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Tax law is rarely popular, especially with both sides of the aisle. But the R&D tax credit has done the unthinkable: change the tax code to appeal to everyone, by incentivizing innovation within the United States. Every 1-2 years since it was created in 1981, the R&D tax credit has been extended with a congressional rubber stamp. And, in 2015, with the passage of the Protecting Americans from Tax Hikes (PATH Act), the R&D credit became permanent law.
But then, just two years later, Donald Trump signed into law his landmark Tax Cuts and Jobs Act (TCJA). The Congressional Budget Office—tasked with nonpartisan analysis of the TCJA, which included a new single corporate tax rate of 21% (down from 35%)—found that the new tax code would vastly increase the national deficit between 2018 and 2028. So in an effort to recoup some of those lost taxes, Congress modified the TCJA to include a massive change to the way R&D expenses are treated, which goes into place next year. And, unfortunately, this change is very, very bad for startups. (Even after this amendment, the CBO still found that the TCJA would increase the deficit by nearly $1.9 trillion.)
As Washington Post columnist Catherine Rampell explained: “To help make their corporate rate cuts as large as possible, Republicans included some measures that would (ostensibly) raise a little bit of money to offset the cost. Among these supposed pay-fors was this change to the tax treatment of R&D spending.”
That change is an amendment to IRC §174: starting next year, Research and Experimental (R&E) expenditures incurred or paid for tax years beginning after December 31, 2021, will no longer be deductible for tax purposes. Instead, American businesses investing in R&D will have to capitalize and amortize expenditures over a five-year period for research conducted within the U.S. or over 15 years for research conducted abroad.
Capitalization and amortization effectively slow down the deductions for R&D (and REALLLLY slows them down for foreign research), which means that when the rule first goes into effect, companies will have fewer deductions and more taxable income in earlier years. Theoretically, they will eventually be able to deduct all costs, but why slow this process down?
Why? It seems likely it was a budgeting trick. The 2022 R&D capitalization rule was a (wildly unpopular) part of the law that was passed to cut corporate tax rates, because when the Congressional Budget Office "scores" legislation, they look at the budget impact over 10 years. Thus, the giant deficit created by dropping the corporate tax rate to 21% was partially masked by the increased revenues from this 2022 capitalization provision. Tax cuts appeared to only create a $1.4 trillion deficit, when in fact it would be much larger without the R&D capitalization provision.
“The presumption at the time was that these provisions might never materialize because future Congresses would step in and reverse them first. One of the architects of that 2017 GOP tax overhaul, Rep. Kevin Brady (R-Tex.), even publicly and repeatedly endorsed proposals to undo his own handiwork,” Rampell wrote. “In other words, the R&D change was a cynical gimmick intended to make the bill look cheaper for official budget scorekeeping purposes—but that leading Republicans never actually expected, or wanted, to happen.
So, what does that mean for your startup?
Well, let’s do the math. If you made $1m in revenue but spent $2m building software inside the United States, you can’t just subtract $2m from $1m and show the IRS you’re $1m in the red. Instead, you must spread that $2m out over 5 years, which would be $400k per year. Now, the math becomes $1m - $400k, meaning your taxable income looks more like $600k. Even at the lowered corporate income tax rate of 21%, that’s a $126k tax bill for a company that did not make any profit. If your R&D expenses were incurred outside the States, the bill is even higher.
Clearly, this amendment to IRC §174 hurts innovation by American companies—and it hurts innovative startups most of all. So what happened? It turns out the history and politics of it all is… everything.
It is always best to start at the beginning, so let us begin at the very start. The earliest known taxes were levied in Mesopotamia 4,500 years ago.… Just kidding. Let’s jump forward a few millennia.
As far as deductions go, the 1933 Supreme Court ruling in Welch v. Helvering created the framework that only expenses that were both “ordinary” and “necessary” could be deducted—eventually, IRC Section 174 allowed taxpayers to deduct R&D costs (like Section 162 expenses), or capitalize and amortize them over a period of at least 5 years.
It took fifty years before the tax code changed again, this time dramatically, when Ronald Reagan passed the Economic Recovery Tax Act of 1981 (ERTA). The most relevant change for tech companies was the creation of the “Credit For Increasing Research Activities (R&D Tax Credit).” IRC §41 allowed companies a credit for certain US-Based R&D expenditures that met a 4-part test (Permitted Purpose; Elimination of Uncertainty; Process of Experimentation; Technological in Nature) could be claimed as a credit. The law, built to incentivize innovation within the United States, allowed companies to claim expenses like salaries, research expenses, and leased time on the mainframe computers popular at the time as credits. Yup! Congress knew AWS was gonna happen way back in 1981! ;)
The credit was originally intended to be a temporary incentive to boost US-based R&D and was set to expire after a couple of years. But it was so popular that Congress kept reinstating it every couple of years—for almost four decades! It wasn’t until the PATH Act of 2015 that it was finally codified as a permanent fixture in the tax code.
At the same time that Congress was codifying the credit, they decided to tackle another issue that had arisen: the R&D credit could only be claimed as a dollar-for-dollar offset of the federal income tax, which meant it was only being used by profitable companies. Congress understood that, in the Age of Tech Startups, many of the most innovative companies in the country were being left out. So, in 2015, as part of the PATH Act, there was a provision that allowed pre-profit startups to claim the R&D credit against payroll taxes for up to 5 years.
In the years since, the tax credits allocated for innovation within America began to go to more than just the country’s largest companies. More and more startups have begun to understand how to access the money they were owed, which promises to further incentivize innovative companies to create novel and disruptive technology in America. But then, the TCJA with its five-year ticking time bomb came due, and it now threatens to make research and development both expensive and an accounting headache going forward.
The change was written to be implemented five years in the future—that’s another clue that lawmakers expected it to be overturned before it ever took effect. What congressperson would want to pass a law that is guaranteed to be deeply unpopular with small business owners? But no one could have predicted the many unexpected factors that made rewriting an unfavorable R&D tax bylaw infeasible these last few years: a global pandemic, a possible recession, and runaway inflation, to name a few…. So, for now, the law remains, though there is bipartisan support to amend IRC §174 again to make it more favorable to innovative companies in the United States.
This new rule disincentivizes R&D by all U.S. companies, but it especially damages pre-revenue and early-stage startups. Because pre-revenue companies have fewer deductions available, they’ll be forced to utilize more of the Net Operation Losses (NOLs) sooner, which will put them at a disadvantage financially when they do eventually turn a profit. We’ll dive deeper into the ramification of that aspect in a future post.
In the rest of our series on R&D Capitalization, we’ll go deep into the Who, What, and Where of it all. We hope you now understand the Why. It’s frustrating for those of us committed to serving the most innovative companies in America that we’ve found ourselves here, but we’re doing our best to bring clarity and solutions to startup founders.
Winston Churchill is credited with writing: “Those that fail to learn from history are doomed to repeat it.” So, now that we’ve done the history section, we’ll try our own hand at a quotation: “Those who don’t learn about capitalization are doomed to lose the money they’re owed.” And no one wants that…