Exciting title, huh? But changing R&D taxability from a simple expense to a capital investment requiring a 5 year amortization will have a profound impact on all software companies if the current law stays in place. To put a headline on it – it will cost RunSignup about $870,000 in additional federal taxes this year. Here is a rough calculation:
Our Software Development costs were about $4.6 Million in 2022 (our largest expense item). In all previous years, that is treated as a simple expense and gets subtracted from revenue to calculate taxable income. In the 2017 Tax Cut, there was a provision to change R&D expenses to a capital expense that gets amortized over 5 years – so 20% per year (but that gets spread out over 12 months so it is really only half of the 20% in that first year).
So only 10% of the 2022 R&D expenses get deducted to calculate taxable income. As the spreadsheet shows, that $4,140,000 gets moved to the balance sheet and will get amortized over 5 years. The tax impact per year becomes less as the balance sheet grows. For example, if we stay at a level $4.6M of R&D expense, then after 5 years we will be back to claiming a full $4.6M of amortized expense. Of course, we hope to grow that, so we will always be a bit behind.
Implications for RunSignup Financial Health
For our employees and customers who might worry, you do not have to. We have a very strong balance sheet after taking a $3M capital investment in 2020 from Payroc and several individuals including myself. We never spent any of that, and have been operating cash flow positively and adding to our balance sheet – thanks at least partly to the PPP and Employer Tax Credit (so we can’t complain about the Government wanting to break even on their investment :-)). So we have no debt and increasing cash – until we pay the tax bill this year.
So we have plenty of cash to cover our tax bills this year and into the future.
In some ways, this might become an opportunity for a long term focused company like RunSignup. We fully intend to keep spending on Software Development. However, other companies may not have the viewpoint, or the ability. Their investors might focus on cutting costs in R&D since this bill from 2017 just made development software more expensive.
Will It Get Changed Back?
This has been a known factor since 2017, yet there has been widespread hope that this would be rolled back. There has been verbal support in congress to eliminate this provision, however it has been stripped from every version of various bills passed in the past 2 years. The most recent hope was the recent Omnibus Bill that was passed, but R&D Expensing did not make the cut.
There is considerable pressure coming from the business community, as exemplified by this lobbying white paper talking about the loss of 260,000 jobs. However, a lot of this is aimed at Tech and Pharmaceutical companies, where there is a broad opinion in the public that they make huge profits. And the IRS just issued rulings clarifying to companies how to proceed with this change. And it means something like $150B+ of tax revenue over the next 10 years – not insignificant.
The other factor here is the reality that developing software is kind of a capital expense. When we develop a new generation of email for our customers, we get benefit from that over the course of a number of years. This is similar to when a company buys a machine and gets benefit from that machine over a number of years. So maybe it should be treated as a capital expense.
Implications for Other Software Companies
Part of the reason I am writing this blog it to share it with my VC and Software Exec and CFO friends to get their input.
But I am sure this is going to be a Tsunami in the software startup world. Many smaller software companies run at a break even level, or if they have funding are spending more than they make. All of a sudden, they are going to be hit with large tax bills because most of their expenses are no longer deductible in full. Venture, Growth and PE investors are either going to have to put more money into their portfolio companies, or will have to cut costs within those companies.
It will force marginal companies into very difficult positions. Some may try to cook their books and claim software development as some other type of expense. Some will have to cut spending (on top of the past couple of years of pandemic and tighter investor flow of funding). Some may no longer be able to operate.
This is a real problem because an increasing number of companies rely on many software vendors to run their own businesses. If some of those services start to become unreliable, or not secure because of cost cuts, it opens many companies to unknown exposure. There is a potential domino effect that happens from this.
Send Me Your Thoughts
Let me know what you think. How will this impact your business? How will it impact consumers of software services? What does it mean to startups? What does it mean to large profitable companies like Salesforce, and what does it mean to the large companies that are not yet profitable like Toast or Hashicorp (two of my favorites), and what does it mean to companies like Eventbrite who carries a large debt load and suddenly has to start paying a lot of taxes?
Post Script – Tax Credits
In 1981 there was a temporary Tax Credit put in place for R&D spending. This was made permanent in 2015. The way it works is that there is a separate filing required to prove work qualifies as R&D. We hire KPMG to run this for us each year at a cost of tens of thousands of dollars. They do a survey of our developers, interview some of them, make them account for their hours doing different types of projects and come out with an answer that say 89% of our $4.6M qualifies for the type of R&D in that tax regulation. We then get something like a 6% credit off of our taxes. So in reality, the calculations shown at the top of the blog are for illustration purposes only to give the concept, and are not meant to be the actual tax filing.
The other obvious comment to make is that the purpose of the original 1954 law of taking R&D as an immediate expense, and the 1981 law of the R&D tax credits are to incentivize R&D. Of course we are in the software development business, so of course we think we should get tax credits, just as every other business thinks they should as well.