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The problem is that this tax change is artificially inflating profits. Companies previously had the choice between expensing (writing off entirely) and amortizi

The problem is that this tax change is artificially inflating profits. Companies previously had the choice between expensing (writing off entirely) and amortizing (spreading out) these costs, and now they must be amortized. It is especially problematic since it categorizes all software development as R&D even if we don't think of it as R&D. It's still unclear what the IRS considers "software development" since they've never had to define it, but the way most big companies with their well-paid accountants are proceeding are that it covers new product development AND new features on existing products, but not bug fixes/maintenance. Let's take a simple example. Imagine a profitable small software company that made $1M in revenue last year, spent $700,000 on developer salaries and $200,000 on other expenses. Ordinarily, they'd be able to write off $900,000 and have a taxable net income of $100,000 that matches their actual profit. Assuming a tax rate of 25% that's a $25,000 tax bill. Now, if you assume developers spent 50% of their time building new products and new features, and 50% of other expenses were on new features, only $420,000 of the salary costs and $110,000 of other expenses are write-offs. Their taxable income just went from $100,000 to $470,000. Assuming a 25% tax rate, their tax bill is now $117,500 for 2022 — which exceeds their actual net income. This also inflates their quarterly tax payments for 2023, both of which hit right now. This gets even worse for companies that aren't profitable, as they don't have the cash flow to cover a tax bill when they hadn't planned on having one at all. And given the current financial environment, it's hard for startups to get any kind of additional financing or funding. This news article about our effort gets into this a bit more: https://technical.ly/civic-news/section-174-small-software-companies-taxes-explainer/ https://technical.ly/civic-news/section-174-small-software-c...

deleted 3y ago
[deleted]
pr337h4m 3y ago
Not very familiar with the US tax system, but is there no option to treat "R&D spending" as a normal business expense, forgoing all R&D incentives or tax credits?
- agwa 3y ago
  There was before 2022. Not anymore.
tgflynn 3y ago
I've seen previous discussions about this on HN but there seemed to be disagreement about whether this change required developer salaries to be treated as R+D or only allowed it. If this is really the way it works, defining some salaries as necessarily not being deductible from revenues, then it makes no sense for multiple reasons. First the developers are still paying income tax on their salaries so that money is getting doubly taxed in the year the revenues are received. Second the government generally seeks to encourage employment. This would have the exact opposite effect because any employee you hire who's doing software development would cost you (1 + 4/5) times their salary in the near term. I wonder how much of the downturn in tech employment this year is being caused by this.
- scrozier 3y ago
  > any employee you hire who's doing software development would cost you (1 + 4/5) times their salary in the near term How can that be true? You only pay them once, not 1 4/5 times.
  - tgflynn 3y ago
    Yeah, what I said isn't completely accurate, because I didn't take into account the tax rate. But the factor is still larger than 1, assuming you have any revenue at all, because in addition to what you payed them in salary you have to pay tax on the 4/5ths of their salary you couldn't deduct in the current year.
scrozier 3y ago
> The problem is that this tax change is artificially inflating profits Not exactly. It's a well-established accounting principle that you capitalize costs that provide a benefit over multiple years. Depreciation is an easy-to-understand example. It's more true that the historic practice of expensing R&D costs was artificially inflating costs. What the tax change is doing is forcing amortization, which, for early-stage companies is difficult, because they have depended on expensing early and recognizing income later. It's a difficult issue. There are good arguments on both sides. But it sounds like this was a surprise, which is surely not optimal. fwiw, when I was running start-ups (80s/90s/00s), my recollection is that we amortized our software development costs. I guess this got turned around by the rise of the sophisticated startup world, with more accountants, lawyers, and lobbyists. And now the government is pushing back, not without reason.
- TuringNYC 3y ago
  >> Not exactly. It's a well-established accounting principle that you capitalize costs that provide a benefit over multiple years. OK, so lets flip this. I'm a founder working for free, as many founders do. We code on nights and weekends and produce hundreds of thousands of dollars of capital value. If the business doesnt work out, can I claim all this as a loss? We cant have it both ways, can we? So I should be able to take losses on these hundreds of git repos I have with thousands of hours of unpaid work?
  - Implicated 3y ago
    I've got lots of 'failed' projects I've spent obscene amounts of time on. Where's the Lambo dealership?
  - pclmulqdq 3y ago
    Technically, I would assume that you probably can claim this as a capital loss if you have actually realized a loss (eg you spent money on software related to the business or something), but those are capped at $6,000 a year. Those expenses previously could have gone on a schedule C, though.
phoehne 3y ago
The burn cash but not necessarily profit. If they built the software in 1 year for 1,000,000, they would carry an asset of 1,000,000. They burned 1,000,000 in cash but have a 1,000,000 asset. They had salary expense of 1,000,000 and revenue of 0. Say they make 300,000 in revenue for the next 5 years based on that software. That means they would be able to expense $200,000 against the $300,000 in income, paying taxes on just $100,000 in income each of those years. At the end of that time the asset has zero value. The other option is they take a 1,000,000 loss that first year, and then pay tax on all $300,000 for each of the succeeding years. Either way, at the end of six years, There was $1,500,000 in revenue and $1,000,000 in expenses. As far as the treatment of bug fixes, the rules around improvements and repairs probably cover that. If you fix a bug like a bad calculation - that's probably opex, like replacing a part on a machine. If you add a feature that extends the life of the product, like adding an API for outside developers, that would be an improvement and capitalized. This is like refurbishing equipment to extend its useful service life.
- alkonaut 3y ago
  > If they built the software in 1 year for 1,000,000, they would carry an asset of 1,000,000. Isn't normal accounting principles usually that if a company pays $M salaries, then regardless of whether those salaries paid for an asset or not, they are an expense that's 100% deducted from the income when calculating taxes? Are we saying that at a company with 2 desks where 1 is a marketing person or accountant and 1 is a software dev, their salaries would deduce differently from the company bottom line, because the software developer is said to create "assets"? Isn't the marketing of that asset likely to be build the value of it in the same way as the research and engineering does?
  - xmcqdpt2 3y ago
    A quick google search shows that advertising is also a treated as an asset, just like software, at least some of the time https://www.journalofaccountancy.com/issues/1999/may/maples.html https://www.journalofaccountancy.com/issues/1999/may/maples.... IMO it does make sense to amortize software expenses like other capital expenditures.
gamblor956 3y ago
R&D = "research and development" If what you are doing is software development then obviously it is a development activity that falls within the meaning of development for purposes of tax laws. Software programming that does not constitute development, such as bug fixing, is not subject to capitalization.
- jdmichal 3y ago
  R+D is "research and development", not "research" and "development". It's specifically development of research into new products. Otherwise a carpenter could be seen as "developing" wood into cabinets. If there's no research or experimental process involved in the work, then it's not R+D.
  - robocat 3y ago
    I can imagine Unicorn Research Inc deciding to rename all “developer” titles to “programmer” titles, and removing the word “Research” from the company name.
  - gamblor956 3y ago
    I love when people on the Internet tell me I've been doing my job wrong for a decade... It's research (as in new knowledge) and development (as in new products based on existing research and knowledge). Software generally falls into the latter category. A scientific process is not required but does make it easier to document qualification for the R&D credit. And yes, a carpenter developing new cabinet designs absolutely would qualify for the R&D credit (and their salary could fall under the scope of this rule change).
    - jdmichal 3y ago
      > It's research (as in new knowledge) and development (as in new products based on existing research and knowledge). This is... Exactly what I said? > And yes, a carpenter developing new cabinet designs absolutely would qualify for the R&D credit (and their salary could fall under the scope of this rule change). I feel I pretty clearly alluded to the physical process of turning wood into a cabinet, not developing novel new techniques for doing such.

deleted 3y ago

[deleted]

pr337h4m 3y ago

Not very familiar with the US tax system, but is there no option to treat "R&D spending" as a normal business expense, forgoing all R&D incentives or tax credits?

agwa 3y ago
There was before 2022. Not anymore.

tgflynn 3y ago

I've seen previous discussions about this on HN but there seemed to be disagreement about whether this change required developer salaries to be treated as R+D or only allowed it. If this is really the way it works, defining some salaries as necessarily not being deductible from revenues, then it makes no sense for multiple reasons. First the developers are still paying income tax on their salaries so that money is getting doubly taxed in the year the revenues are received. Second the government generally seeks to encourage employment. This would have the exact opposite effect because any employee you hire who's doing software development would cost you (1 + 4/5) times their salary in the near term. I wonder how much of the downturn in tech employment this year is being caused by this.

scrozier 3y ago
> any employee you hire who's doing software development would cost you (1 + 4/5) times their salary in the near term How can that be true? You only pay them once, not 1 4/5 times.
- tgflynn 3y ago
  Yeah, what I said isn't completely accurate, because I didn't take into account the tax rate. But the factor is still larger than 1, assuming you have any revenue at all, because in addition to what you payed them in salary you have to pay tax on the 4/5ths of their salary you couldn't deduct in the current year.

scrozier 3y ago

> The problem is that this tax change is artificially inflating profits Not exactly. It's a well-established accounting principle that you capitalize costs that provide a benefit over multiple years. Depreciation is an easy-to-understand example. It's more true that the historic practice of expensing R&D costs was artificially inflating costs. What the tax change is doing is forcing amortization, which, for early-stage companies is difficult, because they have depended on expensing early and recognizing income later. It's a difficult issue. There are good arguments on both sides. But it sounds like this was a surprise, which is surely not optimal. fwiw, when I was running start-ups (80s/90s/00s), my recollection is that we amortized our software development costs. I guess this got turned around by the rise of the sophisticated startup world, with more accountants, lawyers, and lobbyists. And now the government is pushing back, not without reason.

TuringNYC 3y ago
>> Not exactly. It's a well-established accounting principle that you capitalize costs that provide a benefit over multiple years. OK, so lets flip this. I'm a founder working for free, as many founders do. We code on nights and weekends and produce hundreds of thousands of dollars of capital value. If the business doesnt work out, can I claim all this as a loss? We cant have it both ways, can we? So I should be able to take losses on these hundreds of git repos I have with thousands of hours of unpaid work?
- Implicated 3y ago
  I've got lots of 'failed' projects I've spent obscene amounts of time on. Where's the Lambo dealership?
- pclmulqdq 3y ago
  Technically, I would assume that you probably can claim this as a capital loss if you have actually realized a loss (eg you spent money on software related to the business or something), but those are capped at $6,000 a year. Those expenses previously could have gone on a schedule C, though.

phoehne 3y ago

The burn cash but not necessarily profit. If they built the software in 1 year for 1,000,000, they would carry an asset of 1,000,000. They burned 1,000,000 in cash but have a 1,000,000 asset. They had salary expense of 1,000,000 and revenue of 0. Say they make 300,000 in revenue for the next 5 years based on that software. That means they would be able to expense $200,000 against the $300,000 in income, paying taxes on just $100,000 in income each of those years. At the end of that time the asset has zero value. The other option is they take a 1,000,000 loss that first year, and then pay tax on all $300,000 for each of the succeeding years. Either way, at the end of six years, There was $1,500,000 in revenue and $1,000,000 in expenses. As far as the treatment of bug fixes, the rules around improvements and repairs probably cover that. If you fix a bug like a bad calculation - that's probably opex, like replacing a part on a machine. If you add a feature that extends the life of the product, like adding an API for outside developers, that would be an improvement and capitalized. This is like refurbishing equipment to extend its useful service life.

alkonaut 3y ago
> If they built the software in 1 year for 1,000,000, they would carry an asset of 1,000,000. Isn't normal accounting principles usually that if a company pays $M salaries, then regardless of whether those salaries paid for an asset or not, they are an expense that's 100% deducted from the income when calculating taxes? Are we saying that at a company with 2 desks where 1 is a marketing person or accountant and 1 is a software dev, their salaries would deduce differently from the company bottom line, because the software developer is said to create "assets"? Isn't the marketing of that asset likely to be build the value of it in the same way as the research and engineering does?
- xmcqdpt2 3y ago
  A quick google search shows that advertising is also a treated as an asset, just like software, at least some of the time https://www.journalofaccountancy.com/issues/1999/may/maples.html https://www.journalofaccountancy.com/issues/1999/may/maples.... IMO it does make sense to amortize software expenses like other capital expenditures.

gamblor956 3y ago

R&D = "research and development" If what you are doing is software development then obviously it is a development activity that falls within the meaning of development for purposes of tax laws. Software programming that does not constitute development, such as bug fixing, is not subject to capitalization.

jdmichal 3y ago
R+D is "research and development", not "research" and "development". It's specifically development of research into new products. Otherwise a carpenter could be seen as "developing" wood into cabinets. If there's no research or experimental process involved in the work, then it's not R+D.
- robocat 3y ago
  I can imagine Unicorn Research Inc deciding to rename all “developer” titles to “programmer” titles, and removing the word “Research” from the company name.
- gamblor956 3y ago
  I love when people on the Internet tell me I've been doing my job wrong for a decade... It's research (as in new knowledge) and development (as in new products based on existing research and knowledge). Software generally falls into the latter category. A scientific process is not required but does make it easier to document qualification for the R&D credit. And yes, a carpenter developing new cabinet designs absolutely would qualify for the R&D credit (and their salary could fall under the scope of this rule change).
  - jdmichal 3y ago
    > It's research (as in new knowledge) and development (as in new products based on existing research and knowledge). This is... Exactly what I said? > And yes, a carpenter developing new cabinet designs absolutely would qualify for the R&D credit (and their salary could fall under the scope of this rule change). I feel I pretty clearly alluded to the physical process of turning wood into a cabinet, not developing novel new techniques for doing such.