Comment by svara
6 months ago
> For cash-strapped companies, especially those not yet profitable, the result was a painful tax bill just as venture funding dried up and interest rates soared
Can someone explain this? What taxes do unprofitable US businesses owe that this would be deducted against?
Here's a toy example that hopefully makes this clear:
In 2024, your business has $1m in revenue and has $2m in expenses. 100% of these expenses are R&D salaries (engineers you hire.)
Your company loses $1m/year. (You brought in $1m and spent $2m.)
Under the old rules, you'd owe no tax because you were unprofitable.
After Sec 174, what the IRS now says is:
You had revenues of $1m. But you only had $400k in expenses (because you now have to spread that $2m in R&D expense over 5 years).
So actually you had a profit of $600k! And you owe tax on that $600k profit (~$120k)
So you now have an additional $120k tax expense, making your business even more cash-flow negative.
.
Amusingly, if you're pre-revenue, none of this matters (you have no income at all, so it doesn't matter what your expenses are.) You get hardest hit by this change when you have some revenue and when you do a fair bit of R&D.
> Amusingly, if you're pre-revenue, none of this matters (you have no income at all, so it doesn't matter what your expenses are.)
https://youtu.be/BzAdXyPYKQo
There is so much gold in that show. Just rewatching it now. Fucking billionaires...
Wait - they are saying that employee salaries are not expenses?
That is surely wrong? Just because those salaries are for R&D?
I could understand if there was some additional tax break for R&D which was being removed. I can't see how basic operating costs cease to be expenses.
They're still expenses, they just now need to be amortized.
Buying a truck is an expense, as is buying gas for the truck. But the former you have to amortize over x years, the latter you can expense immediately.
The law used to be "employee salaries for software are like buying gas" and now it's "employee salaries for software are like buying a truck".
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Based on my exchange with wdaher, who seems to understand this well, it's a bit more subtle than that:
The salaries are of course expenses, but they are exactly offset by the value of the IP created by the R&D activities.
It's a bit as if you spent money on buying some materials. As long as the material doesn't degrade, the cash is gone but the value is the same and therefore won't reduce your taxes.
If that IP is amortized over a single year, it does not contribute to taxation, but it does if it is amortized over a longer period.
They are expenses, but amortized over 5 years. So if you spent $2m on employee salaries, you would then deduct $400k from your revenue every year for 5 years.
If your employee expenses remained constant, then by year 5 you would be deducting $2m from your revenue since you'd be accumulating the deductions from the previous four years.
So in steady state it wouldn't necessarily be a big problem. But for a startup which is hiring many new employees and whose revenue is growing it's a huge problem.
This was my first reaction when I heard about it before it passed. I was horrified.
>Wait - they are saying that employee salaries are not expenses?
>That is surely wrong? Just because those salaries are for R&D?
The same would be true if you hired a bunch of scientists/engineers and got them to do R&D.
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What other cost do you think goes into software development? Companies are not spending that much money on IDE licenses. The vast, vast majority of software/R&D costs are labor
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Is this true even if you don't capitalize the immaterial IP asset generated by the R&D salaries on the balance sheet? Is that required in the US?
Otherwise I'm quite amazed that salaries can be carried forward as future expenses.
This is what the Sec 174 change said: it says that you do have to capitalize it.
Elsewhere in the world (under IFRS accounting rules) capitalization of R&D costs has been a firm requirement for a while. The US has been somewhat unique in allowing them to be expensed instead, until recently.
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so you are okay, if you start getting revenue when you're five years in?
You can deduct 100% of salaries paid 5 years ago, but only 20% of salaries last year (etc.), and since companies tend to hire more people over time, most of your expenses will have been in the last few years that are still amortizing. You might have enough losses to carry forward in your first year of revenue, but 6 years in that could run out. It depends on the exact circumstances.
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But nobody’s forcing you to classify software developers as R&D.
No, that's literally the Section 174 change. You now must count them as R&D.
The relevant paragraph from Section 174:
> (3) Software development
> For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.
https://www.law.cornell.edu/uscode/text/26/174
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How would that help? R&D developers helped saving taxes, now they don’t.
Classifying them as non R&D doesn’t help saving taxes again.
If the business has some revenue, but is not yet profitable after deducting development costs, it can become profitable on paper (and owe tax) if R&D is capitalized instead.
That is kind of strangely worded, but I think I see what they're getting at.
Say you would have been exactly not-profitable ($0) if you could expense all of your R&D as in the old system, therefore avoiding tax. Now with the new rules you may be on-paper profitable because you can only deduct 20% of the R&D as an expense this year. The remaining 80% of that expense tips you over, becomes profit, and that's taxable.
Right. With concrete numbers, say your main expense is $1 million in developer salaries and you have $500k in revenue. Going by the previous rules, you have a loss of $500k and don't owe income tax. With the new rules, you can only deduct $200k of expenses which gives you a "profit" of $300k, on which you'll owe $62k in taxes.
What taxes do unprofitable US businesses owe that this would be deducted against?
An unprofitable business doesn't pay income taxes. Businesses are taxed on their net income (i.e., profit).
People are railing against this as the cause of tech's recent underperformance, but it was a non-factor for the vast majority of tech companies, because most tech companies aren't profitable and wouldn't have paid taxes anyway.
I thought you could carry forward losses or something. i.e. Once profitable you can use your previous losses as 'tax credits'.
So you're essentially giving the government a 0% interest 5 year loan, in the amount of the pre-paid taxes
Yes, but businesses operate on cash, not tax credits.
If you make it that far.