Congress is working on a tax package (called the Smith/Wyden tax package) that could revive key tax provisions, including the deductibility of research and development expenses. This legislative change is important for startups – under current rules, even money-losing startups could actually owe taxes. 5% of Kruze clients fell into this category last year, even though close to 100% of those startups were burning cash.
The tax treatment of research expenses was changed by the 2017 Tax Cuts and Jobs Act (TCJA). R&D expenses used to reduce taxable income dollar for dollar – if a startup spends $1 million on R&D, its taxable income goes down by $1 million. However, beginning in 2022, startups were required to amortize deductions over five years for expenses in the US or 15 years for expenses incurred outside the US. For many startups, $1 million in US R&D spend became only $100,000 in expenses in 2022, for federal income tax purposes, and many startups that may not have had a tax bill under the old rules could now face a tax obligation.
The current legislation proposes to restore 100% deductibility and would be retroactive to R&D expenses made from the beginning of 2022 to 2025. The overall $78 billion tax package is very complex, and is currently under negotiation.
What’s included in the legislation?
The primary goal of the new legislation is to establish a bipartisan agreement before the tax filing season begins on Jan. 29. The current legislation has several business tax components, rolling back some of the TCJA provisions:
Impact on Startups
Restoring R&D to full deductibility
Businesses will again be allowed to deduct 100% of domestic R&D expenses in the taxable year the expenses are paid. Under current law businesses are required to amortize US R&D expenses over five years or 15 years if the expenses are outside the US.
Business interest deductions deductibility
The limit on business interest deductions will increase due to a change in the formula for calculating a business’s adjusted taxable income (ATI). Currently the deduction is limited to 30% of the taxpayer’s ATI, with some exemptions for small business, farming, and real estate businesses. The TCJA removed depreciation and amortization from the formula for calculating ATI, which made ATI less and reduced the deduction amount. This is not particularly helpful to startups, unless they are close to net income positive and have debt.
MODEST to LOW
100% “bonus” depreciation will be reinstated, which allows taxpayers to immediately deduct all of the purchase price of eligible assets rather than write them off over the “useful life” of the assets. This may be helpful to revenue generating startups that spend a lot on capital expenditure.
The plan calls for these provisions to be retroactive, with the R&D expense and business interest deductions applying from the beginning of 2022, and the bonus depreciation applying from the start of 2023.
The legislation would also expand the Child Tax Credit (CTC) to make it easier for more families to qualify, by allowing families to use their income from either the current or prior year, changing the calculation to increase the benefit, and incrementally increasing the maximum refund amount per child through 2025.
Another provision would extend the statute of limitations for the IRS to pursue fraudulent or erroneous claims of the Employee Retention Tax Credit (ERTC or ERC), and prohibit new claims after January 2024. While intended to help business owners during the pandemic, the ERC has been exploited by aggressive marketing firms that encouraged businesses to file inaccurate claims. The proposal would also increase the penalty for aiding and abetting the understatement of a tax liability by an “ERC promoter” to help address the issue of inaccurate claims. These changes are intended to help offset the cost of the new tax framework. If your startup took ERC funds, read our Crunchbase article on ERC fraud to make sure you are not going to get caught in fraud accusations.
What is the impact for startups and VCs?
The primary impact for startups and small businesses are the “Big Three,” which have been some of the biggest issues for businesses:
- R&D expensing. This revision is the most significant benefit to startups, which often invest heavily in research and development. Startups would once again be able to deduct R&D expenses incurred in the US in the tax year they’re incurred. Frequently referred as Section 174 expensing, based on its Internal Revenue Code (IRC) designation, the legislation proposes to reinstate full deductibility retroactively, beginning with 2022, and continue through 2025. Specific information about how this will be implemented and whether it will require filing amended returns is not available yet. The 15-year amortization for foreign R&D expenses will remain unchanged.
- Business interest deductions. For startups with loans, the current limits on deducting business interest will be revised under the new legislation. IRC Section 163(j) limited the amount of depreciation to 30% (for most years) of the startup’s adjusted taxable income (ATI) excluding depreciation and amortization (effectively changing the startup’s EBITDA to EBIT). Now startups can again add depreciation and amortization back into ATI for 2022 and 2023. Adding those expenses back into ATI increases overall income, which means the 30% ATI amount is larger.
- 100% “bonus” depreciation. Also known as additional first-year depreciation deduction or the IRC Section 168(k) allowance, this provision accelerates depreciation schedules by allowing startups to write off a larger portion of an eligible asset’s cost in the first year it was purchased. The TCJA allowed businesses to immediately write off the full cost of eligible assets that were acquired after Sep. 17, 2017 and before Jan. 1, 2023. Before the TCJA the percentage was 50%, so this was a significant benefit to startups that purchased eligible assets. However, the 100% write-off was decreased by 20% each year (so the percentage was 80% in 2023, 60% in 2024, etc., and decreased to zero in 2027). The new legislation would restore 100% depreciation through Jan. 1, 2026 or Jan. 1, 2027 for some property. The phaseout would begin a year after.
For VCs, the biggest impact may be on portfolio companies that raised ERC funding and now may be accused of tax fraud by the IRS. We encourage venture capitalists to ask their portfolio companies if they participated in the ERC program, and if so, make sure that they are working with an experienced tax CPA to help them stay clear of the upcoming enforcement actions.
What should startup founders expect next?
The House of Representatives’ tax-writing committee approved the bill with bipartisan support on Jan. 19. The House is scheduled to be in recess the week of January 22, 2024, so the earliest the House could hold a floor vote would be January 29. A strong bipartisan House vote would encourage the Senate to also pass the bill. Before that, however, Congress is going to have to act on temporary funding legislation to avoid a partial government shutdown on January 19.
Until the tax package is finalized and approved, the IRS will not be able to provide guidance on tax filings. Since many of the changes to the “Big Three” are retroactive, startups may have to file amended 2022 returns, or adjustments could be made to 2023 returns.
Finally, while we typically stay out of politics, we do encourage founders and investors to contact their legislators. We believe that innovation is a cornerstone of the US economy, and that Congress should support research and development – not tax it.