Comment by testrun
6 months ago
It seems that there is quite a bit of confusion about this. What this does is that it reduce your deductible cost in the tax year.
First you have to make a profit (tax is on profits). Secondly, what this does is to limit your software development expenses for tax purposes in the current year because the development cost is seen as a capital cost that will be amortized over five years opposed to operating expenditure in the same year.
If you are a startup and not make profits, then the loss will be less in the current year, but either way, your tax liability is the same: $ 0.
So software development is moved from opex to capex.
Profit is determined by expenses though.
A simple example to illustrate:
Say you had 100k revenue and 1 software developer you pay 100k per year.
Under the new law, you can only deduct 20k of the developer’s salary, so your profit is 80k, which you have to pay taxes on.
However, you have $0 in the bank because you earned 100k and paid out 100k in salary.
See how that is problematic?
That's a horrible revenue to expense ratio for ditch digging, nevermind software development.
I totally agree, this change affects cash flow negatively. I don't support it at all. But it seems quite a few people are confused how it works.
I can see why it would affect startups not making a profit but why would it dramatically affect FAANG (e.g. some of the most profitable companies in the world that have been running for decades)? The article contributes all these large layoffs in FAANG, in part, to this tax rule.
Because they are profitable. So the cost is deductible over 5 years, instead of one year.
A very simple example:
Revenue: $ 1 000 All other cost except software: $ 500 Software cost: $ 100
Net profit (if software is allowed as opex): $400
Tax on $400 (@30%): $120
Net profit after tax: $280
However, if it is capex(amortized over 5 years):
Revenue: $ 1 000 Other cost (except software): $500 Software cost: $ 100
Net profit before tax: $ 400
Important: But now for tax purposes you can only deduct $20 this year as a cost ($100 amortized over 5 years)
So now you have to add back $80 to net profit for tax purposes: $480
Tax (@30%): $ 144
Net profit after tax: $400 - $144 = $256
So the difference is $280 - $256 = $24
Just a few notes:
1. I assume tax rate at 30%, it can be something else, principle stay the same
2. That all other expenses are tax deductible
There's a difference of $24 but I have $1200 in cash reserves. And I make up the difference later. Oh no! Guess I have to lay off 10% of my employees now.