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Across software development, entrepreneurs are facing a tax season that is threatening their business’s existence. Software startups claim they have been blindsided by shock tax bills due to a change in the law regarding research and developments costs. If Congress doesn’t provide a retroactive solution, the failure of businesses will spread across the industry. This was not a surprise and was a disappointment for major corporations who had lobbied in favor of the measure. As word spreads throughout the software community, some owners are still afraid to look at the full tax cost when they file for extensions and accountants revise their returns. The pain is felt by small software developers with a dozen employees or less, as well as large venture-backed firms that have pre-2022 frothy values. Tax bills are rising and forcing companies to make difficult financial decisions. In a period of tighter lending by banks and higher interest rates, startups are forced to extend credit lines or take out loans. They also have to ask VCs for additional funding in the worst fundraising climate in over a decade. Finally, they must freeze hiring and consider layoffs, if not already done so. They say that many software firms will survive this year. However, if the full R&D expensing is not reinstated, survival may become a problem.
The R&D tax changes have had a major impact on the software development industry. However, many startups in other industries who are working at an early stage of innovation also face huge tax bills. They’ve been raising alarms about possible bankruptcy. Software development talent is the largest expense for software firms. These companies can fully deduct these costs until 2022 as R&D, rather than amortizing them over several years. When software talent costs exceed cash flow or profits, the business model can be unsustainable.
“I’ve been involved in bootstrapped software for 20 years, and I have lots of connections, hundreds of others under $10 million in revenue, and everyone I have 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? Landon Bennett, the co-founder and CEO of Ad Reform in Georgia, a software company that provides automation technologies for the advertising industry said his taxable income had increased by 400%. Bennett said that the year was one of the toughest for ad agencies. “This is like a big bomb on top an already bad year,” said Bennett. He added that he could “take the hit this year but not forever.” He does not need to consider staff changes at this time, as it would be a costly decision to hire and train new employees, plus the knowledge base of seasoned developers is critical for success and growth. He did, however, have to suspend the annual profit-sharing with his employees for the time being. This decision was made in a recent video call to the staff about the R&D Tax issue. Landsman, who estimates a tax increase of between $140,000 and $160,00 this year, said that the situation is “very bad” from a cash-flow perspective. The more time passes, the larger the tax bill becomes. We were not prepared for this huge change. We don’t just have a few million sitting around to write a check and not be too worried,” he said.
The effort to pass legislation has not stopped in Washington. A bill was introduced by Republican Senator Todd Young from Indiana and Democratic senator Maggie Hassan from New Hampshire last month, and a bipartisan House resolution was introduced by Kansas Republican Ron Estes on Tuesday and Connecticut Democrat John Larson on Wednesday, with 60 cosponsors evenly divided along party lines. The challenges are still the same, but they have become more complex. This is highlighted by the need for debt ceiling talks to be held before tax priorities can move forward on Capitol Hill. House Speaker Kevin McCarthy spoke at the New York Stock Exchange on Monday. He stressed the need for spending cuts to reach a debt ceiling agreement that would last one year. However, he admitted in an interview with CNBC that he had not yet received support from his own party. The size of a child tax credit that would match the R&D expenses, which were the main snag in last year’s negotiations, remains a moving target. More GOP members are open to some form of child tax credits, and some Democrats have said they will accept a smaller amount. However, there has not been a formal offer yet.
As the House legislation is introduced, a grassroots effort is gaining momentum among software developers, with nearly 600 small business owners including Landsman and Bennett signing a letter to the Hill desks of House Way and Means Committee chair Jason Smith (R-Missouri) and Senate Finance Committee chair Ron Wyden (D-Oregon) on Tuesday morning, asking for “urgent relief” and warning that failure to bring back full R&D expensing may wipe out their companies.
“You will see damage in the short-term, but the much bigger red alert situation will be in the next 12-24 months,” said Bennett.
“We are now facing difficult choices because of the large, unexpected, and unprecedented tax liability that we face. We have all frozen hiring and suspended projects. Others are borrowing to pay their taxes, either from credit cards, personal savings or lines of credit,” states the letter from ssballiance.org. Others are borrowing to pay our taxes, either from credit cards, personal savings, or lines of credit,” states the letter from the ssballiance.org.
Congressman Estes believes that legislative odds have improved, for two reasons, even though the bipartisan legislation which had well over 100 co-sponsors last year failed to move. He says that even though the debt ceiling is looming, there is still more time to pursue the tax changes this year compared to the rushed effort last year during the lame duck session. And lawmakers are coming to understand the economic consequences of letting this tax issue go unresolved.
“It should have passed last year. “Everyone wanted it, but we ran out time,” said he. There is also a learning from last year’s failure to pass the bill. People may have assumed it was OK not to pass it. They now see that this is an essential cost for both short- and long-term success, and they are more willing to concentrate.
This view is making small business trade associations that have been on the front lines for the longest more optimistic than at the end last year. Karen Kerrigan is the president & CEO at the Small Business & Entrepreneurship Council. She said that Congress often takes action when the things we predicted actually happen. “Congress has begun to hear from small businesses about the negative and widespread impact of these tax bills and what they mean for innovation and their competitiveness. … I can see that there is a way to fix this problem, but it must be done quickly for many small businesses. “
While Bennett and Landsman, small business owners, have never worked with large companies, Rohit Kumar from PwC, the national tax services leader, recently met them. Rohit Kumar is a former Mitch McConnell top aide who discovered the grassroots movement via Twitter and made contact to establish a relationship. Kumar said that all of the same legislative obstacles that hindered the effort last time are still in place, as well as the debt ceiling that must be addressed first. He said that the “increasing volume” of small businesses who are affected by the issue and come to legislators to voice their opinion is a noteworthy development. He said that the “increasing loudness” of small businesses who are affected and show up to express their views is a notable development. “It is not only big companies that write big checks. At the margins, it means less R&D, less investment, and fewer jobs.” This is an abstract issue, even if it has a real economic impact. He said that you can only mortgage something or max out a line of credit for so long. He said that you can only max out a credit line or mortgage an item for a limited time. Some won’t make it this year and many will not in the next two years. He added that they would have to sell at a low price or fold up if the worst case scenario occurred. So they will have to sell at a bad premium or just fold up,” he added.
Some small business owners are said to be contemplating incorporation overseas as a way to avoid the U.S. tax system in a worst-case scenario.
Bennett says the odds may be 50-50, but many software startup founders like him have no choice but to believe that Congress will act, because the alternative to not bringing back full expensing of R&D is non-existence. He said that the alternative to not bringing back full expensing of R&D is non-existence. It’s like a bank run for tech. “