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Just like every other startup, we had our fingers crossed that Congress would come together to undo the new R&D Capitalization rules before they take effect next tax year. But, unfortunately, it seems as though the new reality is here to stay (at least for now).
We built Neo.Tax to make tax season valuable, rather than stressful, for innovative companies. Unfortunately, the new R&D Capitalization rules mean that a 12-month tax strategy has now become essential for founders.
So, here’s our Founder’s Guide to R&D Capitalization.
You can download a PDF copy of our cheatsheet here.
Let’s start with hiring, which any founder can tell you is what makes or breaks a startup. You’ve perfected your talent identification. You’ve honed your interview process. You’ve streamlined your onboarding. But unfortunately, the changes to how R&D spending is calculated means you now must be laser-focused on the where as much as the who.
Before these changes were written into law by Donald Trump in 2017 (see our previous post for more info), 100% of your R&D spend could be deducted from your income. If you brought in $1 mil in revenue and spent $2 mil on R&D to develop your innovative product, you would end the year with $1 mil in Net Operating Losses (NOLs). Now, you have to spread the R&D deduction over 5 or 15 years depending on if the spend is made in the United States or abroad—this is called amortization. Worse than that, only 6 months of the first year of R&D spend can be deducted. So, if the $2 mil you spent on R&D is domestic, you’ll only have $200K to deduct from your $1 mil.
This new reality means that startups that once were pre-profit now look like post-profit companies during tax season—rather than accruing valuable NOLs as they prepare to become cash-flow positive, they’re being saddled with an expensive tax bill.
This is why you now need to start thinking about tax season at the hiring stage.
In that first year, a $2 million R&D spend in the United States leads to a $200K deduction. But if that R&D spend happens overseas? Only $66,666.66 can be deducted from your $1 mil revenue. For tax purposes, that means a foreign employee working on R&D costs you 3 times as much.
Because foreign spend needs to be amortized over 15 years, that means you’ll be feeling the costs every single tax season as well. By Year 2, a domestic R&D spend of $2 million will bring you $600k in deductions. If that spend is foreign? Year 2’s deduction will only be $200k. By Year 3, it’ll be $1m vs. $333,333.33. Year over year, as the spend grows, that 3x difference hurts more and more every April or October.
Most experts agree that the change to R&D Capitalization was “a cynical gimmick intended to make the bill look cheaper for official budget scorekeeping purposes,” as Washington Post columnist Catherine Rampell put it. But taking it at face value, the new law is ostensibly designed to promote hiring and spending within the United States. Until the law is amended, that is the reality for startups when it comes to R&D: unless you can save more than 3x, hiring abroad is probably not worth it.
As we explained above, the changes to R&D Capitalization markedly affects the amount of NOLs that pre-profit companies will collect each year. Whereas before the change, a company that was $1m in the red would receive a $1m NOL going forward, now, due to amortization, that company might appear as though they are $800k in the black. That means, rather than $1m in NOLs, they’ll be burdened with a tax bill of $168k (21% of $800k). All of a sudden, being unprofitable is an expensive prospect for startups.
With this new law, NOLs can be used to offset only 80% of taxable income, but those NOLs can be carried forward indefinitely. (Before the change, NOLs could offset 100% of taxable income, but would only carry forward for 20 years.) Thus, a pre-profit company could spend 5 years in the red, only to get hammered with a massive tax bill once they do become profitable, because they can no longer be entirely rescued by their NOLs. Historically, these NOLs have functioned as a strategic tool for startups—a skilled founder could plan ahead for that first year of profitability and apply their stockpile of NOLs to vastly decrease their tax burden for that year—and even some of the years that followed. In fact, NOLs have even been considered when valuing startups for acquisition.
These new rules have also diluted a startup’s ability to collect NOLs, especially if that startup spends heavily on R&D. Now, it has never been more important to focus on the manner in which you spend on R&D—pay attention to the Four-Part Test and make sure your R&D spending can be claimed as an R&D credit! Because expenses that do not qualify for the R&D credit must be amortized (with only 1/10th being deductible in Year 1), R&D spending that does qualify is more than 10x as valuable to a pre-profit startup.
So, what does that mean for your startup’s tax strategy? It means that it’ll be much harder to remain unprofitable in the view of the IRS. The upshot is that you may need to accelerate your gameplan: it’s exceedingly expensive to be in the red in reality, but in the black when it comes to your taxes. That can lead to a triple whammy, where you burn through your runway, pay an expensive tax bill, and fail to accrue any valuable NOLs.
We’ve built Neo.Tax to give startups peace of mind when it comes to their taxes, and we’ve done this by maximizing R&D credits for our customers. The change to R&D Capitalization has made that more important than ever. We’re tax wonks committed to letting American startups be the most innovative in the world. So, let us help you continue to create incredible innovation and continue to do the work that inspired you to found your company in the first place.