The Impact of R&D and Software Startups
The landscape of the U.S. tech industry is undergoing a significant but not well-known shift. At the core of this change is a tax policy from the Tax Cuts and Jobs Act (TCJA) of 2017. This legislation has introduced a pivotal challenge for software startups and tech companies, particularly in Research and Development (R&D) accounting.
A key amendment to IRS Section 174 under TCJA has altered how businesses account for R&D expenses. Previously, companies could deduct these costs immediately. Now, they must amortize them over several years: five for domestic and fifteen for overseas expenses.
This change, effective from the 2022 tax year, will drastically impact the financials of many startups. For example, a company with $1.5 million in revenue facing $1 million in R&D expenses would see a significant shift in taxable profit. Previously taxed on $500,000, it now faces a much higher taxable amount due to reduced immediate deductions.
Startups are particularly hit hard by this change. In an article from Axios, Lou Steinberg, former CTO of TD Ameritrade, notes that startups operate in a time-sensitive environment. A few years can make or break their success, making the delayed tax relief problematic.
The amended tax law inadvertently incentivizes companies to cut R&D costs. This often means reducing development teams, ironically stifling the innovation the policy aimed to encourage. This impact extends beyond bootstrapped companies to venture-backed startups, altering their growth and hiring strategies.
Large corporations are not immune either. Companies with significant overseas R&D operations now face a lengthy 15-year amortization schedule. This affects not just their current financial strategies but also their long-term investment in innovation.
Efforts in Congress to address these consequences have seen mixed results. The Tax Relief for American Families and Workers Act of 2024 proposes delaying this Section 174 amendment until 2026. However, it's a temporary solution, and its future is still being determined in an election year.
The TCJA's impact on R&D taxation is a significant shift, requiring a delicate balance between progress and profitability during an ongoing change in startup market dynamics from growth to profitability. There's hope in bipartisan efforts to revise the legislation. Until then, US-based startups and tech companies must navigate these new tax challenges.
