Section 174 Rule Changes for US Startups

Published on:

August 5, 2024

What is Section 174?

Section 174 was part of the Tax Cuts and Jobs Act (TCJA), introduced in 2017 and enacted in 2022. This law massively affects how startups hire and build their products. The law states that all research and development (R&D) costs must be amortized over 5 years for locally and 15 years for work done abroad for all US-registered companies.

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Research and Development Costs

What is an R&D cost? It can be many things, but software development costs are the most common use case. According to Section 174, software development is an upgrade or enhancement to software that results in additional functionality—i.e., any cost associated with enhancing existing software's speed, capability, or efficiency.

Amortization means spreading the cost over a consistent period. For example, suppose you buy a server rack for your software business in the first week of operation. R&D states that this cost must be 'spread' over the next five years. Here is how it works:

10% amortized for year 1.

20% amortized for years 2 to 5.

10% for year 6.

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Calculating R&D Costs

Section 174 makes sense for server racks since you'll use them over time. Let's talk about engineers. Imagine running a software business with a revenue of $100k per year. You employ one engineer in the US with a salary of $100k. Excluding other costs, you had no net income in 2021. However, with section 174, their salary would be amortized over the next five years, reducing the cost to $10k and giving you a profit of $90k.

(An example of a bootstrapped startup with $100k in revenue and domestic expenses before/after section 174) . Checkout our free Section 174 Calculator here

Let us discuss what this means for you. You will now require an additional $13k to pay off your income tax in 2022, which is unfortunate since you spent all your revenue on salaries that year!

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Legislative Outlook

In 2017, the Tax Cuts and Jobs Act reduced the top tax bracket from 39.6% to 37%. As a result, the Senate "balanced out" the tax reduction by introducing Section 174. Most experts expected Congress to repeal this law, but for various reasons, it fell through.

As of July 2024, there has yet to be much progress in addressing Section 174. In January 2024, the House passed a bill [1] which will retroactively repeal Section 174 for research and development expenses. This bill moved to the Senate, where it lost most of its momentum. The Senate has a second bill [2], which also aims to repeal Section 174 but has yet to be voted on. Even if it passes, both chambers must negotiate differences before it reaches the President's desk for approval.

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Impacts on US Founders

For now, any potential adjustments to Section 174 remain uncertain. Section 174 will continue to impact early-stage and small tech companies. Some startups have reduced the hiring of engineers, especially from foreign countries like India. Many founders have resorted to buying software rather than building it in-house. Some choose 'reverse-flip' structures, where their subsidiary is in the US, or incorporate in a different country altogether.

Amortization makes business sense, but not always. For example, Google has amortized software developer salaries for products with decent revenue. However, they've historically expensed their developers for pre-launch projects with little revenue [3].

38% of CFOs were confident they were taking full advantage of R&D tax credits for cloud investments [4]. This number is likely lower for first-time startup founders since they usually need more financial background to understand the nuances of tax, compliance, and accounting. If you are a startup founder and want to understand Section 174, use our free tool Click here to estimate your income tax liability. You could also book a call with our team at Inkle. We can help you out!

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