A 2017 law comes back to haunt startups in 2024
The Tax Cuts and Jobs Act of 2017 is impacting some startups' tax bills, thanks to a provision that changes how R&D costs are deducted.
Why it matters: Profits are back in vogue for startups, but it also means some are getting hit with unsustainable tax bills.
Catch up quick: The TCJA amended the IRS Section 174, requiring that businesses amortize R&D costs over five years (15 if overseas) instead of deducting them upfront.
- Qualifying software development (recent guidance narrowed that scope a bit) is now treated as R&D under that section as well.
- The change first kicked in for 2022 taxes.
- It was included as a way to offset the TCJA's corporate tax breaks, and although there have been attempts since then to correct this, none have passed. (More on that below.)
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.
- If the $1 million is in expenses overseas, it would be able to deduct only about $66,667 (1/15th), paying taxes on a profit of about $1.4 million.
What they're saying: "As a startup, telling me it'll all be good in five or 15 years — how many startups make it to 15 years," Lou Steinberg, a former chief technology officer of TD Ameritrade, tells Axios. He now runs CTM Insights, a cybersecurity research lab.
- Because of this change, most of his company's profits went to paying its taxes. The company has since shifted away from developing any new technology and is now focused solely on licensing its existing tech.
- "I can deduct my salespeople, but I can't deduct my engineers," he adds.
Zooming out: So far, bootstrapped companies are the ones feeling the pain, while the venture-backed world isn't so much (at least not yet).
- The former tend to generate revenue much sooner.
- And if you don't have revenue, you're not being taxed on them.
Yes, but: "It impacts you [as a pre-revenue startup] in the sense that eventually you want to start making money, so it will impact you then," says Ross Reiter, a partner at Deloitte's tax practice.
- And there is already some effect on venture-backed startups. Root Ventures general partner Lee Edwards tells Axios that some of his portfolio companies are slowing down their hiring because of the tax's impact on their budgets, though none have had to do layoffs so far.
And to be clear: This also affects very large corporations.
- "Large technology companies that perform [specified research and experimental] activities outside of the U.S. will continue to see a material impact … as those costs must be recovered over 15 years," Kevin Benton, managing director at Grant Thornton's Washington National Tax Office, tells Axios via email.
- In late 2022, 178 chief financial officers from companies including Ford, Boeing, Lockheed Martin, AT&T and Netflix wrote to congressional leaders asking them to repeal the change, per the Wall Street Journal.
After two failed attempts to remedy the taxation issue, a third is currently in play in Washington.
- Section 174 appears to be the latest case of unintended consequences from a big Congressional bill, so there's been bipartisan support to fix the issue.
State of play: As part of the Tax Relief for American Families and Workers Act of 2024, the change to Section 174 would be delayed until Jan. 1, 2026, and apply retroactively.
- The bill was introduced by Chair Jason Smith (R-Mo.) of the House Ways & Means Committee and Chair Ron Wyden (D-Ore.) of the Senate Finance Committees this week, so it's early in the process.
Context: It's unclear how much of a priority this will be for members of Congress during an election year.
- And even if the current proposal passes, it would only kick the can down the road to next year.
The bottom line: Unless Congress takes action, this change to R&D taxation could start to impact the fundraising math of early-stage startups.
Editor's note: This item has been updated to clarify the distinction between startups with taxable revenues, rather than profits.