Section 174: A Hidden Tax Burden Threatening US Tech Startups

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The US tech sector, a crucial engine of innovation and economic growth, faces a significant challenge in the form of a recently implemented tax change.

Section 174 of the 2017 Tax Cuts & Jobs Act, initially overlooked, has emerged as a major concern for early-stage and small technology companies. This provision unexpectedly alters the tax treatment of software development costs, potentially hindering essential growth and investment.

So what does that mean exactly?

Up until recently, labor costs for R&D, including labor for software development, can be immediately expensed.

So if your business makes $1M in revenue, and spends $1M on software development labor, then your profit is $0, and you taxed nothing. However, with the amendment to Section 174 all of that changes.

With the adjustment, all costs related to R&D have to be amortized over 5 years – or 15 if labor is done outside of the US.

Here is how amortization works for labor within the U.S.:

  • 10% amortized for the first year
  • 20% amortized for years 2 to 5
  • 10% for year 6

Going back to our previous example, this means that in the eyes of the government, you would have made $900,000 in profit that year and would have to pay $189,000 in corporate taxes.

2021 2022 2023
 Revenue $1,000,000 $1,000,000 $1,000,000
Software engineering labor costs paid during the year $1,000,000 $1,000,000 $1,000,000
Deductable $1,000,000 $1,000,000 $300,000
(10% from last year
20% from this year)
Profit $0 $900,000 $700,000
Corporate Tax $0
(due in 2022)
(due in 2023)
(due in 2024)

So what happens to a small, bootstrapped company without $189,000 in cash in the bank? You have two options.

  1. Take out a business or potential loan at a relatively high-interest rate (~10%).
  2. Lay off as many software engineers as it takes to pay the bill.

Taking this scenario a step further, given that this company even survives the tax season, it’s not hard to imagine the impact this will have on the product roadmap if they go with option 2.

A Hidden Tax Burden Threatening US Tech Startups image 1

The potential impact of Section 174 on the tech industry

On a larger scale, the changes to Section 174 will directly translate to reduced hiring capacity, potentially leading to talent freezes or even more layoffs. In a competitive landscape where skilled software engineers are essential, this decline in hiring power could potentially slow down innovation.

Furthermore, the provision disincentivizes the employment of international developers. With a longer amortization period of 15 years for foreign workers, companies face a significant tax penalty for remote or contracted development teams.

This could lead to a shift towards outsourcing software development instead of cultivating in-house talent, a potential blow to domestic job creation and knowledge transfer.

Beyond the immediate challenges for startups, Section 174 carries broader implications for the US tech ecosystem. The disincentivized investment in internal software development could benefit SaaS companies and technology vendors, potentially altering the competitive landscape.

Additionally, the tax burden could discourage the incorporation of tech startups within the US, hindering the nation’s ability to attract and nurture promising early-stage ventures.

If you’re wondering why hasn’t big tech sounded the alarm, the answer is they did but it happened in the form of lobbying efforts going as far back as 2018.

What can startups do to protect themselves?

Some startups are exploring creative solutions, such as restructuring operations or embracing remote talent pools, to navigate the new tax landscape.

A Hidden Tax Burden Threatening US Tech Startups image 2

Section 174 presents a significant hurdle for the US tech sector, particularly for early-stage and small companies. Its unexpected impact on tax burdens, hiring capacity, and the utilization of international talent requires immediate attention and potential policy adjustments.

Luckily, there is still a chance all of this will be reversed and things will remain the same. The only question is how long will it take.

If you’re looking to stay competitive in the market and not incur exorbitant fees, then consider looking to scaling your team with Trio. Our 3-step interview process was designed specifically to capture senior-level technical and soft-skill signals and hire the right Top-Tier software developers for your team.

With Trio, you can focus on what you love most – deliver great products while we handpick and shortlist from our pre-vetted talent network. We’ll enable payroll, benefits, taxes, and local compliance and support you with onboarding and long-term talent management.

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With over 10 years of experience in software outsourcing, Alex has assisted in building high-performance teams before co-founding Trio with his partner Daniel. Today he enjoys helping people hire the best software developers from Latin America and writing great content on how to do that!
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