Section 174 of the IRS’ tax code governs how companies may deduct qualified research and development expenses on their tax return. Startup founders must understand that this does not impact how R&D expenses are accounted for on GAAP financial statements - only for how the tax return is calculated. IRC Section 174 changed in the tax year 2022 in a way that is not favorable to startups.
Congress previously used the tax code to try to encourage US companies to invest in innovation and R&D, especially domestically, and Section 174 was the section of the IRS tax code that helped companies lower their taxes directly using their R&D expenses. Previously companies were able to deduct 100% of their R&D expenses from their taxable income. This means that startups’ tax bills would be directly reduced by the amount they invested in research and development.
The Tax Cuts and Jobs Act (TCJA) brought about changes to Section 174 of the tax code, affecting the tax treatment of research and development (R&D) expenses. Unfortunately this change makes it harder and more expensive for US companies to innovate by increasing their immediate tax bill!
Starting from the 2022 tax year, thanks to the TCJA, companies, including startups, that claim R&D expenses must now comply with new capitalization and amortization rules. This means that startups can no longer deduct 100% of their R&D expenses in the year they were incurred, as they could do previously. Instead, they must now amortize specified R&D expenses ratably over five years for US-based R&D, or 15 years for foreign R&D expenses.
This rule change has significant implications for startups conducting R&D, particularly those with expenses that would qualify for the R&D tax credit under Sec. 41 of the tax code. All such companies are subject to the new Sec. 174 capitalization and amortization requirements, which are necessary for tax compliance. Therefore, if a revenue-generating startup had been spending a lot on R&D and previously expected to owe no income tax, they may need to adjust their tax strategy accordingly!
Kruze believes that between 10% and 20% of revenue generating, money-losing VC-backed startups may move into a taxable, net-income positive position - meaning that these money-losing startups may OWE taxes! Of course, this is ignoring NOLs or other startup tax credits like the R&D tax credit, that can be used to offset a taxable income. Older startups - and ones that have been profitable for a while - are in for a massive tax bill shock due to the changes to Section 174 (read this cnbc article to learn more about it).
Section 174 of the tax code defines R&D expenditures as a wide range of costs incurred by companies when developing or improving a product or process. These expenses are defined for how startups need to account for them on their tax returns, again - not for how their GAAP financial statements are presented. These R&D costs are usually incurred to eliminate “uncertainty,” resolve questions related to capability, methodology, or appropriateness of design.
In practice, this definition covers various expenditures, making it broad in scope. Direct costs of Section 174 R&D may include wages, supplies, computer rental (cloud computing), and third-party contractor costs related to R&D activities. On the other hand, indirect costs of Section 174 R&D may include rent, utilities, overhead, allowance for depreciation of property used for research, and attorney fees for obtaining intellectual property protection.
Note that the IRS calls these “research and experimental expenditures” or R&E. At Kruze, we call this R&D, since 1) most startup founders are familiar with that term and 2) up until recently, the biggest use case for how the tax code defined these types of costs was to help calculate the R&D tax credit.
Startups can no longer deduct 100% of R&D expenses right away from their taxes - instead, these expenses must be amortized using a straight line methodology (i.e. the same percentage amount each year for the duration of the amortization). For domestic R&D expenses, the amortization period is 5 years, and for international R&D expenses it’s even worse at 15 years. That means that US expenses only count 20% toward reducing a startup’s tax bill, and international count a punny 6.67%!
But, wait, there’s more! It gets even worse in 2022, the first year that this new capitalization and amortization rule comes into play. Congress decided that in 2022, the first year the change takes effect, the deduction is only half the amount it will be in subsequent years!
When an expense is capitalized, it means that instead of deducting the entire cost in the year it was incurred, the cost is spread out over several years. This is done by depreciating or amortizing the cost over the useful life of the asset.
For example, let’s say a company spends $1,000,000 on a domestic R&D a year. If they expense the entire cost in the year it was incurred, they would reduce their taxable income by $1,000,000 for that year. However, under Section 174, they are forced to capitalize that expense and amortize it over 5 years. So it becomes a tax deduction of $200,000 per year ($1,000,000 divided by 5) from their taxable income over the next 5 years.
Pretty much all startups engaged in research and development (R&D) will experience an impact due to the new Sec. 174 capitalization and amortization requirements. Specifically, businesses with R&D expenses that would meet the criteria for the R&D tax credit under Sec. 41 of the tax code will be affected. To ensure compliance with tax regulations, such businesses must make the necessary adjustments.
We’ve mentioned it a couple of times, but this is important - Section 174 does not impact a startup’s GAAP financial statements. Your CPA will continue to produce your income statement, balance sheet and cash flow statement as they always have - the changes to Section 174 do not impact them at all. It’s easiest to think of it as a company having both tax books and GAAP financial statements.
Tax books and GAAP financial statements serve different purposes, and therefore, there are some key differences between them.
Tax books are prepared for tax reporting purposes, and their primary objective is to calculate the taxable income of a company. Taxable income is the income that is subject to taxation by the government. Tax books are prepared in accordance with tax laws and regulations, and they reflect the financial transactions of a company in a manner that is consistent with the tax laws. Section 174 impacts these books.
On the other hand, GAAP financial statements are prepared for external reporting purposes and so that management can make informed business decisions using financial metrics. Their primary objective is to provide information to investors, creditors, and internal stakeholders about the financial performance and position of a company. Section 174 does not impact these financial statements.
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