Software firms face huge tax bills that threaten the tech startup’s survival


In the software development space, founders are experiencing income tax season that is becoming an existential threat to their company’s survival. Software startups say they’ve been blindsided by a shocking tax law that changed the law on research and development spending, and business setbacks will spread across the industry if Congress doesn’t introduce a retroactive fix.

At the root of the issue is lawmakers’ failure late last year to extend a key tax provision with bipartisan support that allows research and development expenses to be fully expensed under Section 174 of the tax code. It came out of nowhere and was a huge disappointment to the big corporations that lobbied for the measure. But for many small business owners, who often wear multiple hats, don’t have lobbying guns or ties to the big four CPA firms, the change, which requires five years of R&D depreciation, first became apparent this spring when accountants showed them a big tax return. accounts owed to the government. As word spreads through the software community, some owners are too scared to look at the full tax value as they file for tax extensions and accountants revise their returns.

The pain is being felt from the tiniest software developers with a dozen or fewer employees to large venture-backed companies sitting on frothy pre-2022 valuations, tax debt spiraling into cash drains and being forced to make painful financial decisions. Startups must take out loans or extend lines of credit at a time of tighter bank lending and higher interest rates, ask VCs for more money in the worst funding environment in more than a decade, freeze hiring and consider layoffs — if they haven’t already. within a sector that already leads the economy in job losses and is running at a faster rate of layoffs than the worst of the dotcom bubble. Many software firms will close this year, but they say survival will be a challenge if full R&D spending treatment is not restored.

The field of software development is among the most striking examples of the consequences of the R&D tax change – although many scientific start-ups working on early-stage innovations across industries are also facing huge tax bills and raising alarms about potential bankruptcies. The biggest cost, especially for software firms, is software development skills. Developers don’t come cheap, and by the 2022 tax year, these companies could fully expense those costs as R&D instead of amortizing them over several years. The success of the industry relies on the contribution of software talent, but when that cost exceeds cash flow and profits, it potentially makes the business model unviable.

“I’ve been in the software business for 20 years and I have a lot of connections, hundreds of others with less than $10 million in revenue, and everyone I talked to had no idea this was coming,” said Ian Landsman, founder of New York-based customer support software maker HelpSpot.

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How bad is it? According to Landon Bennett, co-founder of Ad Reform, a Georgia-based software firm that provides automation technology for the advertising industry, his taxable income increased 400%. “It’s been a tough year for advertising agencies, the toughest five or six years we’ve ever had, so it’s like a bombshell on top of an already bad year,” he said.

Bennett has already given up all of his compensation for 2022 to pay off his tax debt, and said he’s lucky to be able to use his entire salary to do so. But he added: “I can take this hit this year, but I can’t take it forever.”

He doesn’t have to consider any staffing changes right now, and says it’s the last decision a software firm ever wants to make, given the cost of finding and training people in high-level code and building an internal knowledge base among experienced developers, for success and growth. is important. But he has had to suspend annual profit sharing with employees for now — a decision he recently explained in a video call to employees over the R&D tax issue — and he said the situation is dire for many other small companies and will only get worse. No retroactive changes are made to the tax legislation.

“It’s very bad from a cash flow perspective,” said Landsman, who estimates a $140,000 to $160,000 increase in taxes this year. The longer it lasts, the bigger the annual tax payments. “It’s a huge change, and it’s a change we didn’t expect. We don’t just have a few million people sitting around writing checks and not worrying too much,” he said.

Landsman said he’s been able to apply for lines of credit for now, but they’re paying 9% interest, and he says many other founders he knows don’t have that option. “They’re going to have to foreclose on their homes … others just won’t pay and hope it gets fixed, or they’re not withholding taxes,” he said. Landman is already forced to make decisions that hinder the business. Since one software developer left at the end of last year, the position has not been replaced. “Small software companies aren’t built to just absorb costs for five years,” he said. “It’s all built around revenue and a lot of it has been given back to the workers.”

Legislative efforts have not stopped on Capitol Hill, with a bill introduced last month by Sen. Todd Young, Republican of Indiana, and Sen. Maggie Hassan, Democrat of New Hampshire, and bipartisan House legislation introduced Tuesday by Ron Estes, Republican of Kansas, and John, Democrat of Connecticut. With 60 co-sponsors, Larson is evenly split along party lines.

But the problems haven’t changed, and there are more of them, highlighted by the debt ceiling negotiations that must take place before any tax priorities can be moved on the Hill. On Monday, House Speaker Kevin McCarthy took his message to the New York Stock Exchange, where he stressed the need to cut spending to reach a one-year debt ceiling deal, but admitted in an interview with CNBC that he had not. The party is still on board for the plan. Talks between the GOP and Democrats over the size of any expanded child tax credit remain a moving target to match the R&D spending price tag, a key issue last year, though more GOP members have said they are open to some form of the child tax credit. tax credit, and some Democrats are reportedly willing to accept a lower amount, though there has been no formal proposal yet.

House Speaker Kevin McCarthy on the debt ceiling

Since the introduction of the House legislation, a grassroots effort among software developers has been gaining momentum, with nearly 600 small business owners, including Landsman and Bennett, signing a letter to House Ways and Means Committee Chairman Jason Smith (R-Missouri) and the Senate Hill desk. On Tuesday morning, Finance Committee Chairman Ron Wyden (D-Oregon) called for “urgent help” and warned that not fully recouping R&D costs could destroy his companies.

“You’re going to get hurt in the short term, but the bigger red alert situation is going to be in the next 12 to 24 months,” Bennett said.

“We now face tough choices as we face a huge, unexpected and unprecedented tax liability. Many of us have frozen hiring or stalled projects. Now some of us are considering layoffs or cutting wages. Others are borrowing to pay. From credit cards, personal savings or our taxes on lines of credit,” the letter said.

Congressman Estes believes that even though bipartisan legislation with more than 100 co-sponsors did not move last year, legislative opportunities have improved for two reasons. Even with the debt ceiling looming, he says Congress has more time to enact tax reform this year than last year’s rushed effort. And lawmakers understand the economic consequences of not addressing this tax issue.

“It should have been last year. Everyone liked it and wanted it, but we ran out of time.” “There’s a lesson learned from last year by not doing it, and maybe people assume it would have been fine if we hadn’t gone through it. Now they feel it’s a real cost and it’s short-term and important. It’s about long-term growth and a little more recognition and attention.” get ready.”

This makes small business trade groups more optimistic than they were at the end of last year. “Congress often acts when what we say comes true, and things happen when the impact is real and painful,” said Karen Kerrigan, president and CEO of the Small Business and Entrepreneurship Council. “Congress is starting to hear from small business owners about the widespread and negative impact of these shocking tax laws and what it means for innovation and their competitiveness… I see some kind of fix, but it has to come pretty quickly for many small businesses. “

While small business owners like Bennett and Landsman have never dealt with large companies on this issue, they recently met with Rohit Kumar, head of PwC’s national tax services and a former senior aide to Mitch McConnell. to connect. Kumar says the same legislative hurdles that killed the effort last year remain, along with the debt ceiling, which must be addressed first. But he said the “increasing voice” of small businesses affected and showing up to make their views known to lawmakers is a notable development. “It’s more believable and another reason why Congress doesn’t want to just twiddle their thumbs and miss an opportunity,” he said. “It’s not just big companies writing big checks, here it means fewer R&D projects, less investment and fewer people hired. Even if it’s a real economic result, it’s an abstraction.”

Landsman says many small businesses will “scratch and get by this year,” but if this tax law isn’t fixed, facing a costly deficit next year will set many small businesses up for failure. “You can only mortgage one thing or extend a line of credit for so long,” he said.

For a business model built on software development talent, cash flow that requires the owner to consider letting go of all developers is an impossible position.

“I’m very concerned,” Landsman said. “Some won’t even make it this year, and many will not make it in the next year or two. They won’t make money, and it doesn’t make sense to lay off half of their employees. So they will be. sell at a bad price or just fold,” he added.

Some small business owners are said to be considering incorporating overseas to avoid the US tax system in a worst-case scenario.

The odds may be 50-50, Bennett says, but many software startup founders like him have no choice but to trust that Congress will act, because the alternative to not reimbursing the full costs of R&D is not to exist. “I think it would be existential for the entire tech startup community,” he said. “Kind of like banking, but for technology.”

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