Hardware Startups: Deducting Prototypes, Tooling and Engineering

What can a hardware startup deduct this year under section 174A?

Research done in the US is deducted in the year it is paid or incurred. Research done abroad is spread over 15 years. Tooling and equipment are depreciated, and production units are inventory.

Section 174A (Public Law 119-21, sec. 70302) covers tax years beginning after December 31, 2024. Research means work to remove uncertainty about how to make a product or its right design (26 CFR 1.174-2(a)(1)). Qualifying US costs include engineer pay (with stock-based pay and payroll taxes), materials used up, prototypes, depreciation of research equipment, rent of labs and equipment, patent filing costs and research travel. Interest and general administration do not count (Notice 2023-63, sec. 4.03). That notice is interim guidance written for the old section 174; no proposed regulations yet define research under section 174A.

A case stops being simple when work happens in two countries, a contract manufacturer's invoice mixes engineering, tooling and units, the company elects to amortize, or earlier years were filed under the old rules. Gather payroll by person and location, every contract manufacturer and foundry invoice, tooling agreements, and the date the design was frozen. States choose whether to follow section 174A; check each one where the company files.

Which costs are research, equipment or inventory?

Classify each cost by what the work was and where it was done, not by who sent the invoice.

Are prototypes and EVT or DVT builds research or inventory?

Prototypes built to find out whether the design works are research, even if later sold or kept as demo units. Units built after the design is settled are production costs.

The regulation calls these pilot models: models made to resolve uncertainty during development (26 CFR 1.174-2(a)(4)). That covers EVT and DVT builds (engineering and design validation tests), cold-plate and coolant distribution unit (CDU) prototypes, rectifier prototypes and test chips. Selling one later does not change that (Examples 5 and 7 of the regulation).

• Design frozen. Costs of producing a product after uncertainty is gone are not research (26 CFR 1.174-2(a)(2)). PVT (production validation test) units on a settled design are generally production costs.
• Design test or unit test. Testing whether the design is right is research. Testing whether a unit meets spec is quality control, which is not (26 CFR 1.174-2(a)(6)–(7)).

What changes when prototypes are built at a contract manufacturer or foundry abroad?

Prototype builds and tests done at a contract manufacturer or foundry abroad are foreign research, even though a US company pays the invoice. Location follows where the work is performed, not where the vendor is billed or who runs payroll: an engineer on US payroll who works from Canada or Taiwan does foreign research (Notice 2023-63, sec. 3.04; 26 U.S.C. 41(d)(4)(F)). It is amortized over 15 years from mid-year, so a full first year allows only one-thirtieth.

A DVT unit built in Taiwan and tested in the US splits: the build is foreign, the US testing domestic.

A foundry run is the hard case. Fabricating test chips is part of building a pilot model (compare Example 3 of 26 CFR 1.174-2), so a run abroad likely counts as foreign research. No IRS guidance addresses foundry runs or mask sets directly, and masks the startup owns may be depreciable property instead. The answer turns on each contract: who owns the masks and who bears the risk of a failed run.

The 15-year mechanics and abandoned foreign projects are in Deducting software development done abroad.

How do you split a contract manufacturer's invoice?

Split each line by what was done and where. Engineering that resolves design questions is research, building a tool is a depreciable cost, and units in regular production are inventory.

• NRE (non-recurring engineering). Research when done on the startup's order and at its risk. A performance guarantee, or the price of a product in regular production, takes it out (26 CFR 1.174-2(b)(3)).
• Custom tools. Engineering to work out the tool is research; producing it is not (26 CFR 1.174-2(b)(5), Example 1).
• Assets the startup will own. Depreciable property used in the research that the startup acquires ownership of is not research (26 CFR 1.174-2(a)(10)).

Ask for separate invoice lines. A lump price for "development and first units" forces an allocation someone must defend later.

Is tooling capitalized or expensed, and what is its depreciation life?

Tooling the startup owns is capitalized and depreciated. Tooling the contract manufacturer owns and prices into each unit is not the startup's asset; its cost lands in inventory (Publication 946, Property You Own). If the startup pays separately for manufacturer-owned tooling used only for research, that payment can be research instead (Example 1 of 26 CFR 1.174-2(a)(11)).

Customer-owned tooling kept at the manufacturer's plant is the startup's property. Depreciation starts when the tooling is ready and available for its specific use, for example once sample parts are approved, not when it is paid for. Property used predominantly outside the US must use the alternative depreciation system (ADS), straight line (26 U.S.C. 168(g)(1)(A)), with no bonus depreciation (26 U.S.C. 168(k)(2)(D)) and no Section 179 (Publication 946, excepted property).

The class follows the product the tool makes. These lives are starting points to confirm item by item (Publication 946, Table B-2):

Depreciation on production tooling generally becomes part of inventory cost. Depreciation on tooling used for pilot builds abroad is foreign research (Notice 2023-63, sec. 4.03(1)(c)).

Can we take bonus depreciation or Section 179 on test equipment and lab gear?

Generally yes, for equipment used in a US lab and acquired after January 19, 2025 (Publication 946). The purchase cost is not research; the depreciation is (section 174A(d)(1)).

Machinery and equipment (section 1245 property) used in research is 5-year property (26 U.S.C. 168(e)(3)(B)(v)). In a US lab it generally qualifies for 100% bonus depreciation, so year one matches a research deduction. Used mainly abroad, it goes on ADS over its class life, or 12 years with none (Publication 946, Table B-1, item C). Choosing between Section 179 and bonus, and GPU servers kept for the company's own compute, are covered in Writing off GPU servers.

When do production units become inventory?

Units made after the design is settled are inventory, deducted through cost of goods sold when sold, not when paid for.

Research costs stay out of inventory: section 263A(c)(2), as amended by Public Law 119-21, excludes section 174A costs. A company with average gross receipts up to $32,000,000 (Rev. Proc. 2025-32, sec. 4.30) has simpler options (Publication 538), but generally still deducts units when used or sold.

Should a loss-making startup deduct research now or elect section 174A(c) amortization?

Deducting now is the default. A startup may instead elect to capitalize all of a year's domestic research and amortize it over 60 months or more, starting in the month it first realizes benefits from the research (Public Law 119-21; Rev. Proc. 2025-28, sec. 6.01). A separate section 59(e) election spreads a chosen part over 10 years (Form 4562 instructions).

A current deduction adds to a net operating loss, and carried-forward losses offset only 80% of a later year's taxable income. Amortizing holds deductions for years that may have income. The election is due with the return, including extensions, and binds later years (Rev. Proc. 2025-28, sec. 6.02); the statement is covered in Deducting software development done abroad.

Research for a business not yet earning revenue still counts; see First corporate return with no revenue. A research credit reduces the section 174A deduction unless the corporation elects a reduced credit at Form 6765, Item A, on its timely original return, including extensions (section 280C(c)(2); Form 6765 instructions); credit studies are outside this guide.

We capitalized US research on 2022–2024 returns: can we deduct the rest now?

Yes, if the corporation makes the election on its return for its first tax year beginning after December 31, 2024. The remaining balance can then be deducted in full in that year, or split over that year and the next (Public Law 119-21, sec. 70302(f)(2)).

• How. A statement in place of Form 3115, automatic change number 273 (Rev. Proc. 2025-28, sec. 7, modifying Rev. Proc. 2025-23 sec. 7.02; see also Rev. Proc. 2026-32).
• Which return. The return for that first tax year, filed by its due date with extensions: October 15, 2026 for a calendar-year corporation's 2025 return. A fiscal-year corporation whose first such year began during 2025 may still have that return to file.
• Amending earlier years. The small business route to amend those years closed July 6, 2026 (Rev. Proc. 2025-28, sec. 2.06).

If that return was filed without the statement, the old schedule keeps running; whether it can be fixed depends on the facts. Foreign research from those years keeps its 15 years schedule.

What records prove research, location and tooling ownership?

The company carries the proof. Keep design reviews and test plans showing what was uncertain and when the design froze; payroll by person, project and location; contracts with NRE, prototypes, tooling and units on separate lines; tooling agreements naming the owner and sample approval date; and a log tying each prototype and unit to its build.

Example

Figures are in US dollars, round and illustrative. Each company is a calendar-year Delaware C corporation.

A $6,300,000 chip program in San Jose with a foundry run in Taiwan

The startup pays $4,000,000 of US engineer wages, $300,000 for test boards and lab equipment in its San Jose lab, and $2,000,000 to fabricate test chips at a foundry in Taiwan.

• Wages: $4,000,000 deducted.
• Test boards and lab gear: $300,000, the boards as prototypes and the gear through bonus depreciation.
• Foundry run, if foreign: $2,000,000 ÷ 15 ÷ 2 = $66,667.

Total: $4,366,667 against $6,300,000 spent. With no revenue yet, all of it adds to a loss carried forward. If the run counted as domestic, the deduction would be $6,300,000, a swing of $1,933,333.

A $1,900,000 contract manufacturer invoice for an Austin cooling startup

The contract manufacturer in Taiwan bills $250,000 of NRE done on the startup's order and at its risk, $150,000 for 20 DVT CDU prototypes built there and tested in Austin, $600,000 of molds and brazing fixtures the startup owns and leaves at the plant, and $900,000 for 300 production CDUs.

• NRE and prototypes: $400,000 foreign, so $13,333 this year. Austin testing is deducted now.
• Tooling: ADS, no bonus. Assuming the half-year convention, year one is $30,000 if the tools fall in class 35.0 (10 years), or $100,000 if they are fabricated-metal special tools under class 34.01 (3 years), generally going into inventory. In a US plant, bonus could cover all $600,000, under the same inventory rule.
• Units: 200 sold by December puts $600,000 of purchase price in cost of goods sold; $300,000 stays in inventory. The year's tooling depreciation generally splits the same way, two-thirds to cost of goods sold.

A $1,230,000 catch-up for a Boston power electronics startup

It capitalized $600,000 of US engineering in 2023 and $900,000 in 2024, leaving $1,230,000 at January 1, 2025. Its 2025 return elected the split, deducting $615,000; the 2026 return deducts the other $615,000. Without the statement, the old schedule would run into 2029.

Different for you?

• Firmware or software is part of the product: Deducting software development done abroad.
• A grant or SBIR award funds the research: Research grants and SBIR awards.
• You pay duties on imported prototypes, tooling or units: Tariffs and duties on imported equipment.
• Inventory or growth forces accrual accounting: Switching from cash to accrual accounting.
• Customers pay deposits on units delivered next year: Customer prepayments and deposits.
• Prototypes or units are obsolete: Writing off unsold or obsolete inventory.
• You pay engineers or firms abroad directly: Paying contractors abroad.
• You want to lower tax overall, including credits: Lowering your business tax.
• Work spans countries, a foundry run is at stake, the catch-up statement was missed, or you are weighing the amortization election: these turn on facts and elections that are hard to undo. See Data center services.