As I understand accounting, this means that reported profits would be higher, and therefore incur more corporate income tax liability. Cash flow isn't effected besides tax.
A startup isn't likely to be making a profit yet, under either accounting rule. Is there a benefit to reporting a larger loss?
My first thought is that this effects Google and suchlike, not startups. But... assuming steady state "r&d" expenditure... it's not that much. Everything gets deducted within 5 years anyway.
So... maybe this hinders more modestly profitable, and fast growing companies most. Those that can't afford to carry 5 years worth of paper profits as easily.
Otoh... I am curious about how the difference between r&d expenses and operational ones are determined irl.
This should be quantifiable. How much extra assets are software companies actually booking?
It seems questionable that this "silent killer" had actually affected employment so much.
> A startup isn't likely to be making a profit yet, under either accounting rule. Is there a benefit to reporting a larger loss?
As an example, A two person software startup; both drawing a salary, each making $100,000 per year. Each doing things related to software development.
Startup brings in 200,000K in revenue.
Under pre Section 174 changes, the profit is zero. Both salaries are expensible in the year they were incurred.
Post Section 174, the profit is now $160,000 each year. Now they pay taxes on $160,000, even though they literally have no money left over because revenues equaled expenditures.
At 25% tax rate, that’s $40,000 in taxes, for a business that made literally no money.
That’s why this is so devastating to small software businesses; unless you’re highly profitable and have cash reserves, this change hits hard.
Wait, salary costs do not count as costs for the year they're made in? That is completely nuts, no matter what kind of company you have.
Although for a startup it might be least bad, because for their first few years, their revenue might well be closer to zero; they tend to burn money, sometimes for quite a while.
They count as costs, but towards a capital expense. The expectation is that that expenditure resulted in the creation of a valuable asset (and not one which was sold for $200,000).
The IRS releases guidance on tax code, and one of the issues with section 174 taking effect in 2022 (and the IRS believing it would be repealed before it went into effect) was that the guidance was released in 2023 under notice 2023-63
To answer your question, the following are software development activities that are capitalizable (and instead of quoting the notice itself, I’m quoting from a better written blog post by accountants:
> Section 4.03(1) of the Notice clarifies that labor costs – including those for contract employees and independent contractors – related to those who perform, supervise, or directly support SRE activities are considered Section 174 expenditures. All elements of compensation are to be included with the exception of severance, which is excludable and deducted by taxpayers in the period paid or incurred. SRE-related labor costs expenses included in the Notice expenses related to pension costs and stock-based compensation.
Section 4.03(1)(e) provides guidance pertaining to certain costs related to operation and management (i.e., rent, utilities, etc.) activities. Specifically, in addition to items such as rent, utilities, and insurance, expenditures such as taxes (i.e., property), repairs and maintenance, and security are now considered SREs subject to Section 174.
So what software development activities don’t count as “Specified Research Expenditures” (SRE)”?
> Training of employees in the use of the software
>Maintenance activities after the software is placed into service that do not constitute upgrades or enhancements (i.e., corrective maintenance to debug, diagnose, and fix programming errors)
> Data conversion activities (except activities to develop computer software that facilitates access to existing data or data conversion)
> Installation and other activities related to placing the software into service
> Marketing and promotional activities
> Distribution activities
> Customer support
If you’re a startup and you have a software developer doing the above activities as well as SRE work, then in order to expense the SRE parts of their job you either have to estimate (and be able to defend) the estimations, or your employee needs to track their time for each type of activity they do.
This example only really has the emotional impact it does because of the specific numbers used, but doesn't really generalize for an arbitrary N.
Clearly if two software engineers build a product that brings in $10M, and each pay themselves $5M, it doesn't seem so outrageous that the can't really claim they're running "a business that made literally no money." Clearly in this second example the problem is that the engineers are paying themselves way too high given the return on their efforts.
What this means is that software engineers will be required to bring in more value to justify their high pay. In your example, it simply means that a software engineer that brings in $100,000 of value to the company, probably shouldn't be paid $100,000.
This seems entirely reasonable to me, and doubly so when I consider how many large corporate teams (who I think will ultimately be impacted more than startups) has huge numbers of highly paid engineers not doing all that much.
In most startups I've worked in it was pretty common for engineers to be delivering multiples of their cost in value, and in every big company I've worked in, it was very common to be delivering fractions of one's cost in value.
In case you don't understand: obviously you still pay income tax. What you suggest would mean you now pay income tax on that $10M, which is going to be 40% or even 50% depending, far higher than corporate tax.
So with your suggested tactic the engineers get $2.55 million each. The rest, $4.5 million, is tax.
If those 2 engineers paid themselves $0, and instead paid the $10 million as dividends, they'd get 4.25 million each, and only 1.5 million would be paid as tax.
(Yes, this is a simplification, both situations are artificial and in both cases there'd be other taxes to pay, however, they'd be similar in both cases)
> Post Section 174, the profit is now $160,000 each year. Now they pay taxes on $160,000, even though they literally have no money left over because revenues equaled expenditures.
They have the $200k they pulled from their startup, far more than what most people earn. If you make enough to pay yourself $100k then you make enough to pay taxes.
If you can't afford your taxes your business model was flawed to begin with. In the above example there is more than enough money for it to still be worth doing.
You don't seem to understand the implications here. This requires bootstrapped startups to have gross margins substantially above incumbents in order to compete and not be cash flow negative after paying taxes.
It makes it substantially more cashflow intensive to build a new software business, which entrenches incumbents and reduces competition. It favors companies who have the cash to wait for the full 5-year depreciation cycle, i.e. the opposite of most bootstrapped startups.
Quick example:
$10,000 revenue
$8,000 paid to software developer
$1,000 paid to AWS
leaves $1000 in profit.
You received $10,000 into your business account, but spent 8000+1000 = $9000. Your business account has a balance of $1000 at the end of the year.
Section 174 means you can only deduct 1/10th of the $8000 in the first year, $800. Your total deductible business expenses for the year will be 800+1000 = $1800.
Your taxable profit for the year is 10000-1800 = $8,200. If your effective tax rate is 25% (generously low), you owe $2,050 in taxes.
You pay your $2,050 tax payment and your business account is overdrafted by $1,050. You need to add $1,050 from your personal funds to the business to cover the shortfall.
Your business was cash flow negative for the year. This makes it extremely difficult to bootstrap a software company.
Well, I said elsewhere, this effectively means (heavily) taxing anyone who's doing something new (meaning adding additional taxes on top of income tax). Essentially all of Europe does this, and people here often decry how they totally lack innovation across the entire continent.
I don't think these two are unrelated.
I also don't understand the objection. It's not like anyone's getting away from taxes due to this rule. This is about a temporary exemption from company income tax IF AND ONLY IF companies have someone pay income tax on that money (and only up to the point where that keeps makes sense). This "exemption" lets you not add 15%-20% tax on top of 40-55% income tax just to try a new business as a company.
That was my first thought as well, but on second thought I can see how this might cause problems:
For established profitable software companies there was a cliff edge in 2022 when this change kicked in. Staff costs for previous years had already been fully expensed while only 20% of the current year's costs could be deducted.
Second, any sudden increase in research expenditures is now discouraged. This could make companies less nimble.
For unprofitable startups it could cause issues during a phase of very high revenue growth. They could suddenly be liable to pay corporation tax in spite of the fact that they are not profitable in any reasonable sense of the word. It would smooth out later, but that may be too late for some.
What I do not believe for a second is that this is causing major job losses. Companies like Microsoft or Meta do not reduce research or software development just because there is a temporary tax hit. It could be an extra incentive for an efficiency drive I guess.
> For unprofitable startups it could cause issues during a phase of very high revenue growth.
So I guess my most question is "how this work irl?"
Say a new startup raises money and hires 20 people. Pays $5m in salaries, office space and such. All 20 people are developing a software product. Are 100% of this startups expenses amorotized?
Then they sell the product. They receive $2m in revenue. What does the P&L look like.
If they hire 20 devs in their first year paying $5m in salaries, only $1m or $500k (if the mid-year convention applies) would count as a business expense in that first year.
If their revenue was $2m, that would leave them with $1m (or $1.5m) of taxable profits unless that was eaten by other costs.
It doesn't have to be a problem, but if revenue grows fast and they go on another hiring spree in the following year then it could become a problem.
That said, if revenue grows so fast, it seems likely that they would have huge marketing and sales costs that could be expensed immediately. So maybe this isn't really a problem for many startups. I'm not sure.
1 million profit, while they have 3 million negative cashflow, that's exactly the problem. They can only take 20% of that 5 million in R&D investment as depreciation in the first year.
Your analysis is correct, but most software companies were mostly profitable or fast-growing. For every Google, there’s 1000 wordpress vendors you’ve never heard of.
In another year the initial shock will stabilize, but any growth now has a 5-year tax hit attached. And even Facebook doesn’t want to pay that if it doesn’t have to.
Google was reportedly amortizing (by choice) long before this was in effect, so while it might “affect them”, in practice it’s likely business as usual.
It depends on the department. My salary (in a mature product) was already amortized - I suspect the same is true of all their other mature products like Search, Maps, GMail, Chrome, YouTube, etc. But I think they were deducting salaries in the more research-like areas like Gemini, Jax, Assistant, etc. So there is net still a fairly large charge related to it, even if it isn't as large as it could be.
I'm not an accountant, but as I understand it, you don't pay taxes on profits, but on revenue.
So previously, some 20% of all revenue would be owned as corporate income tax, and startups would deduct it all as they're spending much more on R&D than they owe in corporate income tax. But with this tax change, the deduction would be much lower (80% lower IIUC).
Yes, but the main thing here is that ALL software development is now "profit" in the short term. In theory you've developed a capital good that benefits you over time, hence the amortization.
Simplified 2021 example before 174:
100k Revenue
100k Software Dev Costs
No profit or tax
Simplified 2022 example after 174:
100k Revenue
100k Software Dev Costs
90k "profit"
18.9k taxes
Above example is year one of suddenly having these taxes, because if your software costs are the same or lower over time it gets easier. It's just extremely painful for smaller and especially fast growing companies like startups without a lot of cash, especially when interest rates are so high.
Accountants: If I am wrong about the above, please correct me
That can't be right. It definitely isn't in my country.
If own a car dealership, and I sell a car for $50,000 that I bought from the manufacturer for $40,000, surely I would pay tax on the $10,000 profit? The tax on the the full $50,000 revenue might exceed my profit!
When taxes are paid on revenue rather than profits, the rate is obviously much lower, so that it would add up to roughly the same thing.
However, there are many benefits overall. For one, it completely kills off the various convoluted schemes to avoid classifying something that is obviously a profit as such (by shuffling things around subsidiaries etc, for example). See also: Hollywood accounting.
If companies paid tax on revenue, then there would be a tremendous incentive toward https://en.wikipedia.org/wiki/Vertical_integration , because you wouldn't be allowed to deduct the expenses paid to your suppliers.
Large companies always find a way to not pay taxes. It's the little guys that end up paying (a lot!) more, to the extend that it cripples and kills them. But transformative innovation happens with the little guys. As a result, this tax change cements monopolies for megacorps. They will be fine and still pay nothing.
The little guy always pays all taxes. Corporate tax is just a way to palatably shift tax burden to the low and middle classes and away from the owner class. It is pure double speak.
As I understand accounting, this means that reported profits would be higher, and therefore incur more corporate income tax liability. Cash flow isn't effected besides tax.
A startup isn't likely to be making a profit yet, under either accounting rule. Is there a benefit to reporting a larger loss?
My first thought is that this effects Google and suchlike, not startups. But... assuming steady state "r&d" expenditure... it's not that much. Everything gets deducted within 5 years anyway.
So... maybe this hinders more modestly profitable, and fast growing companies most. Those that can't afford to carry 5 years worth of paper profits as easily.
Otoh... I am curious about how the difference between r&d expenses and operational ones are determined irl.
This should be quantifiable. How much extra assets are software companies actually booking?
It seems questionable that this "silent killer" had actually affected employment so much.