An agency owner pricing overflow help compares two numbers: what a US freelancer costs per hour and what an offshore bench costs per hour. There is a third number that almost nobody puts in the quote, and since 2025 it has gotten bigger. When software is built outside the United States, the tax code makes you recover that cost over 15 years. When the same software is built inside the United States, you can deduct it in the year you pay.
This post walks through what the IRS's own documents say, what that does to a 12-person agency's first-year taxable income, and where the rule stops mattering. It is general information, not tax advice. Your CPA decides how it applies to your books.
What is the Section 174 rule for software development?
Section 174 of the Internal Revenue Code governs research or experimental expenditures, and the Code treats software development as one. In Revenue Procedure 2025-28, the IRS says that under new Section 174A(d)(3), "any amount paid or incurred in connection with the development of any software is treated as a research or experimental expenditure."
Between 2022 and 2024, the 2017 Tax Cuts and Jobs Act forced every company to capitalize those costs and amortize them: over 5 years for domestic research and 15 years for foreign research. The One, Big, Beautiful Bill Act (Public Law 119-21, signed 4 July 2025) changed only the domestic half. Revenue Procedure 2025-28, published by the IRS in September 2025, states that Section 174A now allows a deduction for domestic research or experimental expenditures paid or incurred in taxable years beginning after 31 December 2024. It also states that Section 174 now applies only to foreign research or experimental expenditures, which "continue to be amortized ratably over a 15-year period beginning with the midpoint of the taxable year" in which they are paid.
So the gap between US-built and offshore-built code went from 5 years against 15 to immediate against 15.
Who decides whether work counts as foreign?
The place the work is performed does, not the place the payer sits. IRS Notice 2023-63 defines foreign research as "any research conducted outside the United States, the Commonwealth of Puerto Rico, or any U.S. territory or other possession of the United States." It then says taxpayers must look to where the research activities are performed to decide which bucket an expenditure falls in. Revenue Procedure 2025-28 keeps the same definition, by pointing to Section 41(d)(4)(F).
The notice includes a worked example that matters here. Company C hires Company D, a contractor located in the United States, to build software. The IRS concludes the amortization period is 5 years because the research is performed in the United States, and adds: "Company C's location is not relevant for determination of the applicable § 174 amortization period."
For an agency, that is the whole rule in one line. Your US address, your US bank account and your US-signed contract do not move offshore engineering into the immediate-deduction column. Where the hands are on the keyboard does. That is the same test the IRS uses for sourcing pay, which we covered in the 1099 and W-8BEN paperwork post.
What does it do to a small agency's first year?
Picture a 12-person agency that pays a subcontractor 200,000 dollars over a year for client software builds, and assume (a big assumption, covered in the next section) that those payments are research or experimental expenditures in the agency's hands.
If the subcontractor's engineers work in the United States, Section 174A lets the agency deduct the full 200,000 dollars that year, unless it elects the 60-month amortization option the same section allows.
If the subcontractor's engineers work abroad, Section 174 applies. The 15-year schedule starts at the midpoint of the tax year, so the first year gets half of one fifteenth. That is 200,000 divided by 15, divided by 2, or about 6,667 dollars of deduction. This is my arithmetic from the Revenue Procedure's description, not an IRS example. The other 193,333 dollars is taxable profit the agency does not have in cash. The Revenue Procedure also notes that if the related property is later disposed of or abandoned, no deduction is allowed for the unamortized amount and amortization continues anyway.
In a year when the agency is profitable, the lower offshore rate has to be wide enough to cover that timing hit, and for small or irregular volumes it may not be. That is the reason to model it before you quote, not after the CPA's first call in March.
Does your agency even have these costs?
Not automatically. That is the honest hedge, and it matters. Notice 2023-63, section 6, deals with research performed under contract. It says a research provider that bears financial risk, meaning the risk of a loss if the research fails to produce the desired product, has SRE expenditures. A provider that bears no financial risk and has no right to use or exploit the resulting software generally does not, while the party paying it does.
Take a fixed-bid agency and a time-and-materials agency. The fixed-bid shop eats the overrun if the build runs long, so it looks like it bears financial risk. The time-and-materials shop whose client owns everything and pays by the hour looks like the IRS example's contractor with no risk and no rights. Which one you are is a contract question and a facts question, and it is one to put to your CPA with your actual client agreements in front of you.
Two more caveats, both from the IRS. The 2023 notice is interim guidance written before the 2025 law, and it says the Treasury and IRS intend to propose regulations. I did not find a later document that replaces its contract rules. The notice also invites comment on how to treat research performed both inside and outside the US under one contract, so a mixed team has no safe harbor on paper yet.
What should an agency owner do with this?
Three practical moves, none of which require changing who you work with.
- 1.Ask your CPA the classification question first. Do your client contracts leave you bearing financial risk, and are your build costs Section 174 or 174A costs at all? If the answer is no, the rest of this post is trivia.
- 2.Add a "where is the work performed" column to your subcontractor list. One column, per engineer, per quarter. You need it for the 1099 and W-8 file anyway, and now it also drives a tax schedule.
- 3.Price the timing cost into the quote. If you are a profitable agency and a meaningful slice of your build spend is offshore, run the first-year number above with your own figures before you decide the overflow rate.
My opinion, which I will defend on a call: a US-led pod does not fix this if the engineers sit offshore. People assume a US-signed contract or a California project manager moves the work onshore for tax purposes. The IRS's example says the opposite, and an owner who found out in March would be paying tax on a margin they already spent.
When is offshore still the right answer?
When your agency is not taxable-income positive this year, the deferral costs you little. When the build costs are not research or experimental expenditures in your hands, it costs nothing. When the offshore rate gap is wide and the work is a long-running bench, the cash math can still favour it after the timing hit. And when a client contract bars non-US personnel, the question does not come up because the subcontract should not exist.
Conversely, if you run lean, are profitable, and your overflow need is small and irregular, the tax timing may erase most of the saving. Use US-based capacity for that work and keep the offshore bench for steady, planned load.
If you are weighing overflow capacity and want the tax, contract and quality questions settled through a paid pilot before anything client-facing depends on it, see how our partner arrangement works, or tell us the scope. The margin side of any subcontract is in the economics of white-label development, and the ownership paperwork is in who owns code written by a subcontractor.
