Comment by tgflynn
3 years ago
I have a hard time understanding why this so bad and the article does nothing to explain it. As I understand it companies only pay taxes on their profits, which generally speaking is what's left after expenses, including salaries, are subtracted. If that's the case then why would higher taxes on profits force a company out of business or to layoff staff. If anything layoffs would tend to have the short term effect of increasing profits, which would only further increase taxes.
I can understand how a sudden unexpected change to the tax code could catch people off guard and cause short term problems but overall I don't see why this particular change should be so devastating once any transient effects have been absorbed.
The problem is that this tax change is artificially inflating profits. Companies previously had the choice between expensing (writing off entirely) and amortizing (spreading out) these costs, and now they must be amortized.
It is especially problematic since it categorizes all software development as R&D even if we don't think of it as R&D. It's still unclear what the IRS considers "software development" since they've never had to define it, but the way most big companies with their well-paid accountants are proceeding are that it covers new product development AND new features on existing products, but not bug fixes/maintenance.
Let's take a simple example. Imagine a profitable small software company that made $1M in revenue last year, spent $700,000 on developer salaries and $200,000 on other expenses. Ordinarily, they'd be able to write off $900,000 and have a taxable net income of $100,000 that matches their actual profit. Assuming a tax rate of 25% that's a $25,000 tax bill.
Now, if you assume developers spent 50% of their time building new products and new features, and 50% of other expenses were on new features, only $420,000 of the salary costs and $110,000 of other expenses are write-offs. Their taxable income just went from $100,000 to $470,000.
Assuming a 25% tax rate, their tax bill is now $117,500 for 2022 — which exceeds their actual net income. This also inflates their quarterly tax payments for 2023, both of which hit right now.
This gets even worse for companies that aren't profitable, as they don't have the cash flow to cover a tax bill when they hadn't planned on having one at all. And given the current financial environment, it's hard for startups to get any kind of additional financing or funding.
This news article about our effort gets into this a bit more: https://technical.ly/civic-news/section-174-small-software-c...
> The problem is that this tax change is artificially inflating profits
Not exactly. It's a well-established accounting principle that you capitalize costs that provide a benefit over multiple years. Depreciation is an easy-to-understand example. It's more true that the historic practice of expensing R&D costs was artificially inflating costs.
What the tax change is doing is forcing amortization, which, for early-stage companies is difficult, because they have depended on expensing early and recognizing income later.
It's a difficult issue. There are good arguments on both sides. But it sounds like this was a surprise, which is surely not optimal.
fwiw, when I was running start-ups (80s/90s/00s), my recollection is that we amortized our software development costs. I guess this got turned around by the rise of the sophisticated startup world, with more accountants, lawyers, and lobbyists. And now the government is pushing back, not without reason.
>> Not exactly. It's a well-established accounting principle that you capitalize costs that provide a benefit over multiple years.
OK, so lets flip this. I'm a founder working for free, as many founders do. We code on nights and weekends and produce hundreds of thousands of dollars of capital value. If the business doesnt work out, can I claim all this as a loss?
We cant have it both ways, can we? So I should be able to take losses on these hundreds of git repos I have with thousands of hours of unpaid work?
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> And now the government is pushing back, not without reason.
Is it? Seems like lawmakers just messed up in reaching an agreement to extend something that is usually extended. Typical congress games.
From light reading, Republican leadership seems to be the main blocker since extending the provision has bipartisan support. You would think that extending this and child tax credits would be no-brainers for Republican leadership, but here we are.
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> And now the government is pushing back, not without reason.
What reason is that? Increased tax revenue (in the short term at least)? Because if there's no difference in the long term then it seems pretty dumb to inflict financial turmoil for no net gain.
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> that you capitalize costs that provide a benefit over multiple years
Do you see a difference between software development in a consulting business model (instant one-off benefit) and software development in a saas product business model (benefit over multiple years)?
> There are good arguments on both sides. Can you provide the good arguments for capitalizing software development costs and not expensing it?
Can you explain the reasoning of charging taxes to a company that has revenue beyond merely 1/5th of its expenses (actually 1/10th in the first year, or 1/30th for international operations) and hence still heavily investing cash?
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I've seen previous discussions about this on HN but there seemed to be disagreement about whether this change required developer salaries to be treated as R+D or only allowed it.
If this is really the way it works, defining some salaries as necessarily not being deductible from revenues, then it makes no sense for multiple reasons.
First the developers are still paying income tax on their salaries so that money is getting doubly taxed in the year the revenues are received.
Second the government generally seeks to encourage employment. This would have the exact opposite effect because any employee you hire who's doing software development would cost you (1 + 4/5) times their salary in the near term.
I wonder how much of the downturn in tech employment this year is being caused by this.
> any employee you hire who's doing software development would cost you (1 + 4/5) times their salary in the near term
How can that be true? You only pay them once, not 1 4/5 times.
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The burn cash but not necessarily profit. If they built the software in 1 year for 1,000,000, they would carry an asset of 1,000,000. They burned 1,000,000 in cash but have a 1,000,000 asset. They had salary expense of 1,000,000 and revenue of 0. Say they make 300,000 in revenue for the next 5 years based on that software. That means they would be able to expense $200,000 against the $300,000 in income, paying taxes on just $100,000 in income each of those years. At the end of that time the asset has zero value.
The other option is they take a 1,000,000 loss that first year, and then pay tax on all $300,000 for each of the succeeding years. Either way, at the end of six years, There was $1,500,000 in revenue and $1,000,000 in expenses.
As far as the treatment of bug fixes, the rules around improvements and repairs probably cover that. If you fix a bug like a bad calculation - that's probably opex, like replacing a part on a machine. If you add a feature that extends the life of the product, like adding an API for outside developers, that would be an improvement and capitalized. This is like refurbishing equipment to extend its useful service life.
> If they built the software in 1 year for 1,000,000, they would carry an asset of 1,000,000.
Isn't normal accounting principles usually that if a company pays $M salaries, then regardless of whether those salaries paid for an asset or not, they are an expense that's 100% deducted from the income when calculating taxes?
Are we saying that at a company with 2 desks where 1 is a marketing person or accountant and 1 is a software dev, their salaries would deduce differently from the company bottom line, because the software developer is said to create "assets"? Isn't the marketing of that asset likely to be build the value of it in the same way as the research and engineering does?
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Not very familiar with the US tax system, but is there no option to treat "R&D spending" as a normal business expense, forgoing all R&D incentives or tax credits?
There was before 2022. Not anymore.
R&D = "research and development"
If what you are doing is software development then obviously it is a development activity that falls within the meaning of development for purposes of tax laws.
Software programming that does not constitute development, such as bug fixing, is not subject to capitalization.
R+D is "research and development", not "research" and "development". It's specifically development of research into new products. Otherwise a carpenter could be seen as "developing" wood into cabinets. If there's no research or experimental process involved in the work, then it's not R+D.
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What about work-for-hire?
You’re off about the major problem with Section 174 — money is being taxed *before* expenses, and there is no “out” because software has been labeled fully R&D back in 2017 (of course the republicans carved an out for oil, mineral, and gas lol).
What makes it worse is that accountants at real deal firms like Plante Moran didn’t bother sounding the alarm early because they figured like every time in the last 70 years Congress would push off the effects.
It is an absolutely crushing situation that is going to put a lot of shops out of business unless they have cash on hand to weather the 5 year R&D tax amortization schedule.
Even if you have the cash, in a high inflation environment with higher costs of lending, paying tax on ~80% today and getting that tax back over 4 years, leads to indirect costs. Especially for startups.
The issue here is in the way it is deducted.
Previously, $1.000.000 spent on R&D in 2023 would result in a $1.000.000 deduction on your 2023 taxes. Under the new system the same spending would result in a $200.000 deduction in 2023, $200.000 in 2024, $200.000 in 2025, $200.000 in 2026, and $200.000 in 2027.
You still get the same deduction, but spread out over multiple years. However, it also means that you can now deduct $800.000 less in 2023 than expected, resulting in a far higher tax bill this year! If you are a startup you probably don't have that spare $800.000 just lying around doing nothing.
>The issue here is in the way it is deducted.
The issue is that the rules changed. Businesses that relied on the former rules are now faced with a (possibly insurmountable) challenge to accommodate the new rules.
Washington loves to fiddle with tax rules, and lobbyists spend a lot of time and money encouraging it, but nobody can anticipate the ripple effects. It all looks great on CBO spreadsheets and congressional press releases, but the real-world impacts can be devastating.
I only hope they include some kind of small letter that the same person needs to still be employed to get the amortization - I think that's actually implied by it. The same way you got to keep a machine to keep deducting it. I think the gov't got fed up of the mass layoffs and this is how they are fixing it.
If you can deduct the remaining amortized expense immediately upon termination, could companies just fire everybody and rehire them the next day?
Assuming you had no other expenses the tax bill would be $168k on the $800k right? So what we're saying is a business with $1M each in revenue and salary expense would have an additional $168k in current year tax expense?
its like a weird inverse of paying quarterly taxes...the same goal - more of your money stays with the government longer
That's still taxed off profits, not gross.
Yes, but it's changing the way profits are calculated, which massively impacts cash flows.
If I can only deduct 200k of the 1m I spent that inflates my net profits by 800k that I dont actually have, because I spent it on what I thought was an expense.
It changes what is considered a deductible expense.
Profits = Revenue net Costs
Taxes are a cost. Taxes are defined as some rate t, tax = t * (Revenue net Deductible Expenses)
So Profits = Revenue - t * (Revenue - Deductible Expense) - Non-deductible Expense
Percent of t is small relative to the value of 100% applied to non-deductible expense. What this has done is to take salary, deployment infra, everything, from Deductible to Non-deductible expense, leaving 20% of what was there before. That is very large.
You deduct (eligible) expenses from revenue to get (taxable) profit
If you make $2,000,000 gross, spend $800,000 on operating expenses, and $1,000,000 on R&D, you practically have $200,000 profit; but you have pay $210,000 in federal tax on $1,000,000.
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The companies spent all the money this year on R&D expenditures. That was cash out of their pocket (they spent it this year, so it reduced this year's cash on hand). The effect of the rollback is that they can now only count 20% of those expenditures to reduce their profits (and, by extension, their taxes) this year, so they are paying taxes this year on the remaining 80%. While yes, the profits are higher, the cash is not any higher, and cash pays the tax bill.
Note, this was not an "unexpected" change (it's been in the code), but it WAS unexpected that the provision was not extended.
Note that this affects not just startups. My wife's firm is a small, employee-owned, non-tech S-corp. This hit them as well. It resulted in tax bills for the shareholders approximately 25-30% greater than the firm's accountants expected them to be. The shareholders are on the hook for those higher taxes, although the company did the right thing and distributed extra cash to them to offset the higher taxes.
I've been wanted to someday start an employee-owned, non-tech S-corp. However these changes are squeezing out small players.
Previously: fully deduct R&D salaries from income to calculate taxable profit.
Now: deduct 20% of R&D salaries from income to calculate taxable profit, with the remaining 80% spread 1/5 per year over the next 4 years.
For software companies, where costs are basically eng salaries, this is a huge tax increase. It will kind of even out over time, but it wacks new companies very hard.
"It will kind of even out over time, but it wacks new companies very hard."
Amortizing salaries seems really weird since they are recurring every year. After 5 years you can deduct your full salary expenses for that year. And after you have laid off everybody you can deduct for a few more years. Definitely makes it hard to hire a lot of people quickly if you don't have a ton of profit.
> R&D salaries
> For software companies, where costs are basically eng salaries,
... it smells like this might be fallout from mis-classifying workers and/or fudging categorization of labor for some benefit. Am I on to something?
Even companies that don't take R&D credits (which is a benefit which can be fudged) are still forced to treat software development expenses as R&E subject to 5 year amortization. Companies have no choice in that matter (see https://www.law.cornell.edu/uscode/text/26/174 (c)(3))
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The IRS forces the miscategorization, leading to tax bills that can exceed actual net income.
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Well, yeah because you're a normal person who pays tax by the book and don't look at tax optimization schemes all your waking hours. Classing devs as R&D was morally wrong anyway due to the 100% tax credit. Although I think a better approach could have been an immediate credit in the same year, but a reduced amount.