Comment by mjwhansen
3 years ago
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?
Catch 22: if you claimed the loss for the value of the hours worked, you would also end up having to pay income tax on the value of hours worked.
Paying yourself is a lose-lose game.
I've got lots of 'failed' projects I've spent obscene amounts of time on. Where's the Lambo dealership?
Technically, I would assume that you probably can claim this as a capital loss if you have actually realized a loss (eg you spent money on software related to the business or something), but those are capped at $6,000 a year. Those expenses previously could have gone on a schedule C, though.
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Founders work for free because they're investing, taking a risk like all investments. If they lose the bet, they lose. No harm, no foul. That's true of any investment you and I make. People lose money on investments every day.
There are a lot concepts being not very well defined here: employment, investing, taxation, salaries. It's not all one thing.
What is it that you think "we" are having both ways?
> 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.
That could well be. But maybe it's not so obviously a good thing as it may sound to startup ears. Matching income and expenses is a pretty good way to keep your financial head about you.
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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.
Well, yes, increased tax revenue, of course. There may be no/little difference in the long term; that's over my economics pay grade. It seems like the model of raise a lot of money, spend a lot of money, expense it, pay no taxes, then go bankrupt is a pretty straightforward way there might be a difference long term. And that's a very common scenario, I think you'd agree.
> 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?
> 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)?
Yes. Not sure what that has to do with this discussion.
> Can you provide the good arguments for capitalizing software development costs and not expensing it?
Yes. The well-established accounting principle of matching income and expenses.
> 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?
Yes. See the answer to your second question. Companies often have to make investments. If they buy a Big Machine, they don't get to write it off in one year. There's nothing nefarious about amortizing costs over their useful life.
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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.
Yeah, what I said isn't completely accurate, because I didn't take into account the tax rate. But the factor is still larger than 1, assuming you have any revenue at all, because in addition to what you payed them in salary you have to pay tax on the 4/5ths of their salary you couldn't deduct in the current year.
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?
A quick google search shows that advertising is also a treated as an asset, just like software, at least some of the time
https://www.journalofaccountancy.com/issues/1999/may/maples....
IMO it does make sense to amortize software expenses like other capital expenditures.
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Yes, that is the case. If you’re building a warehouse, the wages paid to the construction workers are capitalized. The wages paid to your accounts payable are probably not capitalized with construction cost.
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.
I can imagine Unicorn Research Inc deciding to rename all “developer” titles to “programmer” titles, and removing the word “Research” from the company name.
I love when people on the Internet tell me I've been doing my job wrong for a decade...
It's research (as in new knowledge) and development (as in new products based on existing research and knowledge). Software generally falls into the latter category. A scientific process is not required but does make it easier to document qualification for the R&D credit.
And yes, a carpenter developing new cabinet designs absolutely would qualify for the R&D credit (and their salary could fall under the scope of this rule change).
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What about work-for-hire?