A US federal tax change that took effect in 2022 thanks to a time-triggered portion of the Trump-era Tax Cuts and Jobs Act may leave entrepreneurs with massive tax bills.
Section 174 of the US tax code – prior to the passage of the 2017 TCJA – allowed companies to handle the tax bill of their specified research or experimental (SRE) budgets in one of two ways: Either capitalized and amortized over the course of five years, or written off annually.
Of the many things covered by SRE, most crucially for our purposes is “any amount paid or incurred in connection with the development of any software,” which includes developer salaries.
The TCJA included a post-dated change to Section 174 that took effect on January 1, 2022 that would no longer allow companies to automatically expense any SRE costs on an annual basis. Going forward they’d all have to be amortized over five years – a potential budgetary disaster for companies that haven’t been doing so in the past.
As pointed out by Gergely Orosz of The Pragmatic Engineer, a theoretical company with $1m in revenue and $1m of software developer salary costs could have claimed it had no taxable profit in 2021. The required SRE amortization rate of 10 percent would mean the org had $900k in profit in 2022 – and a six-figure tax bill coming due the following year.
This isn’t theoretical – Orosz said that he recently spoke to several engineers and entrepreneurs who’ve been surprised with massive tax bills that have led to layoffs, reduced hiring, and left some companies in financial distress.
House of Representatives member Ron Estes (R-KS), who last year sponsored a bill to restore Section 174 to its pre-TCJA option to expense or amortize, likewise said an a late-2023 op-ed that the changes have led to R&D at US companies – not just in the tech sector – shrinking considerably.
“Since amortization took effect, the growth rate of R&D spending has slowed dramatically from 6.6 percent on average over the previous five years to less than one-half of 1 percent over the last 12 months,” Estes said. “The [R&D] sector is down by more than 14,000 jobs.”
A group of tech giants including Amazon, Microsoft, Boeing, Intel, and others formed the R&D Coalition in 2018 to prevent the 2022 change to Section 174 from becoming reality, claiming that amortization “will significantly diminish the near-term value of R&D investments.”
That, and the Section 174 changes make the US far less enticing as a place to open a business or do R&D, and the only one with such forced amortization in the world.
“The forced amortization of R&D expenses makes the US an outlier with respect to the treatment of R&D. As a result, we are seeing a negative impact on the ability for businesses – particularly small businesses – to invest in R&D,” warned Intel tax chief and R&D Coalition chair Sharon Heck.
But little actual effort seems to be being spent toward fixing the TCJA problem with Section 174.
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Estes’ bill, which he contends was one of the most co-sponsored pieces of legislation in 2023, hasn’t even had a committee hearing since being introduced in April. An accompanying bill, introduced in the Senate in March 2023, similarly hasn’t budged since being introduced to committee. Neither Estes nor Senator Maggie Hassan (D-NH) responded to questions.
The White House hasn’t mentioned anything about Section 174 and its effect on the tech industry, and didn’t respond to questions for this story either.
The IRS, meanwhile, days ago released a notice [PDF] reminding tax payers that yes, those Section 174 changes did happen, and that proposed regulations finalizing the updated rules will be issued soon.
Looks like that TCJA chicken may have just come home to roost for good. ®
