By Michael Blackstone, MD
Entrepreneur and Father
CEO & Founder, SutureHealth
Businesses exist to create and enhance their products, activities which under the tax code are known as "research and experimentation" (R&E). We all rely on businesses to do this so that our economy grows and society succeeds. However, recent changes to the law penalize companies who invest in innovation, harming everyone - consumers, employees, and businesses, especially and disproportionately smaller businesses in every industry (i.e. it is not limited to "research"companies). Congress has a narrow window to fix this bomb before it explodes and catalyzes significant economic hardship that will ripple across all social classes. A very real "Pandora's Box." This is the proverbial "seminal moment;" if we do not act now, the repercussions will be felt far and wide.
DO NOT DISMISS THIS CALL TO ACTION. Many business owners are still unaware, only to find out when they get their tax return. You can verify the issue here, here, and here.
Prior to 2022 businesses were able to deduct all of their R&E expenses in the year incurred as ordinary operating expenses, which is critical for growth-minded, innovative small businesses and startups to survive because it accounts for 80-90% of their expenses.
The Tax Cuts and Jobs Act (TCJA) of 2017 changed US Tax Code Section 174, which went into effect FY 2022so that BUSINESSES CAN NO LONGER DEDUCT PAYROLL and ALL EXPENSES incurred to create or enhance their products and processes, even if only for internal use. These expenses can only be deducted over 5 years when in the US, and over 15 years when outside the US (i.e. foreign contractors). Under this model, even companies operating at a loss or break even will now be taxed as if they have potentially significant income commensurate with the amount of R&E spend. THIS IS A THREAT TO EVERY SMALL BUSINESS, AND MANY WILL NOT SURVIVE.
Yet, as of this writing, the Section 174 changes are not even listed on the IRS webpage outlining the TCJA changes for businesses.
By delaying R&E expense deduction, it effectively creates a new, regressive federal tax to innovate (“Innovation Penalty”) that will cost companies $0.925 for every $1 spent in the US over 5 years that they will not get back - just to innovate! For each $100,000 in R&E spend, that is an additional $92,500 that a company must pay to innovate. Most tech startups leverage non-US contractors to get over the startup hurdle, but it will now cost them $2.775 for every $1 spent over 15 years!
To make matters worse, in 2023 and thereafter, companies that would historically not owe any taxes must also pay estimated tax payments on this "phantom income," further tightening the noose even throughout the year, not just year end.
For startups and small companies with a high R&E spend, making them innovators by definition, they will never be able to start unless they have significant capital to cover both the delayed expense deduction and the Innovation Penalty, killing the American dream. Why are we taxing and penalizing innovation in America while China increases R&E deductions to 75-100% for small- and medium-sized technology companies? Why are we treating all companies the same when 9 out of 10 startups fail, all of them succumbing in one way or another to cash flow failure?
Delayed deduction and the Innovation Penalty is a regressive, double-hit to small business’s cash flow that will eliminate a significant percentage of small businesses and our economy while increasing unemployment.
Below are 4 scenarios for a $5M dollar company, assuming the same income and expenses over time. In reality, the Innovation Penalty will increase as the company grows and adds more R&E expenses since the actual expense growth will likely outpace expense deduction. Note that under pre-2022 law, companies operating at a loss or breakeven pay their fair share through employment taxes. Note also the deleterious impact using non-US talent will have on the common and economically important tech startup, just as the AI revolution begins. Do we really want to hinder our country's ability to lead in this space?
Since most startups and small businesses are pass-through entities, we use the 37% tax rate.
In every scenario, these companies will require investment or a loan to pay these unexpected taxes. Do not let the banks lobby against the average American!
It appears that the tax cuts established by the TCJA disproportionately transferred the tax burden from large corporations to small businesses, but the effects were hidden for five years by its deferred effective date. The Section 174 provision was added for budget scoring, and it was supposed get fixed before going into effect. However, politics and COVID got in the way. It is now being used for political leverage, while otherwise healthy companies hang in the balance. The fact that it hasn't been fixed yet is inexcusable. There is bipartisan support to fix it, but not the urgency it needs - till now. Efforts to reverse or defer this have failed (here, here, and here) but HR 7024 now has the steam and support needed to pass the House and Senate!
We still support reverting Section 174 to what it was, allowing all companies to elect either deduction or amortization for R&E expenses. Research has shown that innovation is the main driver of economic success, and in turn taxable income, which is what the government is ultimately after.
Undoubtedly fueled by COVID, a record 5.4 million applications were filed to form new businesses in 2021. 1.8 million of those were likely to hire employees. Historically the time to become taxable was 2-3 years, but this new law accelerates it to 1-1.5 years with the delayed expense deduction. Consequently, in 2022 there was a record number of startups becoming taxable under the new law, making it the absolute worst time for this law to include startups and small businesses, which are the engine of our economy.
Many of the 33 Million Small Businesses will be Irreparably Harmed
In the spirit of democracy and public discourse, we've set up this platform to amplify your voice - voices of real people with real concerns. Everyone is harmed as Section 174 increases the cost of your employment, penalizes the creation of new products and the improvement of existing ones, and decimates our competitiveness in the global market.
Raise your voice now, there is no time for delay!