Taxes and section 174

7 years since my last post (2017!), so many exciting things to talk about: the AV1 video codec was released, we at Two Orioles wrote an AV1 encoder (Eve) and decoder (dav1d). Covid happened. I became a US citizen. Happily married for 15 years. My two boys are now teenagers (and behaving like it). So, let’s talk about … taxes?

In 2017, Congress enacted the Tax Cuts and Jobs Act, which (very briefly) reduces business (permanent) and personal (expires after 2025) tax rates by a few percent points, along with some “magic” to pay for it; some might remember the changes to SALT deductions. In 2023, during tax filing for 2022, more of that magic became clear: the 2017 law included 5-year-deferred changes to section-174, which covers expenses related to “Research & Experimentation” (R&E). The change requires all R&E expenses to be amortized over 5 (domestic) or 15 (foreign) years, and explicitly adds software development as a section-174 expense for tax purposes. This might sound innocent, but it hits small businesses hard.

Imagine a small software development business with $1M in revenue. It might employ 5 software developers ($150k/yr each – all at 50% effective tax rate in NY) plus legal/accounting/bookkeeping ($25k/yr) and office expenses ($25k/yr), leaving $1M - 5x $150k - $25k - $25k = $200k as business profit or taxable income. The profit flows through to the LLC/S-corp owners, who pay 50% tax over that also. Total taxes (federal + state + local) paid: 50% * (5x $150k + $200k) = $475k.

Starting 2022, initial-midyear amortizations means it can deduct only 10% of its R&E expenses (including salaries and office), which means the effective taxable income flowing through to the LLC/S-corp owners is now $1M - 10% * (5x $150k + $25k) - $25k = $897.5k, taxed at 50%, resulting in total taxes increasing to 50% * (5x $150k + 897.5k) = $823.75k. Of course, this money doesn’t actually exist, so the business will go broke unless it lays off some of its employees or the owners take out loans (bonus points for today’s high interest rates). This supposedly slowly resolves itself after 5 years, as long as the business doesn’t grow (i.e. hire new employees) and salaries of existing employees don’t go up: a pretty crazy economic policy to encourage innovation. It’s worse if you hire people outside the US, because now the amortization period is 15 years.

Congress should fix this, and there has been some (late, slow) progress in this area. Unfortunately, the media hasn’t caught on. The NYT blasted the proposed legislation as a “corporate giveaway” that “would benefit profitable companies” who “already pay too little in taxes”. The WSJ called it “at best a modest boost to investment incentives”. Maybe these journalists should read Michele Hansen’s tweet, which lists individual stories from small businesses (like mine) who were hurt by this change in tax law: tax increases by 500%, effective tax rates of 500%, hiring freezes, layoffs, loans, debt – and speaking from personal experience: lots of tears.

Dear Congress: small businesses need you – please fix section 174.

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