The Looming Tax Law That Technology Companies Should Prepare For

Partner, Tax Leader of the National Technology Industry Group, CohnReznick

Technology companies of all sizes, there is a tax law that you should be aware of and start preparing for.

While the Tax Cuts and Jobs Act of 2017 (TCJA) has been around for a few years, a portion of it has only just now taken effect.

The TCJA introduced a massive change to the deduction of research and experimental expenses, which took effect on January 1, 2022. Historically, Internal Revenue Code Section 174 has allowed for the immediate expensing of research and experimental expenditures and, in my experience, this has been far and away the most common choice made by my clients; whether they are in the growth phase or are well-established companies.

Starting with the tax year 2022, companies must now capitalize these expenses each year (over either five or 15 years). Getting ready for this change needs careful consideration and planning. Since these costs specifically include software development, tech companies especially need to get up to speed on the changes, and soon, because corporate estimated tax payments could be due as early as June 15, even if no tax was due in the prior year.

If you’ve been caught off guard, you’re not alone, and there are a couple of reasons why.

First, the elimination of this change has received bipartisan support almost since it was passed. In February of 2021, members of the house introduced the American Innovation and R&D Competitiveness Act of 2021, and then in March of 2021, members of the Senate introduced the American Innovation and Jobs Act, both seeking to eliminate this provision from taking effect. This mantle was then taken up by the Build Back Better Act (BBB), and all of the published versions of that legislation included at least a deferral of these rules taking effect.

Second, the IRS has provided no guidance as to how technology companies and their tax professionals should be identifying and calculating the direct, and indirect, expenses that fall into this category. While many IRS code sections and their related regulations are notoriously dense and lengthy, the updated Section 174 as written by the TCJA can fit neatly on a couple pieces of paper. This delay was interpreted as more evidence that these changes might never come to fruition.

However, if these changes take effect, companies of all sizes, especially those with big spends on software and technology development, need to pay attention. Even if newly proposed legislation passes, the current proposals only delay the treatment until 2025 rather than eliminating the provision altogether. With that in mind, what should companies be thinking about in relation to these changes?

Future Cash Flows And Burn Rate Models

Cash flow projections could require material adjustments if federal, state and local income taxes now become a line item to consider. This could also affect the timing of required capital raises, and even valuations, if current taxes become a material item on the P&L or balance sheet.

Can you separately identify your Section 174 costs?

Historically, it was not necessary to understand what costs relate to Section 174 as they were deductible just like a normal business expense. With these changes, identifying the work performed on research and/or software development is now paramount. The implementation of time tracking software or methods could be the difference in significant tax savings and making that investment pay for itself.

Foreign Development Versus Domestic Development

While the cost of building a team of engineers outside the U.S. may be more efficient, this will now come with an additional tax cost. The updated language of IRC Section 174 requires foreign costs to be amortized over 15 years, while domestic research and experimental activities can be amortized over five years. Companies should make sure they understand the tax impact of using potentially lower cost resources offshore instead of U.S.-based R&D teams.

Even for growth-stage companies, could there be a tax impact?

Most growth stage technology companies that are raising capital, and spending to improve their core product and grow their customer base, end up in a taxable loss position. However, as a result of this change and the limitation on the use of NOLs in a given year, many technology companies could be preparing for their first federal tax bills. This means that burn rates and the plan for future capital raises could be impacted as soon as 2022.

R&D Credits

Companies that are ineligible for the election to use their R&D Credits to offset FICA taxes should also consider revisiting an R&D study and credit claim to cover the current tax impact of the change.

Despite this law’s enactment as of the date of this article, there is still some uncertainty facing these changes. As mentioned previously, there is bipartisan support to either push off or eliminate this change, meaning there is still hope that these challenges could be avoided. Technology companies with significant development activities should understand what these changes could mean for them. This way, they can be prepared if, and when, these changes come into focus.

Disclaimer: Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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