How the New 174 Capitalization Rules Punish Innovation
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A new rule has gone into effect for the 2022 tax year, requiring companies to treat all their research work as a capital expense amortized over time, instead of an operating expense deductible immediately. That might sound like an esoteric accounting rule, but it actually creates large fictional profits (and consequent tax bills) for break-even companies that do research and innovation. We help small businesses claim R&D tax credits, so my colleagues and I are seeing the new 174 capitalization rule hurt companies right now as they file their 2022 taxes.
The impact is most severe on small businesses that are bootstrapping their growth, including my company and many of our clients. We spend only what we earn, so we’re always marginally profitable, and when we have any extra income we invest it by hiring more people and buying more tools. For companies like ours, the new tax takes a huge bite of our cash flow, and is making us hire fewer people and spend less money on innovation. It has a smaller impact on giant tech firms with billions in profit- although they’ll pay higher taxes, they usually have the cash to afford it. And the 174 rule has even less effect on venture-funded startups, which often still won’t pay any corporate tax because they’re so deeply unprofitable.
To see the tax consequences of the new 174 rule, first consider a business that earns $100 in sales and spends that $100 on wages for operating costs. The business makes no profit, so it pays no corporate income tax. But if instead the business spent that $100 on wages for doing research, it can only deduct $10 of those wages on its tax return, and needs to amortize the other $90 over the next five years, which means this year shows a profit of $90 and has a Federal tax bill of $18.90. The research credit can partly offset that, but it only reduces the bill by $7.90, leaving the company with a net $11 of tax to pay for every $100 it spends on research, versus $0 of tax for $100 spent on operating costs.
In the example above, the business gets a small tax benefit in future years by having the capital asset depreciate and offset its profit, but it will require four years of those benefits just to get paid back the money it lost this year on its 174 taxes. And that’s if you don’t consider interest rates: at the interest rates small companies currently pay (8% and above), it takes five years for a company to break even on the net present value of its taxes. All this amounts to a penalty for doing research. If you don’t build new products or do original technical engineering, you pay no taxes, but if you decide to innovate, you effectively need to make a five year loan to the IRS.
It’s easy to conflate 174 capitalization with the R&D tax credit. They both apply to businesses that innovate, but only some 174 expenses are eligible for the R&D credit. If your researchers and engineers are 1099 contractors or an outside contractor firm, all their costs need to be amortized under 174, but only 65% of those costs can generate R&D credits, which basically wipes out the tax benefit you would receive five years down the line. At least, that’s according to what some accountants are saying, because the IRS hasn’t even released guidance on this yet.
There’s a particularly harmful scenario for contract manufacturers and engineering consultants that help other companies innovate: large amounts of their work may be classified as 174 research, but it’s research-for-hire owned by their clients, which makes it ineligible for the R&D credit. They have to pay taxes on a fictional capital asset they don’t own. The American Institute of CPAs highlighted this problem in their 2023 legislative proposals. Engineering consultants are often professional services firms that don’t raise investment and can only grow by reinvesting their profits, so the new 174 tax is especially damaging for them.
We’re facing a lot of uncertainty about how the 174 rule will be applied, and accountants we know are doing hours of legal research and then just making their best guesses. The IRS hasn’t published any explanation on what expenses should be treated as 174; all they’ve released are rules on how to file the overall amortization calculation with your taxes. Also, an IRS auditor’s position is now reversed: for the last 40 years, they’ve been trying to prove that work wasn’t research so companies don’t inflate their R&D credits, but they may suddenly be trying to prove that work was research so companies don’t understate their 174 costs.
Capitalization of software development (software is directly affected by the rule change) is an antiquated notion. In accounting, capitalization is designed for large, one-time expenses like building an expensive factory that’ll be useful for many years. But most software isn’t built or paid for like that; it’s released as early as possible and then continuously improved through an agile development process at ongoing cost. Capitalization is also intended for assets that have some predictable value, but the definition of research (at least for tax purposes) is that it involves doing experiments that may result in nothing.
We urgently need a legislative fix for the 174 rule. Lawmakers on both sides of the aisle have stated their support for undoing the change, including reverting back to immediate expensing. But even with this bipartisan support, policymakers failed to reach a deal last year in an end-of-year tax package, and the timeline for a future fix remains unclear. It’s been beneficial to historically have preferential tax treatment for research- that’s helped make the U.S. the most innovative economy in the world- but at the very least, we should repeal this new tax penalty for doing research. The longer 174 capitalization stays in place, the more it will hurt the abilities of small businesses to hire people and do the work that keeps America exceptional.
Josh Zagorsky is co-founder of Zagaran, Inc., a software development contractor, and CTO of TaxCredit.ai, a data-driven R&D tax credit service firm.
