Ask HN: How are you handling Section 174 changes for bootstrapped companies?
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
194 comments
[ 0.65 ms ] story [ 4228 ms ] threadBut 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..
So it's like:
Year 1: 0.1 Year 2-5: 0.2 Year 6: 0.1
You really can't just read individual sections of the tax code and expect to understand how the thing works as a whole.
My other business has a different CPA that I am waiting to hear from in terms of their advice/interpretation of this.
The articles I linked in the OP is from a multi-national CPA firm.
I am basically here hoping someone else has professional advice from a CPA that contradicts what I've been told since I would love for this to be completely not how this is working.
So I just want to make sure, are you saying you heard from your CPA/tax attorney that this is not how this works? Or are you just basing that on your read of it?
Keep talking to CPAs until you find the one willing to engage in sufficiently aggressive tax treatment to not bankrupt your company. Tax returns are not footnoted; you're not required to explain at time of filing what exact reading of your activity and the tax code leads you to believe you have a vanilla payroll expense vs a capitalized R&D expense.
To be clear my companies are going to be fine either way, but I am not a fan of pulling up the ladder of success behind me and the me of 10 years ago trying to start his first thing shouldn't have to deal with this nonsense.
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…
It’s planned.
OP is right. Manchin gets the blame but 50 others voted against it as well, many who would be willing to cross the aisle but for the toxic partisan environment in this country.
That act changed section 174 in this stupid and extremely detrimental way.
So no. It was exactly "one party" (the Republican party) whose fault this is.
https://pilot.com/pricing
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.”
EDIT:
Let me elaborate: unless you are in the “start up phase” incurring startup costs, you are not required to follow section 174. I suspect the confusion is between how we use “startup” colloquially vs how the IRC uses “startup costs”. Once your business is up and running you are “carrying on” business, even if you aren't yet making a profit. You are only required to follow section 174 if you are choosing to classify your expenses as “startup costs” which in my experience would be very odd after the first year and even after the business is founded.
Not an accountant of course, but nobody is going to tell me to pay taxes on revenue before expenses. And writing software does not automatically mean you are doing R&D. Not even in spirit. If you’re writing a script that speeds up part of your business and makes you more money, thats not “R&E”. It’s just work.
EDIT2:
> In the meantime, the Section 174 amendment should not cause established taxpayers to adjust their accounting methods when applying Section 162. Existing taxpayers incurring R&E costs as part of their ordinary and necessary expenses while carrying on a trade or business can continue to make deductions with confidence that legislative and judicial history support that practice.
https://news.bloombergtax.com/tax-insights-and-commentary/ch...
Honestly my main reason for starting this discussion was a) to see if anyone else's professional advice (e.g. from a CPA) was different, and b) to hopefully drum up awareness so maybe in some roundabout fashion this gets changed.
Sure, bugs happen. But in a system that holds immense power over people's lives, we should be striving for the level of bugs to be similar to life critical safety systems and not some glitchy business website.
The job of a congressional staffer is to ensure reelection so we spend almost our time getting the member on the most powerful committees (for more campaign contributions) and getting on tv (for free media).
Committees do spend more time on the content of bills but each member usually only has one staffer for multiple committees and they are still told how to vote by the party.
I wasn't 23 years old when I was writing these summaries. I was 21. There was no one in the office over 30, and no lawyers.
https://en.wikipedia.org/wiki/Legislative_Digest
Nobody should be subject to a corpus of rules too volumous for them to read and understand.
It's absolutely unforgivable that legislators don't even read the laws they pass.
That does not imply that no one reads any bills. As a change to the tax code, the Section 174 language we’re all talking about was read by at minimum the (very capable) professional staff of the Joint Committee on Taxation and the CBO, for purposes of scoring the revenue impact of the bill.
The impacts of the Section 174 changes are in fact intentional, done to change said scoring. Whether or not they would be popular was not the point; all changes to the tax code are unpopular to someone. The point was to find a configuration of changes that could pass both houses at that time and get signed. That usually means a few big-ticket changes, and then lots of monkeying around with other things (like R&D) to offset those.
It's easy to get a small change in when there's general agreement. But sometimes it's like immigration law --- few like the status quo, but there's no consensus on what direction to change it.
Just because you write, read, and understand anything doesn't mean mistakes don't get through. Should we never release any code unless it's completely bug free?
Fixing these tax issues, on the other hand, would have had to be attached to the NDAA or omni last session, both of which require bipartisan support; big bipartisan bills are so contentious that it's hard to get unrelated deals through, especially since everything goes down to the wire these days. In this case, a deal that would have expanded child tax credits in exchange for a bunch of corporate and high net-worth household goodies, including section 174 fixes, was on the table, but couldn't get through negotiations. (I'll note that, while the Republicans created the section 174 mess in the first place, they are now trying to repeal that and other TCJA changes, but aren't willing to add lower-income individual tax cuts into the mix, which is what stalled things in the last Congress.)
It's a hell of a mess, and things are made crazier by the weird power dynamics in the current House leadership, where a small group of fiscal bomb-throwers have outsized power in the Republican party (and it's not clear that they care about tax minutiae, at least not while they're playing with a federal default on the national debt), but the inter-party margins are so slim that you could potentially cobble together a bipartisan majority on the edges. No one seems to like the section 174 situation, so it's at least theoretically possible that you could get a small coalition together to cut a deal at the last minute -- but I'm not sure we can count on that.
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.
> "Is Section 174 Needed to Deduct R&E Expenses?"
> "In a word, no. During the Supreme Court oral arguments regarding Section 174, the IRS commissioner said that any ongoing business with a history of R&E expenditures could use Section 162, regardless of whether the new activities were in the same trade or business."
This article seems to gloss over the fact that Section 174 was essentially crossed out and rewritten in the TCJA. You can compare the previous version with the new version here: https://law.justia.com/codes/us/2020/title-26/subtitle-a/cha... (Compare the "Section Text" which applies pre-2022, to the amended version under "Editorial Notes" which takes effect in 2022.)
Court rulings and IRS commissioner statements which referred to the previous version of Section 174 may no longer be relevant. The previous version stated:
> "A taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The expenditures so treated shall be allowed as a deduction.".
Okay, if it says a taxpayer "may", that does not mean the taxpayer "must", and it makes sense that the alternative Section 162 deduction was still available for the same expense.
The new version states:
> "In the case of a taxpayer's specified research or experimental expenditures for any taxable year— (1) except as provided in paragraph (2), no deduction shall be allowed for such expenditures"
Paragraph (2) then describes the allowed amortization process. Note that any language suggesting this treatment is optional was removed in the new version. This suggests to me that Section 174 is now intended to supercede Section 162 when applied to research or experimental expenditures and therefore the Section 162 deduction may no longer be available.
If that option exists still, then nobody needs to panic.
If it does not, then maybe everybody should panic.
Or at least, everybody starting up a business requiring in software development.
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.
I still do not see any clear indication that a taxpayer is required to consider any expenditures as R&E expenditures, though the new clause about software is ... troubling.
Not in any way qualified to provide tax advice, don't take the above as anything but idle chat.
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.
unless they are overseas and have no US tax liabilities.
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."
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.
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.
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.
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.
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?
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.
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.
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
Ever heard of sales tax?
> 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"
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?
Of course the cost of using software to support your business is already deductible as an ordinary business expense. Just to be clear, the discussion in this thread is about the deductibility of the cost of developing software.
> Use section 162 not 174.
The point of the discussion is that it's not actually clear whether this is still possible (for software development costs) after the TCJA changes went into effect in 2022. Please see my sibling comment here for further elaboration: https://news.ycombinator.com/item?id=34634335. (In short, the TCJA rewrites Section 174 to imply that it now supercedes Section 162 for the purpose of software development costs.)
Either way, the situation does not appear to be as cut and dry as you seem to be suggesting.
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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.
[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.
[0]https://www.law.cornell.edu/uscode/text/26/174
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.
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?