Can someone explain this? What taxes do unprofitable US businesses owe that this would be deducted against?
In 2024, your business has $1m in revenue and has $2m in expenses. 100% of these expenses are R&D salaries (engineers you hire.)
Your company loses $1m/year. (You brought in $1m and spent $2m.)
Under the old rules, you'd owe no tax because you were unprofitable.
After Sec 174, what the IRS now says is:
You had revenues of $1m. But you only had $400k in expenses (because you now have to spread that $2m in R&D expense over 5 years).
So actually you had a profit of $600k! And you owe tax on that $600k profit (~$120k)
So you now have an additional $120k tax expense, making your business even more cash-flow negative.
.
Amusingly, if you're pre-revenue, none of this matters (you have no income at all, so it doesn't matter what your expenses are.) You get hardest hit by this change when you have some revenue and when you do a fair bit of R&D.
That is surely wrong? Just because those salaries are for R&D?
I could understand if there was some additional tax break for R&D which was being removed. I can't see how basic operating costs cease to be expenses.
Buying a truck is an expense, as is buying gas for the truck. But the former you have to amortize over x years, the latter you can expense immediately.
The law used to be "employee salaries for software are like buying gas" and now it's "employee salaries for software are like buying a truck".
The rationale behind amortization isn't exactly the idea that the asset can be sold, it's that the asset is producing revenue over multiple years. For software, the asset is the codebase.
Let's say you hire a single software dev, for one year, and they write Excel++, which you can sell for the next ten years. It would be entirely appropriate to amortize the cost of creating that software over those ten years, based on the matching principle (a fundamental idea of accounting, matching expenses with revenue).
The issue in the real world is that's not how the software industry actually works, 99% of the time.
What would be a more appropriate model from accounting perspective?
Part of the complication here is companies generally really like amortizing stuff. It lets you smooth your profit across years which is usually better both for tax purposes and for your financial reporting for the market. So this kind of change is fine or even good for a company like Google, but can really suck for a small bootstrapped SAAS. This is why I'd allow companies to pick, with some degree of latitude.
You must have misphrased what you intended to say. If what you wrote was true, a software company's most valuable asset would be the specific programmers in its employ. If true, average tenure of a programmer would be way longer than 1.5->2 years as companies worked really, really hard to keep their most valuable assets from walking out the door into the doors of another company just to get reasonable pay increases.
Perhaps your opinion is influenced by doing post-collapse-sales of a whole bunch of software houses that built just plain bad software? I can't see why else you'd be selling "software IP" independently of the rest of the business.
Anyway. Given that information, how should you have phrased what you wanted to say?
On the other hand, I've worked almost exclusively on software R&D for decades and seen the loss of a single person effectively end a project even when the software was essentially finished. Software R&D is about developing abstract knowledge, concrete implementation code is just a useful byproduct of that since R&D is typically motivated by a specific novel requirement.
If the software IP that results from R&D is not core to your business or a competitive risk, there is money to be made by licensing it. I've licensed this type of IP to big tech companies a number of times. If you are not actually doing software R&D, you are unlikely to be in a position where this is a possibility.
In almost every IP sale and licensing deal for software R&D I've seen, the value of any code is almost entirely conditional on retaining the services of person(s) that designed and wrote it. The entire "acquihire" phenomenon is an explicit admission of this. This is true even when the code is in a mostly finished form. Companies are buying capability, not revenue, so the code can't be a black box to their engineers. Companies usually spend more to acquire people with the code knowledge than the actual code.
The practical reality is that it is difficult to reverse engineer abstract knowledge from a concrete implementation. No one wants your code per se, they want to adapt your code to a different application that requires having a deep understanding of the domain the code represents -- they don't know what they don't know.
If you are just grinding out software that could be vibe coded then there is minimal asset value being created in the software artifacts. Anyone else would be better off reimplementing it themselves.
So yes, almost all of the value of code produced by software R&D vests in the people that wrote it. This is evident across many software IP transactions.
So, what you're saying is one or more of the following:
1) The work of most programmers should not be considered R&D, and shouldn't be covered by tax schemes intended for R&D.
2) Most "software IP" in the industry is not the result of R&D.
3) You've rarely been involved in the sale of non-R&D "software IP". (Do recall that your original statement was "As anyone that has ever sold software IP knows, most of the value is vested in the person that wrote the code, not the code itself.")
I think the third statement is a bit personal so will leave that alone.
The unfortunate thing that kicked off this discussion was that you talked about "...[selling] software IP...". Thanks to active work by copyright maximalists [1] over the past 20+ years, the term "Intellectual Property" applies just as well to plug-and-chug Enterprise CRUD software that sells for megabucks as it does to leading-edge research projects that -like- actually have Key Personnel and die dead if those folks go away. Anyone who is capable of paying attention and has been in the industry for more than a year or three is quite aware that plug-and-chug CRUD is far more valuable than the overwhelming majority of the people who make it.
So, yeah. From that arose the confusion.
[0] ...and because I can't be arsed to go look it up...
[1] My position in brief: copyright and patents are absolutely essential, copyright terms are insanely long, and patents frequently granted when they should not
if anything, the amortization should match copyrights or patent lengths
The salaries are of course expenses, but they are exactly offset by the value of the IP created by the R&D activities.
It's a bit as if you spent money on buying some materials. As long as the material doesn't degrade, the cash is gone but the value is the same and therefore won't reduce your taxes.
If that IP is amortized over a single year, it does not contribute to taxation, but it does if it is amortized over a longer period.
If your employee expenses remained constant, then by year 5 you would be deducting $2m from your revenue since you'd be accumulating the deductions from the previous four years.
So in steady state it wouldn't necessarily be a big problem. But for a startup which is hiring many new employees and whose revenue is growing it's a huge problem.
>That is surely wrong? Just because those salaries are for R&D?
The same would be true if you hired a bunch of scientists/engineers and got them to do R&D.
In the UK, business gets taxed on profit, which is what is left from revenue after subtracting costs.
Otherwise I'm quite amazed that salaries can be carried forward as future expenses.
I know of at least two Western European countries where you don't have to do that. Don't worry, we pay enough taxes either way ;)
Sorry for the noise :(
The relevant paragraph from Section 174:
> (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.
Or is it "using software"?
A person typing an essay with a word processor in doing more work than many of the users tweaking no code software.
The nature of the tweak involved probably determines the classification of the effort, but for tax purposes and R&D expense amortization, it is a percentage of time basis.
If the executive tweaks the code once, the percentage is so small it won't count as far as anyone cares.
If 20% of the executive's time is tweaking the tool, then odds are the company cannot expense 20% of the executive's salary and instead must claim that portion as R&D over five years.
Back before 174, I worked for a company that did claim R&D but only for one of the projects I worked on. As such, I had to be careful filling out my timesheet because they wanted an accurate accounting of what was salary expense and what was R&D.
how about "business process mechanization"?
Have you seen who's leading the most powerful orgs these days?
Have you seen what's going on?
"business process mechanization" is a fair description of what we do and probably would be just fine, tax-wise
Classifying them as non R&D doesn’t help saving taxes again.
Say you would have been exactly not-profitable ($0) if you could expense all of your R&D as in the old system, therefore avoiding tax. Now with the new rules you may be on-paper profitable because you can only deduct 20% of the R&D as an expense this year. The remaining 80% of that expense tips you over, becomes profit, and that's taxable.
An unprofitable business doesn't pay income taxes. Businesses are taxed on their net income (i.e., profit).
People are railing against this as the cause of tech's recent underperformance, but it was a non-factor for the vast majority of tech companies, because most tech companies aren't profitable and wouldn't have paid taxes anyway.