R&D Capitalization Changes – A Tax Trap for Your SaaS Company?
May 24, 2023
Your SaaS company might be a lot more “profitable” on paper – and hence owe more taxes – than you realize this year.
The 2023 tax season (filings for calendar year 2022) is the first time that companies are actually having to deal with 2017 changes to research and development capitalization accounting rules, also known as “Section 174” or R&D amortization rules. These rules were passed into law years ago with the “Tax Cuts and Jobs Act” (TCJA), with a future start date of tax year 2022. And here we are.
The Problem in A Nutshell
The short version of the problem is in this phrase inserted into the Tax Code: “any amount paid or incurred in connection with the development of any software shall be treated as a research or experimental expenditure.”
Taken literally, and in conjunction with the rest of Section 174, this means that the law requires all software development spending to be amortized over at least a five-year period, not recognized and deducted in the current tax year which is what almost every normal SaaS business has done with software development historically.
This means you could have “net income” (profit) according to tax rules – and therefore owe money to the IRS – even if you actually broke even or lost money on a cash basis that year!
A Concrete Example
Let’s say you earned $5 M in topline revenue in 2022 and spent a total of $5 M that year: $1 M in direct COGS to deliver that service (80% gross margin), and $2 M in SG&A to run the business plus another $2 M in R&D to keep building your software capabilities. Historically, almost every company would have considered that to be $5 M gross and $0 net: a breakeven year, with no taxable income.
However, under the R&D amortization rules, you can’t deduct as a current expense the full $2 M spent on software development. Instead, it must be “capitalized” and amortized over five years, meaning you can only deduct $400k per year. That means instead of a $0 net income, your company would show a $1.6 M net income for the year – and would owe income tax on that amount.
It’s Crazy but It’s True
Nobody who takes a look at the rules believes they’re real at first, because it all seems so absurd. After all, for the entire history of the SaaS industry, capitalizing development has been strictly optional (and something we’ve discouraged).
To try and validate this concern, I spoke to a senior tax professional who handles filings for tech companies in a variety of sizes from startup to IPO. “Lots of people are in denial,” he said, exasperated. “I’ve spoken to many companies who asked their accountant about the issue, and the accountant flatly didn’t believe it could be true. Well, they’re starting to believe it now.”
We realize that SaaS Capital, while a trusted name in our niche, may not be your go-to authority on tax matters. Try seeing what PWC or Deloitte have had to say. It is real, and it probably affects your company.
Congress Is the Only Fix, and the Fix Ain’t in Yet
The IRS acting alone can sometimes clarify ambiguous or absurd interpretations, through issuing “Revenue Procedures,” but in this case the 2017 text was black-and-white and is now the law of the land, leaving the IRS powerless to independently issue a “fix.”
The current version of Section 174 is law, and the only way for it to be changed is (literally) an act of Congress. It is rumored that this section was included in TCJA as a bargaining chit that was never meant to last long enough to go into effect. As such, politicians, IRS agents, operators, and tax professionals have all been operating under the assumption that it would be revised before now. And there are a couple of bills in motion to rectify the section, but it isn’t a current focus of Congress.
The Senate has a bill in process, the American Innovation and Jobs Act, that contains a fix, as does a House bill. But, as of May 2023, both are still pending, and there’s no sign that either will move ahead anytime soon, given the political gridlock over the debt ceiling among other issues.
What Some Companies Are Doing in 2023
All affected SaaS companies should consult their tax advisors and get the latest update for their own situations. Particularly for smaller companies (under $5 M in ARR), there may be sufficient offsetting tax credits to avoid a near-term cash hit. You might also consider writing to your Congressional representatives to help create some urgency.
Pay It. If you calculate your tax due under the new rules, and if you can afford it, you can always pay the tax as calculated, and then file later for a refund if / when the rule gets reversed or altered. This is the lowest-risk option vis-a-vis the IRS, but could be prohibitive depending on your amount notionally due and your liquidity.
Argue It. Some companies are taking a stand that their software spend isn’t “development” but instead is more properly maintenance, dev ops, or otherwise not properly encompassed in the expanded “software development” definition of research and experimentation. This makes economic sense, but is untested in practice.
Extend and Pretend. We’ve also heard of some companies who normally wouldn’t owe tax, but have been hit by this change, choosing to file an extension showing the estimated tax due, and then just … not sending the wire transfer along with the extension. This is a higher-risk strategy, but these companies seem to be betting that Congress will fix the issue before the IRS catches up; if the fix doesn’t come in time, they’ll set up a payment plan and beg forgiveness.
Ignore It. Perhaps the riskiest strategy – but one that will be disturbingly common as a result of the widespread lack of understanding – will be simply to plow ahead as before and take the full expense deduction for R&D spending. This may be the default approach for early-stage, cash-burning companies who have no expectation of tax liability and hence may have been casual about filing their 1120s at all. But the danger here is being found willfully to have failed to file when owing taxes, which could subject you to 5% per month interest and all manner of horrible penalties (tax liens etc.).
What We Think Will Happen
We do think that on balance, a legislative fix is likely and will probably happen by the end of calendar 2023, if only because of a desire to avoid another full tax year’s confusion and mayhem. The sheer scale of this problem will likely make aggressive, timely, and literal enforcement of the rules untenable for the IRS.
We don’t think, however, it’s a given that we’ll see a full return to the old regime – of expensing and deducting in the current year 100% of unlimited software development costs (even though we think that’s the best economic way to represent a SaaS company’s P&L. Congress wanted more money out of corporations, and this was one (clumsy) way to achieve that. It’s possible we see some kind of carve-out for companies or expenses of a certain age or size, perhaps done through another tax credit or deduction, but that would keep some version of the current Section 174, creating yet more accounting complexity and reporting and filing requirements.
Unless Congress’ fix for Section 174 comes with a retroactive blanket amnesty, however, some companies may be unraveling their 2022 tax year situations for months or years to come. Watch this space and ask your tax advisor for timely updates during this evolving situation.
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