How Section 174 Impacts Corporate Taxes

Feb 8, 2024 · Tracking the Tax Cuts and Jobs Act, Section 174, and why it matters for bootstrapped and early-stage companies

Taylor Davidson

CEO / Founder

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A change in tax laws in the USA has created a lot of chatter recently:

Ben Thompson at Stratechery explained it in April 2023, Startups and the R&D Tax Credit:

For many years research and development costs have effectively counted as normal expenses, which means they decrease a company’s tax liability (because they reduce profits).

Because the 2017 “Tax Cuts and Jobs Act” was passed via the reconciliation process (in order to avoid a filibuster), it had to be budget neutral after 10 years; one tactic used to accomplish this is to make future changes to the tax code that increase revenue, even though the bill’s drafters anticipate those changes will be rolled back before they are implemented.

One of these changes was to change research and development costs from expenses that could be realized immediately to expenses that could only be amortized over a minimum of 5 years (and 15 years for international research and development) starting in 2022; this amortization schedule also starts on July 1 of the year in which the expenses are incurred.

The reason why this has created some panic is that it significantly impacts corporate income taxes for companies where software development is a major expense; previously you could deduct the full cost of software development (primarily salaries for software engineers you employ) as an expense, but now you have to amortize it, over either 5 years for domestic expenses or 15 years for foreign expenses. Here's an example of the math:

How it used to work: If a company had $1.5 million in revenue and $1 million in expenses (let's say it was entirely domestic R&D), it would pay taxes on its $500,000 profit.

How it works now: In the same example, the company would have to amortize the $1 million in expenses over five years, so it would deduct only $200,000 (one fifth) and would pay taxes on $1.3 million in profit.

The implications on this for technology companies investing in software development with revenues operating close to break-even on a cash flow basis are enormous, and the industry has been lobbying for Congress to amend the law. While the IRS has been providing updating guidance (Dec 22, 2023) providing limited relief, Congress has yet to pass legislation addressing the core concern of companies.

The impact is real. The elimination of expensing research and development (R&D) disincentivizes companies to spend on software development (and software engineers). And while companies do get the benefit of amortizing the expenses in years 2-5 (meaning, that over time companies get the benefit from the amortization of previous years expenses), startups that are not around in five years will not see that benefit.

There is hope; as part of the Tax Relief for American Families and Workers Act of 2024, there would be temporary reprieve by (a) delaying the change to Section 174 to Jan 1 2026 and (b) applying the reprieve retroactively, allowing companies to amend their 2022 tax filings. On January 31 the bill passed the US House of Representatives, but it is unknown if or when it could pass in the US Senate.

So the question remains for the business that has to file their taxes: what do they do? Gusto covers the options, in short:

  1. If the bill becomes law before the tax deadlines,

If passed, taxpayers can fully expense US-based R&D costs for the current tax year (2023) through tax year 2025. The requirement to charge US-based R&D expenses to a capital account and amortize it over five years will be delayed until tax years beginning after December 31, 2025. The requirement to amortize non-US R&E expenditures for fifteen years remains unchanged.

  1. If the bill becomes law after the tax deadlines,

If you have already filed your tax return you will want to consult with your tax advisor to review how the R&D expenditures were reported on the filed tax return and if they advise filing an amendment to make any adjustments.

  1. If the bill does not pass,

If the bill doesn’t pass, Section 174 requirements will remain, which means that under current law, U.S. research and experimental expenditures paid or incurred in tax years beginning after December 31, 2021, are required to be amortized over a five-year period. Costs attributable to research or experimentation outside the U.S. must be deducted over a 15-year period.

And so, we wait. Updates to come.

If you're wondering how to handle this in a financial model, the Standard Model was amended in Dec 2023 to make it easier to categorize an expense for amortization, input the amortization period, and the model will automatically handle amortization and any associated impact to corporate income taxes and consolidated financial statements.

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