Navigating Internally Developed Software Costs: U.S. GAAP vs. Tax Treatment for SaaS Innovators

In the fast-paced world of Software as a Service (SaaS), where innovation drives growth and private equity (PE) or venture capital (VC) backing fuels ambitious scaling, managing the financial intricacies of internally developed software can be a critical differentiator. For tech companies reporting under U.S. GAAP, aligning accounting methods with business goals is key. However, many overlook how sharply these accounting rules can diverge from U.S. tax treatment. Those differences can impact your financial statements, valuations, tax liabilities and even investor perceptions.

It’s important to know how software development costs are treated under the two primary GAAP standards and how those treatments compare with current and evolving tax rules, especially in light of the recently enacted One Big Beautiful Bill Act (OBBBA). These differences carry real implications for SaaS companies, influencing everything from capitalization timing to tax strategy and investor readiness.

Choosing the Right GAAP Standard: ASC 350-40 vs. ASC 985-20

When accounting for software development costs, companies must first determine which U.S. GAAP standard applies: ASC 350-40 (internal use software) or ASC 985-20 (costs of software to be sold, leased or marketed). These two standards differ in scope, capitalization criteria and applicability. Selecting the right one is essential for accurate reporting.

Key differences in scope

• ASC 350-40: ASC 350-40 applies to software acquired, internally developed or modified solely for an entity’s internal needs, with no substantive plan to market it externally (ASC 350-40-15-2A). This includes certain hosted software in cloud arrangements where customers cannot take possession of the software without significant penalty or run it independently (ASC 350-40-15-4C).
• ASC 985-20: In contrast, ASC 985-20 covers costs for software intended to be sold, leased or otherwise marketed as a separate product or part of another process, whether developed internally or purchased (ASC 985-20-15-2). It applies to arrangements where customers obtain a “license” per the accounting standards as they have the right to take possession without penalty and can feasibly host the software themselves or via a third party (ASC 985-20-15-5). This may be applicable even when it is available as a hosted (or cloud-based) product.

Capitalization timing

One of the most important distinctions between the two standards lies in when capitalization begins.

• ASC 350-40: Capitalization begins during the application development stage once the preliminary stage is complete, management commits to funding and project completion is probable (ASC 350-40-25-2; ASC 350-40-25-12).
• ASC 985-20: Capitalization begins only after technological feasibility is established, typically through a detailed program design or a working model. All prior costs must be expensed as research and development (R&D) under ASC 985-20-25-1 and ASC 985-20-25-3. This higher threshold often leads to more costs being expensed upfront compared to ASC 350-40.

Which standard fits SaaS companies?

For most SaaS companies, ASC 350-40 is the better fit. While the platform is offered to customers, the software typically remains hosted by the provider, and customers don’t take possession or install it themselves. That means the software qualifies as internal use even if it supports externally facing services. Using ASC 350-40 allows for earlier capitalization, bolstering balance sheets for growth-focused companies.

Understanding U.S. GAAP Treatment Under ASC 350-40 for Internally Developed Software

Under U.S. GAAP, the accounting for costs related to software developed for internal use is guided by a staged approach, allowing for capitalization in certain phases to reflect the asset’s long-term value.

Stage 1: Preliminary project stage

During this initial phase, activities such as planning, evaluating alternatives, and formulating concepts occur. Costs incurred here are expensed as incurred since there isn’t a clear path to generating probable future economic benefit (ASC 350-40-25-1 through 25-6).

Stage 2: Application development stage

Once the project moves beyond planning and management commits to funding, certain costs may be capitalized (ASC 350-40-25-7 through 25-12). This stage includes activities such as coding and software configuration, hardware installation and system testing, including parallel processing. Capitalization during this phase helps SaaS companies present a stronger balance sheet by recognizing the software as an intangible asset, which is then amortized over its useful life (ASC 350-40-35).

Stage 3: Post implementation or operation stage

Activities following the completion of development, such as training, maintenance and upgrades do not contribute to the software’s initial functionality and are expensed as incurred (ASC 350-40-25-13 through 25-15).

U.S. Tax Treatment: A Shift Toward Capitalization and Back?

While U.S. GAAP applies a phased approach to capitalizing internally developed software costs, the U.S. tax code has historically taken a broader, more uniform stance, particularly under Internal Revenue Code (IRC) Section 174, which governs research and experimental (R&E) expenditures.

Section 174 and the TCJA Changes

Before 2022, many software development costs could be expensed immediately as R&E expenditures. However, the Tax Cuts and Jobs Act (TCJA) changed that, requiring companies to capitalize and amortize these costs for tax years beginning after December 31, 2021.

Under TCJA IRC Section 174(a) (2022-2024):

• R&E expenditures must be capitalized and amortized over five years if conducted in the U.S. or 15 years if conducted outside the U.S., starting from the midpoint of the tax year in which the expense is incurred.
• Software development expenditures were specifically deemed to constitute R&E expenditures (IRC Section 174(c)(3)).
• Software development includes a wide range of activities, from coding and testing to payments made to third-party developers, to costs incident to the development or improvement of a product (Treas. Reg. 1.174-2(a)(1)).

Unlike GAAP, there’s no staged differentiation. Nearly all R&E related expenditures were required to be capitalized, thereby increasing near-term taxable income and reducing immediate deductions. These rules applied regardless of whether the software was intended for internal use or external sale, posing challenges for SaaS companies investing in proprietary platforms.

Under OBBBA IRC Section 174A (2025 and forward)

The landscape shifted again with the passage of the OBBBA in 2025, which introduced IRC Section 174A. This new legislation restores immediate deductibility for domestic R&E expenditures, bringing relief to companies that had been burdened by the prior amortization requirement.

Key points under OBBBA IRC Section 174A:

• Domestic R&E expenditures are now fully deductible in the year incurred, starting with tax years beginning after December 31, 2024.
• This change effectively repeals the TCJA’s capitalization mandate for U.S.-based R&E expenditures.
• Foreign R&E expenditures must still be capitalized and amortized over 15 years
• The broad scope of what is considered an R&E expenditure remains unchanged.

For SaaS companies investing heavily in domestic software development, this update can improve cash flow, reduce taxable income and better align tax treatment with GAAP, at least for U.S.-based costs.

Why Key Differences Matter for Your SaaS Business

The contrast between U.S. GAAP and tax treatment of internally developed software can create book-tax differences that affect everything from your effective tax rate to cash flow planning especially with the recent legislative changes.

• Expensing vs. capitalization timing: GAAP allows expensing in preliminary and post implementation stages but capitalization during development (ASC 350-40), while tax historically required full capitalization and amortization over five years (IRC Section 174). However, under the OBBBA, domestic costs can now be expensed immediately (IRC Section 174A), reducing temporary differences and potentially simplifying deferred tax accounting for U.S.-focused SaaS firms.
• Scope of costs: GAAP focuses on direct, attributable costs in the development phase (ASC 350-40-25), whereas tax captures a wider net, including indirect costs tied to R&E activities (Treas. Reg. 1.174-2(a)(1)). The new bill maintains this broad scope but shifts to immediate deductibility for domestic R&E expenditures (IRC Section 174A).
• Amortization periods: Capitalized GAAP costs are amortized over the software’s estimated useful life, often three to five years (ASC 350-40-35), compared to the fixed five-year (or 15-year) tax amortization under old rules (IRC Section 174(d)). With the new legislation, domestic amortization is no longer required, offering a clear win for cash-strapped startups.

For PE/VC-backed SaaS firms, these nuances and the 2025 changes can influence valuation during funding rounds, compliance with debt covenants and strategic decisions on R&E investments. Mismanaging them might result in audit risks, overstated taxes, poor valuations during fundraising or suboptimal financial reporting issues that could erode investor confidence in your tech-driven growth story. The new bill’s expensing restoration could be a competitive boost, but it also highlights the need for vigilant tracking of domestic vs. foreign costs.

More Changes on the Horizon

In addition to the changing tax landscape, the Financial Accounting Standards Board (FASB) has proposed a new standard that would significantly impact software capitalization, including eliminating the concept of stages under ASC 350-40.

Weaver Can Optimize Your Approach

To navigate GAAP-tax gaps and take advantage of new opportunities under the latest legislation, companies need tailored strategies, from precise cost tracking to leveraging available credits like the Research Tax Credit (RTC) under IRC Section 41. Our team’s experience with U.S. GAAP-compliant tech companies can help ensure your internally developed software costs are handled efficiently to support both scaling and profitability. Contact us to learn how we can support your goals.

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