Ask HN: How are you handling Section 174 changes for bootstrapped companies?

[silverlight]

Hey everyone,

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

[phphphphp]

I am not a tax expert but my understanding is that a business would claim expenditure as R&D because of the beneficial tax treatment: it's a choice you make to categorise expenditure as R&D, you're under no obligation to do so. If the tax treatment of R&D spend has changed to be less favourable in your circumstance (i.e: you can't afford the short term cost of amortisation) then you would not claim the spend to be R&D related. After all, a small technology company working on their revenue-generating product is not doing anything experimental: it's only experimental if you massage it as such.

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.

[silverlight]

This is how it worked in previous years. Previously, you could elect to take the R&E expenses either entirely in a single year or amortized over the longer period. This year the change is:

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.

[riku_iki]

> it's a choice you make to categorise expenditure as R&D, you're under no obligation to do so

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.

[moneywoes]

So how would someone categorize those expenses differently?

[hesdeadjim]

It’s an absolutely fucked situation. In what world is revenue taxed *before* expenses. It’s a nuclear bomb for US innovation. Meanwhile China offers a 2x credit and the EU is almost as generous.

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.

[Majromax]

> In what world is revenue taxed before expenses.

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.

[MNCPAGuy]

Revenue taxed before expenses? That’s not what is happening or a good way of explaining it . It’s a temporary timing difference for recognizing expenses and deducting them on the tax return.

[dcow]

That’s not how it works. OP is misinformed.

[thaumasiotes]

> It’s an absolutely fucked situation. In what world is revenue taxed before expenses.

Ever heard of sales tax?

[w4]

Everyone commenting in this thread that R&D can be written off is working with outdated information and is not up to date with the current state of play.

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

[phphphphp]

The point being made by myself and others in this thread doesn’t contradict yours: all software development is not R&D, R&D is a specific activity related to speculative work. A bunch of people churning out code to support a revenue generating product are not engaged in R&D. Historically, it has been beneficial to classify as much as possible as R&D because of credits. The point of contention is not whether R&D must be amortized, it’s whether or not R&D classification is a choice.

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.

[silverlight]

I did contact my Congressional Representative but I would love to know what interest groups are working on this actively that I can support further.

Thank you for sharing your own experience with your CPA as well.

[MNCPAGuy]

Great info and comment. Thanks!

[alexb_]

>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.

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.

[ilikeatari]

Yes, it's a big issue. It's fascinating how little it's talked about. I think this requires that we organize grassroots visibility into this. Also, wouldn't YC have some mechanisms to organize? I mean, I think this impacts every tech business other than unicorns.

[silverlight]

I have also been surprised since I found out at the lack of discussion. Based on this post, it seems like many people didn't know. I assume a lot more are going to find out as we get closer to actually filing taxes.

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.

[jedberg]

I have a tax pro for this very reason, but my understanding is that you have a choice on how you want the tax treatment -- you can deduct it now as a business expense or over five years as R&D, which gives you a better tax deduction in the long run but fewer up front benefits. But at the end of the day I pay the tax guy to worry about it for me.

[silverlight]

Did you talk to them about this specific change recently? Because how you're describing it is how it used to work, just not starting this year.

Also thanks for Reddit ;)

[w4]

You don't have a choice anymore. It's required to be amortized as of FY22. I had the same conversation with my CPA in January.

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.

[brentm]

According to Journal Of Accountancy[0] this seems to only apply to software expenses that are also treated as R&D expenses. So if you expense the costs and don't claim R&D credit you lose the credit but would also not have the cash flow issue being described. It's still a net negative but at least less negative for current year cash flow.

[0] https://www.journalofaccountancy.com/issues/2022/nov/amortiz...

[silverlight]

I don't really see anywhere in that article where it says that you can have software development expenses that aren't R&E expenses under the new definition. Am I missing it or?

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.

[usefulperstive1]

> ...and spend $90k making the software

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."

[silverlight]

This is not the same as the tax credit. That is a different deal. Even if you do not claim the credit at all, you still have to do this amortization.

> 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.

[danielrhodes]

There are obviously stupid loopholes in tax law that serve no wider benefit, but that's not the case here. This was very intentional and not crazy at all.

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.

[ilamont]

Wow. I had no idea this was happening. Not a peep from my accountant, either.

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.

[hesdeadjim]

My expensive accountants didn’t bother mentioning the Section 174 changes because like every year since the 50’s that law has been delayed or overridden through other legislation.

Manchin killed the bill last year that would have extended the protection from 174…

[silverlight]

Correct, my company is a partnership LLC and these "phantom profits" are going to flow through to me personally to owe taxes on.

[pclmulqdq]

I am not a tax expert at all, but I pay some tax experts a lot of money, because I do a lot of bootstrapped R&D and the tax laws around it are nuts. My accountant has suggested that I am totally fine, but my lawyer told me he wanted to do more research (not that this was an outright bad rule), but didn't think I would be stuck on this. I declined on the research (legal research is very expensive). My lawyer is very conservative, and my accountant is very liberal on this sort of thing, so that's the range of opinions I'm looking at.

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.

[bombcar]

As a general reminder as long as you have a reasonable interpretation of the tax code; even if it is NOT the IRS's (and the judge eventually rules for the IRS), you will likely be clear of penalties.

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-...

[silverlight]

So you're saying that the advice you got was that if it's a launched product, you can treat software development as an operating expense and just ignore the fact that 174 says software development is an R&E expense?

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.

[mountainriver]

This sounds right to me, if the government started coming after software companies and penalizing them for this they will have an absolute storm on their hands

[voakbasda]

Gosh, doesn't this just reek of a move to entrench established big business by erecting regulatory hurdles, designed primarily to prevent anyone from following their path to success.

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.

[bryanlarsen]

> 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?

You can go to the bank and take out a loan. It's called a "factor loan", and tax receivables are solid collateral.

[silverlight]

That may be one option, but now I'm paying interest to give the government an interest-free loan in an inflationary environment. Great.

[leetrout]

It also says in Sec. 1.174-3 Treatment as expenses:

> 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"

[jjk166]

Sounds like you paid $9k for software development and $81k for other computer services.

[idlewords]

The answer is you spend part of the 10% profit on a CPA or tax lawyer. The legal deductions, they are so many. I've run a bootstrapped software business for 14 years and I never even heard of this one until your post.

[nightpool]

see https://news.ycombinator.com/item?id=34628269, this caught everybody by surprised because they assumed Congress would fix their mistake before tax season but it's new this year and it's seemingly pretty devastating. see some replies from actual CPAs in the thread.

[moneywoes]

Is there a list of these deductions somewhere for those who can’t afford a cpa or tax lawyer

[itake]

How do you deduct payroll / dev costs?

[linuxftw]

There's an R&D tax credit. See [1]. I would aggressively pursue this option. Much better than a deduction anyway.

1: https://www.hklaw.com/en/insights/publications/2023/01/rd-co...

[codazoda]

Specifically, that law firm says...

> 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.

[nodamage]

Under the previous law it was not a mutually exclusive choice, you could deduct the R&E expense under Section 174 and also claim the R&D credit under Section 41.

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.

[worik]

I have been reading the comments, I cannot help.

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

[govert]

I am in the same position - my accountant got an opinion from a CPA who said that software development costs _must_ now be capitalized. My company sells support and maintenance contracts for some open-source software, and so the 'software development' entails updating the software to work on newer operating systems and platforms etc. Contractor programmers are paid to do this software maintenance work.

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?

[MissTake]

Granted I may be reading this wrong (dog knows I’m confused over the US tax code at the best of times), but I got the impression from reading this link (https://www.plantemoran.com/explore-our-thinking/insight/202...) that the 5 year rule wasn’t yet in place.

[jollyllama]

IANAL but maybe marketing took up way more of your time this year

[silverlight]

Yes I assume the definition of "software development" is going to be stretched as far as possible by most companies this year.