Partner, National Technology Industry Group Tax Director, CohnReznick
Tech companies of all sizes have a tax code that you should understand and start preparing for.
While the Tax Cuts and Jobs Act of 2017 (TCJA) has been around for a few years, some of it is only just going into effect.
The TCJA has made significant changes to the deduction for research and experimental fees, effective January 1, 2022. Historically, Section 174 of the Internal Revenue Code has allowed immediate expenses for research and experimentation, and in my experience, this has been the most common choice for my clients; whether they are growth-stage or established companies.
Companies must now capitalize these expenses annually (5 or 15 years) starting with the 2022 tax year. Preparing for this change requires careful consideration and planning. Since those costs include software development in particular, tech companies in particular need to keep up with the pace of change, and soon, as businesses’ estimated taxes could be due as early as June 15, even if they weren’t paid in the previous year.
If you’re caught off guard, you’re not alone for a number of reasons.
First, eliminating the change has had bipartisan support almost since it was passed. In February 2021, members of the House of Representatives introduced the U.S. Innovation and R&D Competitiveness Act of 2021, and then in March 2021, members of the Senate introduced the U.S. Innovation and Jobs Act, both of which sought to rescind the provision. Then, the Build Back Better Act (BBB) took on that responsibility, and all published versions of the legislation include at least delaying the entry into force of these rules.
Second, the IRS has not provided any guidance on how tech companies and their tax professionals should identify and calculate direct and indirect expenses that fall into this category. While many IRS code sections and their associated regulations are notoriously dense and lengthy, the updated Section 174 written by the TCJA can fit neatly on several sheets. The delay was interpreted as more evidence that the changes may never materialize.
But if these changes take effect, companies of all sizes, especially those investing heavily in software and technology development, need to take notice. Even if the newly proposed legislation were to pass, the current proposal would simply delay treatment until 2025, rather than remove the provision entirely. With that in mind, what should companies be thinking about with these changes?
Future cash flow and burn rate models
If federal, state, and local income taxes are now an item to consider, cash flow projections may require significant adjustments. If current taxes become a significant item on the income statement or balance sheet, this could also affect the timing of the required capital raising and even the valuation.
Can you determine your Section 174 fees individually?
Historically, it has not been necessary to understand the costs associated with Section 174 because they are deductible like normal business expenses. With these changes, identifying work performed in research and/or software development is now critical. The implementation of time-tracking software or methodologies can result in significant tax savings and pay for the investment.
foreign development and domestic development
While it may be more cost effective to build a team of engineers outside the U.S., this now comes with additional tax costs. The updated IRC Section 174 requires foreign cost-sharing for 15 years and domestic research and experimental activities for 5 years. Companies should ensure they understand the tax implications of using potentially cheaper overseas resources rather than U.S. R&D teams.
Are there tax implications even for companies in the growth stage?
Most growth-stage tech companies are raising capital and spending to improve their core products and expand their customer base, ending up at a taxable loss. However, because of this change and restrictions on NOL use in specific years, many tech companies may be preparing for their first federal tax return. This means burn rates and future funding plans could be affected as early as 2022.
Companies not eligible to use their R&D credits to offset FICA taxes should also consider re-examining their R&D research and credit claims to cover the current tax impact of the change.
Although the law was enacted on the date of this article, there is still some uncertainty surrounding the changes. As mentioned, there is bipartisan support for pushing or eliminating the change, which means there is still hope that these challenges can be avoided. Tech companies engaged in major development activities should understand what these changes mean for them. That way, they can be prepared when those changes come into focus.
Disclaimer: Any advice contained in this communication, including attachments and attachments, is not intended to be a thorough, in-depth analysis of a particular issue. Avoiding tax-related penalties is also not enough. This article is for informational and general guidance only and does not constitute professional advice. You should not act on the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents any other person who takes or refrains from taking action on any decision of the publication.
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