Tax Law Changes Create Big Headaches for Small Tech Firms
Patrick Flanagan was in disbelief when his accountant reached out a few weeks ago about some worrying tax law changes.
He was told that, for the 2022 tax year, he could only deduct a fraction of research and development expenses from his company’s taxable income. In prior years, those deductions helped significantly cut down on taxes for his company and scores of other small businesses. But, this year, he says he’s likely going to have to borrow money to pay his company’s tax bill.
“It sounded absolutely crazy to learn that the category of expenses that’s the overwhelming majority of our expenses can no longer be deducted,” says Flanagan, CEO of Minneapolis-based audio software company Resonant Cavity LLC and founder of vocal effects app Voloco. “It was a bizarre and surreal feeling.”
The changes stem from the 2017 Tax Cuts and Jobs Act, which cut the corporate tax rate from 35% to 21%. Passed under former President Donald Trump, the law was, at the time, a boon for many businesses. Several went on to post record profits. But those tax cuts come at a cost. The 2017 law stipulated that, beginning in the 2022 tax year, businesses are required to deduct research expenses over a five-year period instead of taking them all at once. The technical tax term for that is “amortization.” Companies that performed research outside of the U.S. must take research deductions over a 15-year period.
What all of this means in practice is that some businesses may now be considered profitable by the government even if they lost money last year. “Fake profits” is how Flangan describes it. “That cash has already left the bank account,” he says.
The change is creating a big burden for tech firms, manufacturers, and other research-oriented companies of all sizes, but it poses more dire challenges for smaller firms with less immediate capital on hand. Alexa Claybon, principal in the national tax department at accounting firm Ernst & Young, says she’s been hearing from clients “pretty much all day, every day” about the topic.
“All of our clients are very concerned,” says Claybon, who also serves as technical lead for the firm’s U.S. R&D incentives practice. “It’s a dramatic change from what they’re used to.”
Claybon notes that many of the businesses that EY serves are “very large clients with very large research expenditures.” That includes companies working in fields like pharmaceuticals, aerospace, defense, and manufacturing.
The 2017 tax law’s changes pertain to Section 174 in the tax code. Enacted in 1954, that provision was designed to encourage American businesses to conduct research by providing tax credits for it. Businesses can, of course, still claim deductions for research, development, and experimentation, but now they must amortize them – i.e., spread them out over multiple tax years.
“Congress has always supported research in the form of credits,” Claybon notes. “Congress is definitely pro-research. This is the first time they’ve kind of gone that other way. … I think they were really just looking for revenue, and this was an easy target.”
The way the 2017 law defines research expenses is part of the reason its effects are so broad. Section 174 now defines such expenses this way: “research or experimental expenditures which are paid or incurred by the taxpayer during such taxable year in connection with the taxpayer’s trade or business.”
What’s more, the law now specifically defines software development as a research and experimentation expense. Even salaries for developers would likely count. For some software entrepreneurs, it’s a bit of a head-scratcher.
Flanagan says that software development “doesn’t feel at all like research and experimentation to me.”
“That part of the law is, to me, very silly,” he says.
The Silicon Valley Bank collapse, meanwhile, couldn’t have come at a worse time. Under normal circumstances, it’s a bank that many tech companies would have turned to for loans. Flangan’s own accountant had, in fact, told him he would have recommended SVB as a lender. “They understood the software business, and they’re familiar with tech,” Flanagan says.
When Flanagan reached out to other founders about the tax law changes, they were just as surprised. “You would expect [venture capital firms] and more people in the tech community to be alarmed, but I think they’ve just been distracted by the Silicon Valley Bank problem,” Flanagan says.
Political squabbles persist
To be sure, it wouldn’t be quite correct to describe the tax code changes as unexpected. “It’s been sort of facing us,” says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. “It would have only been unexpected if you didn’t know about it or assumed Congress was going to take some action since 2017.”
There have, of course, been bipartisan efforts to undo the changes to Section 174, but none of them have made it into law in time for the 2022 tax year. Last year, there appeared to be some serious momentum on that front, but disagreements over expanded child tax credits curtailed it.
To limit the financial fallout of 2017’s big tax cuts, Congress set the provisions of the Tax Cuts and Jobs Act to expire by 2026. “That was so that those costs wouldn’t go beyond 10 years,” Luscombe adds. “A lot of budget gimmicks go on to try to get this thing paid for, and this is one of those gimmicks.”
Indeed, the changes to Section 174 were just one way of paying for the massive tax cuts in 2017. The law also included attempts to recover untaxed profits overseas, for instance.
The price of research?
These tax code changes may have been scheduled to take effect for years now, but that doesn’t make them any more palatable for business owners. “This hit me like a brick,” is how the chief executive of one Minnesota manufacturer summed up her feelings to The Wall Street Journal recently.
Michael Morton, senior adviser for policy at the Golden Valley-based Medical Alley Association, says he’s been hearing “serious concern” from member companies.
“I wouldn’t characterize it as panic, but I’d clearly say that it’s been serious, serious, concern – kind of disbelief,” Morton says.
Small tech companies that might not be at the revenue-generating stage are especially vulnerable. That could include companies that are working on grant-funded research. “They’re cash strapped,” Morton says. “They’re not selling a product, or they’re selling only one or two products, and at the same time, they’re spending a tremendous amount on R&D. To not be able to take those tax credits in a single year puts a tremendous burden on them.”
Indeed, as anyone who works in research knows: Research is often an incredibly costly endeavor. Meeting regulatory standards for a new drug or medical device, for instance, can take months or even years of testing.
Research doesn’t always guarantee revenue, either. “Research fails all the time, or it becomes irrelevant, especially in the software and high-tech space,” EY’s Claybon says. “You’re still amortizing those research costs over five years even when the revenue from it is gone. You don’t have any revenue to offset those costs.”
It remains to be seen how exactly companies will respond to these changes in the years ahead. But it’s entirely possible it may have a chilling effect on research and development efforts. “If there’s no tax incentive to spend on R&D, that’s truly going to have an effect on some of these companies,” Morton says. “I know CEOs are going to have to be making some tough decisions.”
Flanagan at Resonant Cavity says his company will “absolutely have to pull back on spending in order to increase short-term profit margins as much as possible.”
If there are any lessons to be learned from the fiasco, perhaps it’s this: In the future, don’t wait on Congress to act. “Lobby your congressperson,” says Claybon. “That’s all you can do at this point.”