Startup Tax Panic as 2017 Changes to Deductibility of R&D Expenses Take Effect

Tucked inside the 2017 Tax Cuts and Jobs Act, a.ka. the Trump tax cuts, was a change to Section 174 of the tax code, which governs how companies deduct R&D expenses. Instead of allowing companies to fully deduct their costs in the year incurred, the revision requires companies to amortize the deduction over five years. The change was scheduled to take effect Jan. 1, 2022, which means it is showing up now as big tax bills that are both tech startups and tech giants.

At the time of passage in 2017, it was widely assumed that Congress would restore the full deductibility of R&D costs before it took effect, but that expectation was derailed by the Covid pandemic. When unemployment peaked because of covid shutdowns, Congress changed the Child Tax Credit from an annual tax refund of $3,600 per child under 6 and $3,000 per child ages 6 through 17, families were paid $300 per child under 6 and up to $250 per child under 18. That arrangement also expired in 2022. When Democrats moved to restore the Section 174 full R&D deductibility, they paired it with restoring the monthly Child Tax Credit payments. Republicans balked and the two sides remain stalemated.

US is stingy with R&D incentives

Long ago, the US was a global leader in support for R&D but that support has been declining for decades.Combined federal and state tax support for private sector R&D is now less than in comparable countries around the world, according to a study in 2020 by the Information Technology & Innovation Foundation.

“Federal and state tax support for R&D in the United States accounts for only 9.5 percent of R&D spending in the economy, which is a little more than a third of what China offers in tax incentives,” economist John Lester, who co-authored the report for ITIF, said at the time. “A fiscally responsible target would be to increase the overall subsidy rate to at least 15.5 percent. That would put America close to par among comparable countries. More importantly, a benefit-cost analysis shows it would provide a solid boost to real incomes because of the way R&D drives innovation, productivity, and competitiveness.”

The study found that the United States ranks 24th in a comparison group of 34 countries in the Organization for Economic Cooperation and Development (OECD) plus the four “BRICs” (Brazil, Russia, India, and China). The authors warned against failing to restore full deductibility of R&D costs in the year they are incurred. Now that the failure has occurred the United States is “one of only a few countries that doesn’t allow expensing of current R&D costs.”

Business is telling Congress that this is a big deal

This issue has mostly flown under the media radar but businesses are making certain that it on the screen in Congress. The accounting firm RSM organized a large group of a signatories to a letter calling for the reinstatement of immediate R&D expensing.

“This shift from immediate expensing of these costs is harmful to businesses of all sizes and is contrary to the United States mission of supporting and encouraging domestic research activities,” the group wrote.

Business groups clamoring for legislation to return the full tax deduction are addressing a sympathetic audience. A bipartisan bill introduced in the Senate, the American Innovation and Jobs Act, would make R&D costs fully deductible. It would additionally increase the amount of another incentive, the refundable R&D tax credit, and extend eligibility to more startups and small businesses. House Republicans are reportedly preparing legislation to make R&D expenses fully deductible in the year they are incurred.