Due to a provision in the Tax Cuts and Jobs Act (TCJA), many unprofitable startups will have a surprise tax bill on April 18, 2023. This is caused by changes in how the tax law treats research and development expenses, pushing many money-losing startups into owing taxes. Experts estimate that this will reduce U.S.-based spending on R&D by $4.1 billion in the first few years.
V.C. Backed Startups Will Owe Taxes. It is estimated that 10 to 20 percent of revenue-generating startups losing money will show positive net income on their tax return, which means they will have to pay federal taxes. This will disproportionately impact startups generating revenue yet investing heavily in research and development. The TCJA forces companies to capitalize on their R&D expenses, recognizing them over a 5-year schedule. Only one-tenth of the first year’s R&D will be counted in the first year. Innovation outside the U.S. is worse for a company as the amount that can be recognized is even lower. Since many VC-backed startups invest heavily in R&D, many startups generating revenue will be caught in a situation where their cash expenses are meaningfully higher than their tax expenses. Thousands of revenue-generating startups heavily investing in R&D in the U.S. will now have to consider how their research spending impacts their tax position
Hypothetically, say a startup generates $2 million in revenue, spends $500k on non-R&D expenses, and another $5 million on R&D expenses. This company is losing $3.5 million a year, a healthy burn rate for a V.C.-backed company. Ordinarily, they would not owe any taxes since they have negative net income. However, in 2022 this company would only be able to deduct one-tenth of its $5 million in R&D expenses, only $500,000. What this means for tax purposes is they will generate $1 million in pre-tax profit and will end up owing over $200,000 in federal taxes. Assuming the company’s financials are stable the subsequent year, the startup deducts one-fifth of their R&D expenses, $1 million, leaving them with $500,000 in taxable income and just over a $100,000 tax bill.
Does Congress want to promote innovation or tax it? Recently Congress passed the Inflation Reduction Act, which doubled the R&D tax credit in an attempt to encourage innovation in the United States. The R&D tax credit is a powerful incentive that helps money-losing startups spend on U.S.-based research. But the TCJA clearly moves against this incentive. According to the Information Technology and Innovation Foundation (ITIF), the U.S. is now one of only a few countries that don’t allow immediate spending for R&D costs. As of 2020, the ITIF noted that tax support for research and development in the U.S. ranked 24th out of a comparison group of 34 countries in the Organization for Economic Cooperation and Development (OECD). The ITIF notes that this new R&D amortization rule may bring the U.S. ranking down to 32 out of 34 countries.
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