Section 174 of the tax code relates to research and experimental expenditures (R&E) for companies. Given there is a lot of R&E in the technology industry, it is an important piece of legislation.
Section 174 Challenges
Previously, R&E expenses, like software engineer and software developer salaries were an expense to tech companies.
Nevertheless, starting in 2022, as part of the Tax Cuts and Jobs Act (TCJA), companies were no longer allowed to deduct R&E expenses such as salaries paid to software engineers, like all other employee wages.
Changes in Expenses
Instead the R&E costs were to be amortized for 5 years for US developers and 15 years for non US developers. More on amortization in the section below. Software engineering salaries are typically a big cost to technology companies, especially those in the early stage. So this harmed a lot of tech businesses.
As you can see from the table below, a small bootstrapped company with $2mm in revenue and zero profits would pay no tax under the old rules. However starting in 2022 they would have to pay $336k in taxes!
Section 174 Comparison
| 2021 | 2022 (Section 174) | 2023 (Section 174) | |
|---|---|---|---|
| Revenue | $2,000,000 | $2,000,000 | $2,000,000 |
| Software Engineering Costs | $2,000,000 | $2,000,000 | $2,000,000 |
| Amount Deductible | $2,000,000 | $400,000 | $800,000 |
| Income before Taxes | $0 | $1,600,000 | $1,200,000 |
| Taxes Due | $0 | $336,000 | $252,000 |
Amortization Story
Amortization is one of those funny accounting words that I will explain with an example.
One day, you lose your phone, and get stuck in the rain. You are soaked, angry, and frustrated, but you walk by your favorite cookie store. You enter and want to turn your day around but you can’t pay with your phone because it’s long gone. The cost for a small box of soft and warm chocolate chip cookies is $10. You have no money in your pocket.
So you make a deal with the shop owner, who you know very well. You agree to pay a dollar each week for ten weeks and you take the cookies home. Hopefully it doesn’t take 10 weeks to eat them.
Tax Law Changes to Section 174
However, the latest tax law changed Section 174. Now R&E expenses can be deducted as a cost to the business.
Companies can redo their books and taxes for the year 2022-2024 and expense costs retroactively using the old expense rules.
Read the Fine Print
There’s a catch. Always a catch! US companies making foreign software development
related expenditures like hiring staff, or paying for contracts abroad, are still mandated to be amortized over 15 years under Section 174.
So companies are likely to cut developers abroad and recruit less outside the US while reducing their taxes.