America, we have a big innovation problem. An obscure modified rule, IRS Section 174, is written in a way to not reward but instead aggressively punish small bootstrapped software startups and stymie innovation by forcing startups to pay up to 75% of their gross revenues in taxes.
You may not have heard of Section 174 as the rules disproportionately affect small bootstrapped businesses and not the larger VC-backed businesses or larger companies that have the funds to survive multiple years.
If not handled soon, the implementation of Section 174 will likely cause a crash in small new bootstrapped startup businesses (and SBIR applications) and directly affect America’s innovation in the space.
What is Section 174?
With recent changes in our tax law, companies are required to amortize software development costs that produce any new feature over five years domestically or 15 years for international labor, rather than deducting them immediately.
In other words, a company can only expense 20% of salaries, benefits, and office space of pretty much all software developers and their support staff (product managers, managers, Q/A, Designers).
An Example Of Why This is Bad=
Let’s say you are a software developer who in 2023 created a really cool AI product (from your 1 person LLC) that lets people create music videos that are similar to but not quite like a duet who kind of looks like but really isn’t Taylor Swift and Travis Kelce. You built the product yourself and it was a hit, earning $250K in revenue in your first year. To compensate yourself, you took $250K in salary as a developer. Common sense would think your company broke even ($250K revenue - $250K in salary = $0 profit ) and you would be taxed $250K in salary. Unfortunately, that’s not what the IRS thinks. They think you earned $450K in taxable income.
As only 20% of your salary is expensable since it was mostly in software development, your LLC earned $250K-$50K or $200K in taxable profits so your total income is $250K + $200K = $450K. A quick tax calculation shows in CA you would be paying out $187K in taxes on the $250K you made in revenue and keeping $63K.
Given this, why would you even build a business vs join a big company? Even worse, why even innovate in software?
What were they thinking?
If I were to guess, the IRS's decision to modify Section 174 was not intended to totally destroy small bootstrapped startups and American innovation. It was primarily aimed at treating software businesses on par with their hardware counterparts. Recognizing that software can be an asset with a long usage life, the IRS likely sought to generate additional revenue and address loopholes in the R&D tax credit system.
The road to tax hell is paved with good intentions, and this one's no exception. Here's the reasons why this rule is terrible for America and needs to be repealed ASAP:
Bootstrapped Businesses Bear the Brunt: New small, bootstrapped businesses, already scrimping to get by, will be forced to pay extra taxes in their first years putting them at a much higher risk of failure. VC-backed companies or larger companies with bigger pocketbooks will be able to recoup the losses as they have the pocketbooks to withstand the first lean years.
Punishes Risky Ventures: By amortizing over 5-15 years, the tax law assumes every R&D venture will result in 5-15 years of use. This specifically punishes risky ventures that may not last 2-5 years as they will never get benefits for the costs they incurred. It will have the adverse effect of having people focus on “safe” bets that can last at least 5 years and not take the bigger risky innovations that are less likely to succeed but much more likely to change our world for the better.
A Blow to SBIR Grants: Section 174 may affect SBIR grants as grant recipients will have to take into account the fact that the expenses they incur paying software developers to develop Phase I and Phase II implementations of SBIR grants will be double-taxed. The grant money is worth 25-50% less than it was before the change. The result will likely be fewer people taking grants as the reward is not worth the effort.
Reduced Global Competitiveness: With Section 174, startups are specifically punished for finding great international talent. They are basically limited by the tax code to hire only in the US. While we have great talent in the US, we are forcibly tying the hands of our startups from getting the best worldwide talent to compete. Combined with the lack of a good immigration program, America may start losing its innovation advantage to other countries who will take advantage of America’s mistake by hiring the best talent in the world and not just from a local region.
The Software You Use Will Get Even Worse: Unlike hardware, software is constantly evolving, often on an annual basis. Given the pace of software development, software created 5 years ago in most competitive spaces would likely do poorly today. A five-year (or worse, fifteen-year) amortization schedule seems out of touch with the industry's pace. With these restrictions, the law is encouraging companies to slow down development by reducing their spending on the developers and product managers who innovate.
So, what can be done? Here are some suggestions:
Limit amortization to just companies who want the extra deductions: Before these recent changes, companies were given extra incentives to do R&D via tax deductions. Instead of amortizing all software development, amortize the software development that gets these specific bonus deductions. This will force companies to choose how to allocate their resources and allow our current pace of innovation to continue.
Minimum Revenue Threshold: Like many taxes and regulations that focus on larger businesses, Section 174 deductions could also have a minimum revenue threshold. Set the tax law to be for companies making at least $10M or $20M in annual revenue to help smaller startups.
While the intention behind updating Section 174 may be to create a fairer tax system, the reality is that it will unintentionally severely stifle innovation and unfairly burden small, bootstrapped software startups, especially in AI - just when we most need to compete globally. What once was a tax system that rewarded taking chances, researching, developing, and innovating products that help improve the world, is now a tax system that specifically punishes that type of innovation
It’s time for our tax system to go back to helping American small businesses rather than hurting them.
Update: On Friday, January 19, a congressional committee approved 40-3 a proposed tax bill that would delay Section 174 changes until 2026 (except if you are hiring international talent). This is not ideal but far better than the current situation. If you have a Republican Congressman, use this site to please call and email them to get this bill to the floor so we can at least get partly back to where we were. I would encourage you also to have them remove punishment for hiring international talent so small businesses can continue to be globally competitive. Great American engineers are smart enough that they do not need artificial "help" to compete internationally.