress. 

Many companies either initially ignored the changes to Section 174 or failed to
fully comply because it was too confusing and difficult to implement, hoping the
changes would eventually be reversed. But with the recent release of new
information from the IRS, Section 174 now looks like it’s here to stay.
Fortunately, the new guidance on Section 174, which clarifies and narrows its
scope, offers an opportunity for software companies capable of properly
capitalizing their costs. 

Instead of hoping for the unlikely repeal of Section 174, forward-thinking
finance leaders should now focus on deploying rigorous processes to identify and
separate capitalizable and non-capitalizable engineering efforts to reduce their
tax burden. Some CFOs may attempt to achieve this by forcing engineers to track
time or asking engineering managers to estimate what portion of their work is
capitalizable. But for Jellyfish customers, our automated DevFinOps solution
makes it possible to quickly identify capitalizable expenses, alleviating the
burden and overhead from engineering and finance teams.


WHY SOFTWARE CAPITALIZATION MATTERS

Software capitalization — an accounting practice that lists the costs of
software R&D as investments rather than expenses — is an important tool for
taxes, helping companies manage tax burdens that could otherwise obliterate cash
flow. Capitalizing and amortizing software development costs is a requirement
from the IRS for taxes, and the IRS also requires businesses to maintain
thorough documentation of their software development activities to support their
eligibility for tax benefits and avoid potential audits. 

Engineering and finance leaders understand the importance of capitalization, but
it’s incredibly difficult to accurately assess where engineers are spending
their time. Engineers often work on several projects at once, and the task of
labeling that work is made even more complicated by iterative methodologies like
Agile software development. In a 2023 PWC survey, only 38% of CFOs reported
being very confident that they were taking full advantage of R&D tax credits for
cloud investments. 

In order to more easily and accurately track the costs of engineering, software
companies are turning to DevFinOps — the integration of financial strategies and
finance teams into the operations of software development. DevFinOps seeks to
measure how much a new product or feature costs to develop and maintain, as well
as whether the team it’s providing the expected return on investment. The data
can facilitate strategic product and personnel decisions — and help more
accurately capitalize costs to improve a company’s bottom line. With the right
tools, DevFinOps can also improve efficiency; the right tools can automate many
manual, time-consuming processes and lead to more accurate results.


HOW JELLYFISH HELPS COMPANIES SEIZE THE SECTION 174 OPPORTUNITY

Historically, sourcing data for cost capitalization involved frustrated
engineers manually logging hours or engineering leaders making estimates on work
allocation based on their team’s structure and roles. Both of these methods are
painful for those doing the manual work, and the results are often wildly
inaccurate. Cost capitalization could also become a source of friction between
the engineering and finance organizations: engineers and their managers push
back against the request to log their hours, while finance teams are frustrated
by the inaccurate information or lack of information entirely.

At Jellyfish, we shine a light into this black box. Our platform captures
workflow data like pull requests or code commits from Jira and other tools
engineers use on a daily basis. Jellyfish identifies what engineers are spending
their time on, then automatically allocates the work across the various
engineering projects, delivering a granular report of capitalizable time in
context. 

That data is particularly valuable as companies adjust to the new IRS guidance
for Section 174. The updates to Section 174 make it more difficult for companies
to deduct those expenses, particularly when working with overseas engineers —
capitalizing those engineering costs over a 15-year period may significantly
increase a company’s tax burden.


What do those changes look like in practice? Prior to Section 174’s mandatory
capitalization requirements, a company with $10 million in taxable income, $2
million in administrative wages and $3 million in software development wages
would have been able to claim a $5 million deduction and pay $1,050,000 in
taxes. With the new changes, the same company would only be able to deduct $2.3
million in wages, increasing their taxes to $1,617,000 — if they use foreign
software developers, the tax bill balloons further to $1,659,000.

The new guidance from the IRS emphasizes the importance of categorizing software
development work and properly identifying the percentage of that work that is
capitalizable. With Jellyfish, companies can automatically visualize and
understand capitalizable R&D expenses, rather than relying on time cards and
guesswork — or an unlikely repeal in Congress. Companies that use Jellyfish to
capitalize their software development expenses will gain a competitive advantage
— and happier engineering and finance teams — as they save time and file taxes
with confidence.

Jellyfish offers this information as general guidance only and does not offer
legal advice, tax advice, accounting services, or investment advice. Please
consult your own tax, legal, or accounting advisor before making any
transactions.


DIVE DEEPER WITH JELLYFISH CONTENT

Post

ENGINEERING METRICS: HOW TO COMMUNICATE WITH YOUR BOARD OF DIRECTORS

Learn more
Post

Q&A WITH TAX SPECIALIST BILL BARNES ON SECTION 174, AUDITS, AND SOFTWARE
CAPITALIZATION

Learn more
Post

3 THINGS THAT KEEP ENGINEERING MANAGERS UP AT NIGHT

Learn more


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