> 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.
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".
The critical difference is that the business owns the truck but not the employee. The amortization assumes that the asset can be sold for value. An employee can quit at any time for any reason. You don’t retain the right to their labor for five years.
If they're producing a capital asset, you do retain the right to the fruits of their labor, even if they quit.
The rationale behind amortization isn't exactly the idea that the asset can be sold, it's that the asset is producing revenue over multiple years. For software, the asset is the codebase.
Let's say you hire a single software dev, for one year, and they write Excel++, which you can sell for the next ten years. It would be entirely appropriate to amortize the cost of creating that software over those ten years, based on the matching principle (a fundamental idea of accounting, matching expenses with revenue).
The issue in the real world is that's not how the software industry actually works, 99% of the time.
As anyone that has ever sold software IP knows, most of the value is vested in the person that wrote the code, not the code itself. The code is not a factory, it is the output of the factory.
> ...most of the value is vested in the person that wrote the code, not the code itself.
You must have misphrased what you intended to say. If what you wrote was true, a software company's most valuable asset would be the specific programmers in its employ. If true, average tenure of a programmer would be way longer than 1.5->2 years as companies worked really, really hard to keep their most valuable assets from walking out the door into the doors of another company just to get reasonable pay increases.
Perhaps your opinion is influenced by doing post-collapse-sales of a whole bunch of software houses that built just plain bad software? I can't see why else you'd be selling "software IP" independently of the rest of the business.
Anyway. Given that information, how should you have phrased what you wanted to say?
Most programmers do approximately zero work that is R&D. The most you lose if they walk out the door is institutional knowledge.
On the other hand, I've worked almost exclusively on software R&D for decades and seen the loss of a single person effectively end a project even when the software was essentially finished. Software R&D is about developing abstract knowledge, concrete implementation code is just a useful byproduct of that since R&D is typically motivated by a specific novel requirement.
If the software IP that results from R&D is not core to your business or a competitive risk, there is money to be made by licensing it. I've licensed this type of IP to big tech companies a number of times. If you are not actually doing software R&D, you are unlikely to be in a position where this is a possibility.
In almost every IP sale and licensing deal for software R&D I've seen, the value of any code is almost entirely conditional on retaining the services of person(s) that designed and wrote it. The entire "acquihire" phenomenon is an explicit admission of this. This is true even when the code is in a mostly finished form. Companies are buying capability, not revenue, so the code can't be a black box to their engineers. Companies usually spend more to acquire people with the code knowledge than the actual code.
The practical reality is that it is difficult to reverse engineer abstract knowledge from a concrete implementation. No one wants your code per se, they want to adapt your code to a different application that requires having a deep understanding of the domain the code represents -- they don't know what they don't know.
If you are just grinding out software that could be vibe coded then there is minimal asset value being created in the software artifacts. Anyone else would be better off reimplementing it themselves.
So yes, almost all of the value of code produced by software R&D vests in the people that wrote it. This is evident across many software IP transactions.
> Most programmers do approximately zero work that is R&D.
So, what you're saying is one or more of the following:
1) The work of most programmers should not be considered R&D, and shouldn't be covered by tax schemes intended for R&D.
2) Most "software IP" in the industry is not the result of R&D.
3) You've rarely been involved in the sale of non-R&D "software IP". (Do recall that your original statement was "As anyone that has ever sold software IP knows, most of the value is vested in the person that wrote the code, not the code itself.")
The first two statements would upset a lot of people but I think you'd find theyre arguably true. Most software products are various flavours of configuration. Unless you're genuinely leveraging some novel algorithm/hardware etc it's very hard to argue it's R&D if it's just branding on a collected bag of software various OSS/commercial companies developed. Claiming all software is R&D because you leverage OSS and put a known algorithm on top of some components would be like a supermarket claiming to be a research company because they have a different mix of products + customer experience to their rivals.
I think the third statement is a bit personal so will leave that alone.
So, it seems that you and I are definitely in agreement about the rough proportion of novel research done to "figure out how to fit preexisting things together and patch over the areas where the parts mate poorly" in the software field. I'd argue that the latter activity does qualify for inclusion in the development half of R&D, but -because I don't know [0] the relevant legal definition of the term, I won't strongly argue for the position.
The unfortunate thing that kicked off this discussion was that you talked about "...[selling] software IP...". Thanks to active work by copyright maximalists [1] over the past 20+ years, the term "Intellectual Property" applies just as well to plug-and-chug Enterprise CRUD software that sells for megabucks as it does to leading-edge research projects that -like- actually have Key Personnel and die dead if those folks go away. Anyone who is capable of paying attention and has been in the industry for more than a year or three is quite aware that plug-and-chug CRUD is far more valuable than the overwhelming majority of the people who make it.
So, yeah. From that arose the confusion.
[0] ...and because I can't be arsed to go look it up...
[1] My position in brief: copyright and patents are absolutely essential, copyright terms are insanely long, and patents frequently granted when they should not
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.
Buildings have to be depreciated, so probably? If you have to depreciate a building if you buy it, why should you get a free pass just because you built it yourself?
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
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.
Yeah, seems I was wrong about that. Apparently most IFRS countries allow expensing R&D for tax purposes, regardless of accounting. Many even have an R&D superdeduction nowadays.
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.
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.
What "in connection with" means is vague. I think a reasonably competent tax attorney could probably argue that the costs of running your production cloud serving existing customers don't count, but IANAL.
A person typing an essay with a word processor is producing an essay. A person using a no-code tool to modify a software process is producing software processes.
The nature of the tweak involved probably determines the classification of the effort, but for tax purposes and R&D expense amortization, it is a percentage of time basis.
If the executive tweaks the code once, the percentage is so small it won't count as far as anyone cares.
If 20% of the executive's time is tweaking the tool, then odds are the company cannot expense 20% of the executive's salary and instead must claim that portion as R&D over five years.
Back before 174, I worked for a company that did claim R&D but only for one of the projects I worked on. As such, I had to be careful filling out my timesheet because they wanted an accurate accounting of what was salary expense and what was R&D.
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.
Can someone explain this? What taxes do unprofitable US businesses owe that this would be deducted against?