Was just starting the tax process for 2022 and found out about the changes that have been made to Section 174 that take effect this year. Essentially, all R&E expenses must now be amortized over 5 years (instead of taking them as a regular full deduction in the year in which they are incurred), and on top of that all "software development" is now an R&E expense. [1][2]
This seems like a disaster for any bootstrapped software company. As an example, if you make $100k in income, and spend $90k making the software, at first glance you've got a successful company bringing in a 10% profit margin. Previously, you would have just paid tax on that $10k in profit. Makes sense.
Under these new rules, the US actually says "that $90k you spent to make the software has to be spread over 5 years, and you can actually only take 10% of it in the first year." Suddenly you've gone from a profit of $10k to a "profit" of $91k for tax purposes. Even at a 30% tax rate (which isn't even close to the top rate in the US), you're staring down a $27k tax bill that you're somehow supposed to pay out of the $10k in actual cash you have left on hand.
To be clear, you will eventually get the taxes you pay back over the next 5 years. But how are bootstrapped companies without access to large capital reserves or investment supposed to come up with the money to pay these tax bills while they wait it out? For every dollar you spend on making software, you've now got to have 30+ cents in reserve just to pay the tax bill for the year!
I am completely flabbergasted as to how this was thought to be a good idea...it seems like it drastically increases the cost of starting a bootstrapped software company in the US, which is just terrible policy in general.
Was just curious -- is this interpretation what others are hearing from their own tax professionals? Is it affecting others and if so how are you dealing with it?
[1] https://rsmus.com/insights/services/business-tax/looming-required-capitalization-of-section-174-expenditures.html
[2] https://www.taxnotes.com/research/federal/usc26/174
I could be far off the mark -- so please correct me if I am wrong -- but your framing suggests that if a business spends money on software development then they must amortise the cost which does not seem to be correct.
1) You can no longer take it all in the single year, and 2) All software development is now R&E automatically, no exceptions.
Note that this is separate from the R&E tax credit that you can also claim, that's a different deal in addition to this.
“There's pretty widespread bipartisan distaste for that change and there have been multiple attempts to extend the deadline or amend the change, but they haven't picked up steam yet. Still possible it will be changed retroactively. The saving grace is that a lot of the expenses they are talking about you needing to amortize would qualify for the R&D credits you'll be getting. So there's often a substantial offset between the two.”
1. It passed in the 2017 tax changes
2. The Congress ending on Jan 3, 2023, did nothing about it, even though they totally could have
3. I think R&D credits will usually be significantly smaller compared to the salary paid
My team also wrote an article on this subject a few weeks back with takeaways and graphs to show the potential math: https://capstantax.com/rev-proc-2023-11/
If anyone wants to reach out to me, feel free to do so as my contact info is at the bottom of the above article.
Link provided by author says there is no choice:
(3) Software development. For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.
There are other requirements to meet for expenditure to qualify as R&D, like experimentation and consideration of alternatives: if all software development is R&D and R&D must have alternatives considered and justified, are companies even permitted to engage in software development if suitable alternatives exist?
It is not a choice anymore, if it is software dev, it's R&E now. They added a specific callout for software development only right to the tax code.
Example: if you are a restaurant and you buy an off the shelf point of sale software, this doesn't apply. If you are in the business of making a point of sale software to sell to restaurants, or your restaurant chain develops its own point of sale software internally, it applies to all costs related to the development of that software now.
Not in any way qualified to provide tax advice, don't take the above as anything but idle chat.
I’m not familiar with this tax law, why would the “be allowed” verbiage here not mean it’s an election the taxpayer could choose to apply to their situation rather than a mandate as the OP is presenting it?
i.e. software development is always an R&E expenditure but you are only “allowed” (not “required”) to amortize it.
(1) except as provided in paragraph (2), no deduction shall be allowed for such expenditures, and
What that means is, you can't take it as a normal business expense deduction, except by following (2) which is to amortize it.
One of the key questions that defines "R&D" is technical risk: are you answering a question of "Can it be done?" or "How can we do it?" If you know how and you are just slapping it together, it's an opex.
Our accountants have been apologizing for a month now about the lack of heads up because they were confident congress would extend it like they always have. Nope.
All of them, for capital expenditures.
If I buy a widget-maker for $100,000 and use it to make a profit of $50k/yr on widget sales (net of staff and materials), then I don't have a $50k loss in my first year and $50k in profits thereafter.
Instead, the cost of the machinery must be amortized (depreciated) over several years, with a five-year period being typical but not universal. In the latter case, even though I had a $100k cash outlay for the machinery, I'd still record a tax-time profit of $30k for the year ($50k operational net revenue less $100k/5 years).
Is software an operational or a capital expense? There are arguments for each approach, and reasonable governments might decide the issue differently.
1) You can't just go get a loan for "a software" like you can "a widget maker." Most businesses with these large capital assets get loans on them and then it works out nicely as you pay back the loan on the asset while you depreciate it.
2) This would be like the law saying "anything you do in the business of making widgets at all is now a capital outlay" which is obviously ridiculous. It's not that they said "if you buy expensive tools to make software now you have to capitalize them", it's written that any expense at all in service to software development is something now capitalized.
Not that you agree with what's been done and I appreciate your example, but I think it does give a good contrast to see the differences.
Let's say someone bootstraps a company under the current laws. They deposit $200k into a corporate bank account. In 2023 they pay themselves $50k and make no revenue. In 2024 they pull in $60k in revenue and pay themselves $50k again. For tax purposes, they'd have $60k - ($10k from year 1) - ($10k from year 2) = $40k in profit to pay corporate taxes on?
In theory you could treat your one man startup as a C corp, but that would make very little tax sense, regardless of these changes. Also if it's your own 200k, you don't pay tax on it because you've put it in the bank and then taking it back, even in a C corp: you pay tax on the revenue from others.
The problem seems to arise for purely bootstrapped companies with contractors that have no startup capital. This is quite rare i think, because you'd probably start incurring expenses for a couple of years before you earn any revenue, expenses that you can then amortize once the revenue appears. If you are a small company but not a startup, then your software expenses are probably not R&E, they are ordinary section 162 expenses.
It's a law in the opposite direction nevertheless impeding innovation (i wonder the intent!), because it adds complexity for the tiny poorly funded businesses
I think it would be much more helpful if you tried avoiding stating this as objective truth, and state more like your non-accountant opinion is that's how it works.
Ever heard of sales tax?
I have an S-Corp so "profit" would pass through to my personal taxes.
I've found over the years that most people writing and administering tax and business regulations at the local, state, and federal level have little clue about the needs of small businesses, whether it's a software startup or a local pizza place.
Manchin killed the bill last year that would have extended the protection from 174…
unless they are overseas and have no US tax liabilities.
But also seems like you could sidestep this by taking your salary as CEO rather than as a software developer or...something?
Let's say I took a 500k year salary and paid 1M to my developers.
I always claim development as R&D.
I now need to pay taxes on (500k + .8 * 1M = 1.3M?) Despite only taking 500K salary? At some point I would owe more in taxes than I took in salary..
In general, I'm not so sure this is particularly apocalyptic unless you are bootstrapping with high expenses, and you are doing hard tech without a launched product. If you have a launched product, software development can be an operating expense. If you don't, it's harder to justify. If what you are doing has low technical risk, you can also put the number in a different spot on your income/loss statement and operationalize it. If what you are doing has low expenses, it probably doesn't matter much either way because it's not worth anyone's time to figure out if you can actually claim the credit.
If you are bootstrapping a hard tech product and have not launched anything yet, I hope you can afford the amoritzation, because you might not be able to afford your technical risk either.
If you try to avoid ever getting entangled with the IRS you will way overpay.
E.g,: https://johntreed.com/products/aggressive-tax-avoidance-for-...
I mean that sounds great to me...I just also feel like it's probably a very "liberal" interpretation indeed.
The part I'm getting hung up on is essentially, previously R&E expenses (as you note) were a lot more fungible, it depended on a number of factors including how risky the endeavor was. Things that you just do day-to-day in the service of keeping your company afloat (which for a launched SaaS for example would include fixing bugs or even developing basic features) were likely not R&E. Maybe if you embarked on a journey to develop a totally new product, it would have been.
It seems like the most basic reading of this is pretty straightforward: they've taken that decision making away and said "if it's software dev, it's R&E." Not "if it's software dev for a new feature, but hey existing bug fixes and maintenance don't count," just, "software is R&E now always."
Obviously everyone has their own risk tolerance for how they interpret things and what definition they use.
And yes, I would say that software that isn't continually developed rots, so if you have a launched product, you aren't really working out your technical risks, you're keeping your revenue stream alive. That sounds like a cost of goods sold to me.
Previously, all of our accountants wanted our work to be R&D, which is why we include things like "all software development" in R&D. Now, we may not want it. There are a lot of other places you can put it.
EDIT: CRUD apps have always been on the line between R&D and not R&D, so let's just put our toes on the other side for 2022 and beyond. In comparison, biotech and hard tech endeavors are screwed because that's not even arguable.
1: https://www.hklaw.com/en/insights/publications/2023/01/rd-co...
> Startups unable to utilize the credit under Section 41 should consider whether an amortizable expense under Section 174 or an immediate deduction under Section 162 is more appropriate.
So, their interpretation seems to be that you have three options.
Though, I'm not sure you can split the credit or carry any forward, etc. Every tax situation is different.
Under the current law you can no longer do both, if you want to take the R&D credit you have to instead amortize the R&E expense under Section 174.
Or from the other comments in this thread it sounds like you can maybe skip the R&D credit and then continue to deduct the R&E expense under Section 162. But it's not clear (to me anyway) whether Section 174 supercedes Section 162 in the case of software development costs, in which case you might no longer be allowed to apply Section 162.
I had the exact same conversation with my CPA last month. They told me the same things that you were told by your CPA: R&D expenses, including software development, must always be amortized over 5 years starting in FY22. The R&D tax credit has nothing to do with it. There is no option to deduct these expenses. Amortization also now applies to failed or abandoned R&D projects, which is a major change that seems likely to be devastating to innovation.
In my opinion this rule is a disaster. Call your congressperson and your senators: https://www.congress.gov/members/find-your-member
Some in this thread have argued that the rule change means that all software development is now R&D which would be a radical change and would have the impact that the OP describes.
I’m still not convinced by the argument that all software development is now R&D: it just doesn’t seem plausible, what on earth would be the reasoning behind that? Yes, this bill is garbage and it may have unintended consequences, but to suggest they’ve accidentally made all software development be R&D seems inconceivable — even before considering the amortisation consequence.
Setting aside the apparently absurd state of things as they stand today, I agree in principle that coding that doesn’t result in a new asset shouldn’t be treated as R&D and thus should be deductible even under this regime. However, the issue that we’ve been grappling with is that even if we end up there, it’s still not totally clear where the line is with regards to software, as software is markedly different from other asset classes (e.g. machinery or equipment). Code written to support an existing revenue generating piece of software may still be R&D. For example, is adding a new feature to software R&D that creates a new asset (the new feature and new software version), or is it maintenance of an existing asset (the existing software)? It’s a mess. Under the previous regime this wasn’t an issue; you had an option to treat software development either way, so no one was worried about these nuances because it was a choice, meaning there was no way to get it wrong. Not so anymore, and the IRS is not helping to understand it right now based on what I’ve been told.
Then add in the administrative burden presented by this change: Software devs are likely to get very familiar with 0.1 time tracking that lawyers and other professionals suffer with if this change sticks, so that businesses can figure out what is deductible and what must be amortized.
Another issue is that if you dispose of or retire the asset there doesn’t seem to be any provision to accelerate or write off the depreciation immediately. This starts to look like a particularly pernicious challenge in the case of startups, for whom cash flow is an issue and who may very well fail before the 5 year amortization period is up. It’s also a major potential issue in the case of re-writes.
The apparent inability to write off failed R&D is also a devastating change in my opinion, and its impacts extend well beyond software. It greatly increases the risk of R&D at a time when we need it most to confront challenges like climate change, to remain competitive with China, to capitalize on opportunities in AI, and so forth.
So while I agree with you in principle, even if that’s where we end up - and it makes sense that it’s a reasonable outcome if deductibility is not restored - it’s still a real mess compared to where we were previously, and will have the effect of stifling innovation and economic growth.
EDIT: Cleaned up a bit. A lot of folks do contradict my point: They’re saying that you can still deduct software development R&D citing old info, or that you can deduct it if you don’t take the credit. That’s just wrong.
Thank you for sharing your own experience with your CPA as well.
Same. If you learn of any please drop a comment, and I will do the same!
Well, did you spend the $90k on W2 salaried employees, or to a vendor?
> Essentially, all R&E expenses...
The R&D tax credit was too good to be true anyway.
The crazy loopholes are crazy. What were people expecting?
Congress was not going to let people outsource "R&D", which in the bulk of cases is large companies like Accenture and small companies like bullshit agencies doing straight-up software customization that had little to do with real research or development.
Insofar as it affects startups, the amended law seems to exist explicitly to rein in the pro-forma declarations / reports template-generated by non-specialists.
Every tax or HR related firm in existence has been hawking this bullshit to tech companies for a while. Truly a bunch of parasites.
Congress needs to repeal the R&D tax credit as it exists today and allow people to ordinarily expense whatever it is that they are doing.
If it feels there is a good reason to make the money-to-US-salaries tax-reduced, it should make a simple blanket declaration checkbox for a narrow set of qualifications that would obviate the need of "R&D tax credit specialists."
> Well, did you spend the $90k on W2 salaried employees, or to a vendor?
It wouldn't matter, if the expense is related to the business of developing software, it counts now.
The reality is that even if you hire a “software developer,” they aren’t going to spend 100% on it. So now you have a situation where the IRS is supposed to audit how? Watch how much support you did? How much training and coaching other developers? How much email/scheduling/admin bs? Was that meeting about software development or customer research? The fools who write these laws are just ridiculously out of touch.
The whole reason this tax credit exists is to promote more R&D. If you are doing heavy R&D you can pay less income taxes. It's an incentive for companies to not hoard cash but to put it into creating new business and opportunities and stay competitive. They still have to pay payroll tax, which is a substantial portion of the tax companies pay to the federal government anyways. But even that too is an incentive for companies to run more efficiently: the fewer people you have on payroll and the more R&D you do, the more your company is an innovation machine - that ends up being good for the economy.
There are obviously lots of cases where American companies use loop holes to not pay taxes (especially on international income). That's a separate debate. But if you see a big company (like Amazon) not paying income taxes, it could mean they heavily invest in R&D. That's why when I hear politicians whining about this, I know they are not always doing so in good faith.
If you do “R&D” you can elect to receive a credit. This credit which used to come all in one year, now must be amortized over 5.
If you don’t want that to happen or cant afford it, don’t take the credit. It’s that simple. Not all software development is automatically forced to be R&D. That’s absurd.
IANAA just a poor misinformed internet soul and this is not tax advice.
I think you should review what I linked or talk to a CPA because this this indeed the change this year, and it is indeed nonsensical.
This is not the same thing as the R&D tax credit.
> Generally, section 174 expenditures escape the application of being classified as “start-up costs” under section 195, which generally requires expenditures that qualify as an expenditure under section 162 to be capitalized and recovered over 15 years once the taxpayer begins their business.
Startup costs are things paid to start the business. Once the business is up and running you are “carrying-on” even if you’re not making money. It’s unfortunate that we use the word startup colloquially to mean non-profitable company, because thats not what it means in the IRC.
That's the question isn't it? What is considered your profit depends on what costs you must amortize vs. expense in year one. I'm not super familiar with this legislation but the concern is that it shifts development costs that were previously expensed to now be amortized.
Everyone knows taking the R&D credit (Section 41) is optional, that's not what is being discussed here.
The actual question is: if you have incurred software development expenses (e.g. wages paid to software developers), are you required to treat them as R&E expenses under Section 174, or can you instead treat them as ordinary expenses under Section 162?
Also thanks for Reddit ;)
To make matters worse, failed or abandoned R&D projects can also no longer be written off, and must also be amortized even though they resulted in no new products or innovations. All of these changes greatly increase the risk of new R&D projects. It's an absolute disaster for innovation in a time when the US is ostensibly entering into a great-powers competition with China.
I'm more just frustrated at the need to do any of it, as the underlying principle is so anti-small-business. Why are we making anyone in the software field jump through all these extra hoops now just to keep their company viable?
What I've heard is that there's already strong support for changing this but it's just a matter of Congress actually being functional, which political affiliation aside, it's not right now.
I'm glad it made it to the HN front page, but I'd like the desired change to make it into a bill to be passed by Congress before we all pay our 2022 taxes on April 15.
What groups out there are fighting this?
[0] https://www.journalofaccountancy.com/issues/2022/nov/amortiz...
In fact it says:
> The TCJA added a special rule under Sec. 174(c)(3) for the treatment for software development costs, stating that “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.” Prior to this addition, taxpayers relied on Rev. Proc. 2000-50, which stated that the costs of developing computer software so closely resemble Sec. 174 R&E expenditures that a similar accounting treatment should be used. When this revenue procedure was issued, R&E expenditures were currently deducted. Under the TCJA, software development costs are treated as R&E expenses but are now subject to five- or 15-year amortization.
...which is what I am saying in my example -- software dev costs are now forced to be 5-year amortized.
> companies engaged in research and development (R&D) activities should be implementing this significant change
I think it might require backing up into tax code Sec 174 "Amortization of research and experimental expenditures"[0] itself though. There it says:
> (3)Software development - For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.
Keying in on "For purposes of this section" I think we'd need to figure out is software development expense always required to be treated under this section, or is this just talking about software development expenses that are made in connection with R&D expenses which are under this section. It's hard to imagine all and any software development expenses are R&D. E.g. if you're running a software service company and have 10 engineers building something for a client, maybe it's R&D for the client but it's in not at all R&D for the service provider....right? I am not a lawyer or tax accountant so I may be way off base here.
You can go to the bank and take out a loan. It's called a "factor loan", and tax receivables are solid collateral.
Better than bankruptcy, though, and it's often better than accepting VC terms.
If I run a software business that brings in 100k but spends 90k on developers, then thats money going for salaries or contracting, both of which are fully deductible.
This is new as of the 2022 tax year, thus the considerable confusion.
In my experience the IRS isn't dumb or unreasonable.
The purpose of R&D tax credits is to stimulate R&D spending. It isn't to penalize you for ordinary business expenses.
The following two scenarios should compute the same way:
1) You operate a software services business. 100% of the development you do is for other people. You bring in revenue and pay your team, which is a straight expense. You pay salaries, and you get taxed on net income.
2) You run a software business. You hired engineers to build software. You sell it in some way to bring in revenue. You deduct your expenses, pay taxes on net income.
Now, our government has decided that companies should be rewarded for doing R&D. This means that, if you were able to demonstrate certain expenses as R&D expenses - you get to claim the R&D tax credit for those expenses. Maybe this is how some companies expense certain employee perks (massages, lunches etc..) that don't get accounted as employee compensation.
There seems to be enough confusion on how to claim R&D credits, that many companies don't even bother:
- https://taxfoundation.org/research-and-development-tax/#Eval...
(Obligatory "should ask a CPA" but I don't see much mention of this case around anywhere)
Your client agreements may also have an impact on the answer (for example, does the client own the IP or do they license it from you?). So you really need to talk to a CPA!
Tax concerns aside, downstream effects may be an issue for you: If my understanding is correct, clients will no longer be able to immediately expense your fees, and will be required to amortize them over five years. I would expect that this will therefore likely result in less demand for software contracting services in the overall economy as businesses become aware of the change and reevaluate their build vs. buy decisions.
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These rules were established as part of the 2017 tax bill and take effect this year.
FTA: "The short answer is that the conclusion of the current congressional session with no action on this issue means required capitalization of R&E expenditures remains applicable to the 2022 tax year."
Oh it's a terrible policy for you. Yes, for you, the person who may want to actually create something which threatens the people who own large businesses, this is quite terrible. But for the people with lobbyists who want to make sure competition is made almost impossible to happen, it's just amazing.
That may not be a charitable take, but the politicians and corporations no longer deserve an ounce of beneficial doubt when it comes to the games they play.
> Research or experimental expenditures paid or incurred by a taxpayer during the taxable year in connection with his trade or business are deductible as expenses, and are not chargeable to capital account, if the taxpayer adopts the method provided in section 174(a)
Seems like there could be room to challenge "all software dev is R&D"
But it is a powerful argument for simple tax codes.
I like the idea of tax. I'm happy to pay my share. I am in unhappy about all the leeching lawyers
I expect in your country as in mine, rules are made by lawyers and mainly benefit them
At issue seems to be the interpretation of the change introduced in Section 174(3) saying:
"(3) Software development For purposes of this section, any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure."
Does this mean that payments to programmers to fulfill the software maintenance contract _must_ be considered R&E expenditure (and can thus not be deducted as Section 162 "Trade or business expenses" and _must_ be capitalized in terms of the amendments to Section 174).
If this is the correct interpretation of the amended law, I would expect large companies like Apple and Alphabet to be subject to this problem as well - surely it would be material if one of their main costs (being software developer salaries) cannot be expensed from this year. Yet I have seen no comments around this from that side, either explaining suddenly higher earnings or higher taxes due.
If that is not the correct interpretation of Section 174(3), and some programming related costs are not to be considered R&E expenditure, how do I explain the reasoning to my accountant?
