ASC 350-40 and Section 174: Capitalizing Custom Software Costs

01What ASC 350-40 covers, and what this guide is not

ASC 350-40, Intangibles, Goodwill and Other, Internal-Use Software, is the part of the FASB Accounting Standards Codification that tells a business reporting under US GAAP how to account for software it builds or buys to run its own operations, such as an internal job tracker, a customer portal or a custom quoting tool. It also applies, through the hosting arrangement guidance in paragraph 350-40-25-18, to implementation costs of a cloud service contract. Software you sell, lease or otherwise market follows a different subtopic, ASC 985-20.

This is a plain-language explainer, not accounting or tax advice. Many small businesses prepare tax-basis or cash-basis statements rather than GAAP statements, and the right treatment depends on your facts. Confirm every conclusion with your CPA.

02Software capitalization under the current stage model

Until a business adopts ASU 2025-06, ASC 350-40 sorts software project costs by the stage in which they occur. FASB's own background to the update summarizes the model: entities generally expense costs in the preliminary project stage, capitalize eligible costs in the application development stage, and expense maintenance in the post-implementation operation stage, while upgrades that add functionality can be capitalized.

03Which costs can be capitalized?

Being in the right stage is not enough on its own; the cost also has to be the right kind. Paragraph 350-40-30-1, as shown in ASU 2025-06, limits capitalized costs to a short list, and other paragraphs push several common project costs to expense.

• Capitalizable: external direct costs of materials and services, such as fees paid to a developer to build the software, costs to obtain software from third parties, and employee travel directly tied to development.
• Capitalizable: payroll and payroll-related costs, such as benefits, for employees directly associated with the project, to the extent of the time they spend directly on it.
• Capitalizable: interest costs during development, under the separate rules of Subtopic 835-20.
• Capitalizable: costs to develop or obtain software that lets new systems access or convert old data.
• Expensed: general and administrative costs and overhead.
• Expensed: training costs.
• Expensed: data conversion work such as purging, cleansing and reconciling old data, apart from the conversion software noted above.
• Expensed: maintenance, and internal costs that cannot be separated cost-effectively between maintenance and minor upgrades.

04What ASU 2025-06 changes

FASB issued ASU 2025-06 on September 18, 2025, after stakeholders said the stage model was hard to apply to agile and other iterative development. The update removes every reference to project stages. Under the amended paragraph 350-40-25-12, capitalization begins when both of the following are true: management with the relevant authority has authorized and committed to funding the project, and it is probable that the project will be completed and the software used to perform its intended function. FASB calls the second condition the probable-to-complete recognition threshold. Signing a contract with a developer or approving internal development spending are examples of authorization and commitment.

The threshold is not met while there is significant development uncertainty. Under the new paragraph 350-40-25-12A, that exists if the software has novel, unique or unproven functions or features whose uncertainty has not been resolved through coding and testing, or if its significant performance requirements have not been identified or are still being substantially revised. FASB's stated expectation is no significant change in capitalization for most types of software and a possible decrease for software provided as a cloud service. The update also folds website development cost guidance from Subtopic 350-50 into 350-40.

05When ASU 2025-06 takes effect

The amendments are effective for all entities for annual reporting periods beginning after December 15, 2027, and interim periods within them. For a calendar-year business, that is the year beginning January 1, 2028. Early adoption is permitted as of the beginning of an annual reporting period. A business may adopt prospectively, use a modified approach based on the status of each project and whether costs were already capitalized, or apply the update retrospectively. FASB decided not to offer private companies an alternative or practical expedient.

If your business is mid-project during the change, ask your CPA which transition approach fits before you restate any records.

06What happens after launch or if a project stops

Capitalization stops no later than when the software is substantially complete and ready for its intended use, which ASC 350-40-25-14 describes as the point after all substantial testing is completed. From then on the capitalized cost is an asset that is amortized, and the property, plant and equipment disclosure requirements in Subtopic 360-10 apply to it and its amortization.

If completion stops being probable, no further costs are capitalized and the impairment guidance applies. Paragraph 350-40-35-3 reports such an asset at the lower of carrying amount or fair value less costs to sell, with a rebuttable presumption that uncompleted software has a fair value of zero. Its listed warning signs include a lack of budgeted spending, programming problems that cannot be resolved in time, significant cost overruns, and a decision to buy third-party software instead.

07Section 174 and 174A: how tax treats software development

Federal income tax does not follow ASC 350-40. For tax years beginning after December 31, 2021, the 2017 tax law (TCJA) version of Section 174 required businesses to capitalize specified research or experimental expenditures and amortize domestic amounts over five years from the midpoint of the tax year, as Rev. Proc. 2025-28 summarizes. IRS Notice 2023-63 explains that the same law added Section 174(c)(3), which treats amounts paid or incurred to develop any software as research or experimental expenditures.

Public Law 119-21, signed July 4, 2025, changed that. Its section 70302 added Section 174A. For amounts paid or incurred in tax years beginning after December 31, 2024, a business may deduct domestic research or experimental expenditures in the year paid or incurred, or elect to capitalize them and amortize them ratably over a period of at least 60 months, beginning with the month the business first realizes benefits. Section 174A(d)(3) treats any amount spent in connection with developing any software as a research or experimental expenditure. Foreign research costs stay under Section 174 with 15-year amortization.

08Transition rules for 2022 through 2024 costs

Section 70302 also gave businesses ways to recover domestic costs capitalized under the TCJA rule during the 2022 to 2024 period (tax years beginning after December 31, 2021, and before January 1, 2025). A business may elect to deduct the remaining unamortized amount in its first tax year that starts after December 31, 2024, or split it evenly between that year and the next.

A separate election let eligible small businesses apply Section 174A retroactively to tax years beginning after December 31, 2021, generally by filing amended returns. Eligibility turned on the gross receipts test in Section 448(c), and tax shelters were excluded; Rev. Proc. 2025-28 notes the inflation-adjusted threshold for a tax year beginning in 2025 is $31,000,000 and says that election had to be made by the earlier of July 6, 2026, or the close of the refund claim period for the year. That date has passed. Ask your CPA which elections, if any, remain available for your situation and how they interact with the research credit.

09Records to keep from a software project

Good records cost little during a project and are hard to rebuild afterward. They let your CPA apply either the current stage model or the ASU 2025-06 test, and support the tax treatment. Ask your developer to invoice in a way that separates these items.

• The dated approval to fund the project, such as a signed contract, board minute or approved budget.
• Requirements and their revision history, showing when the significant performance requirements stopped changing.
• Notes on any novel or unproven feature and the testing that resolved it.
• Employee time by person, date and activity, such as planning, design, coding, testing, data conversion, training and maintenance.
• Developer invoices split by the same activities, with hosting and license charges listed separately.
• Where the work was performed, because domestic and foreign research costs are treated differently for tax.
• The date the software was substantially complete and ready for use, and the month it first produced benefits.
• Any decision to pause, cancel or replace the project, with the reason.

10How this affects a custom software budget

Capitalization and tax elections change when a cost appears in your financial statements and on your tax return. They do not change what you pay the developer or when the cash leaves your account. Budget the project on cash first, including running costs after launch, then ask your CPA how the timing of expense and deduction affects profit, covenants or estimated taxes.