Are small software companies at risk of ruin this tax season? Understanding Section 174

In December 2017, the Tax Cuts and Jobs Act of 2017 was passed, delivering corporate tax cuts and higher standard deductions. Who was going to pay for it? Apparently, at least on paper, businesses that spend money on research and experimentation (R&E), including small software companies.

Since 1954, businesses could deduct R&E costs under Section 174, significantly reducing their tax bills. It made innovation from the ground up possible. The Tax Cuts and Jobs Act amended Section 174 so that it would require capitalization of all R&E costs, beginning in the 2022 tax year.

The changes to Section 174 were unpopular, but they weren’t expected to stick. The manufacturing industry and various trade groups strongly opposed it, and made it known to Congress. Changing Section 174 back to it’s pre-2022 state had such bipartisan support that it was expected to be reverted by the end of 2022, before anyone had to deal with the new code.

Yet nothing happened. Congress let it take effect.

Simply put, software companies spend a ton on R&E — salaries included. Under the 70-year-old code, companies could deduct that work, which would lower their taxable profit. Now, they can’t in the same way. Without those deductions, their taxable amount is significantly higher, and so are their taxes.

For small software companies like the one cofounded by Michele Hansen, the news that they would have to amortize their R&E expenses, and the impact it would have on their tax bill, was a shock.

https://twitter.com/mjwhansen/status/1628081503916662786?t=XCLpdiO3ru454c8U6wIlSg&s=19

“From what I have been told, nobody in Washington thinks this is good tax policy,” Hansen told Technical.ly. “But they have not felt the urgency to fix it. So now we are in 2023, everyone is doing their 2022 taxes, and small business owners like myself are now being told by our accountants that this change took effect. People are seeing their tax bills go up hundreds of a percent. A friend of mine in Georgia who runs a small software company, his tax bill went up 466%.”

She’s taken on an advocacy role to spread the word.

“We are getting involved at this point because we’re not big companies,” said Hansen, whose company, Geocodio, is headquartered in Arlington, Virginia. “We have tax preparers that we pay, but we don’t have the big firms on retainer. And so we’re playing catch up a little bit and only finding out about this now.”

Just got our taxes done. I lied. Section 174 increases our taxable income for 2022 by 466% not 350%.

WTF.

Why are tech entreprenuers/VC not talking about this? This is insane. https://t.co/te4AZaz3FO

— Landon Bennett (@LandonB32) March 15, 2023

There is still some hope: Senate Bill 866 to retroactively revert Section 174 is gaining cosponsors from both sides of the aisle.

The problem is, even with an extension, it’s unlikely the bill will pass in time to prevent serious damage to small software companies without urgent action. Companies don’t have to file by the tax deadline with an extension, but they still have to pay. S.866 isn’t expected to move until September or even December — and by then it could be too late. Small companies could be bankrupt by then.

“We cannot wait nine months,” Hansen said. “We cannot loan the IRS several hundred thousand dollars for a couple of months while Congress sorts this out. People are already freezing their hiring, considering layoffs, cutting salaries, going without pay themselves, paying their taxes on credit cards, using line lines of credit if they have them. We are not the tech companies that people picture when they think of tech companies. We’re not the software companies with giant campuses in California.”

Hansen drafted a letter to Congress to be signed by a coalition of small software businesses. As of Wednesday afternoon, it’s collected about 100 signatures. They’re aiming for 1,000 signatures by April 10, to be delivered by Tax Day.

“We’re in a situation right now where a lot of small software business owners don’t realize this is happening,” she said. “The more time goes on, the more people are coming to me — and quite frankly, the more panicked they are. This is not a hypothetical problem. This is a very real problem that is impacting small software businesses, right now, and the longer it goes on resolved, the more of a problem it will be.”

Given the crushing impact Section 174 is having and will have on small software biz, I've set a goal of a thousand signatures on this letter… before April 10th so we can deliver it to Congress before Tax Day.

Sign and tell your founder friends to sign: https://t.co/oV8uWL8bge

— Michele Hansen (@mjwhansen) March 28, 2023