The Hidden Threat to Startups: Section 174 Tax Code

In the past two years, many startups (including my own) have faced unexpected financial hurdles, and the main culprit quietly leading this charge is Section 174 of the U.S. tax code. This change, which took effect in 2022, requires businesses to amortize their research and development (R&D) expenses over five years (for domestic expenses) or 15 years (for foreign expenses), instead of allowing these expenses to be fully deducted in the year they occur.

For software and life science startups, where innovation is everything, this adjustment in tax treatment has real consequences. Let's break down how Section 174 is harming startups and why we need reform.

What is Section 174, and What Changed?

For almost 70 years prior to 2022, companies could immediately deduct their R&D expenses in the same year, significantly helping startups manage their cash flow. For startups, every dollar counts, especially when it comes to funding innovation through software development, salaries, and experimentation.

However, starting in 2022, Section 174 now requires that all R&D costs—yes, even software development costs—be amortized. Instead of deducting 100% of their R&D spending in one year, startups must spread those deductions over five years. This change disproportionately impacts young, cash-strapped software companies that heavily invest in research early on without generating significant revenue.

This change does affect non-software and non-startup companies as well. Last week, I met with the founder of a life science company who indicated that they had stopped working on a life-saving drug until next year, because they did not have the cash flow to pay the tax bill to continue the R&D.

Earlier in 2024, a comprehensive tax package was put together to restore the Section 174 deductions, even retroactively ... only to be shut down by Senator Mike Crapo and his team. Why was it shut down? Because the Senator felt that in 2025 that they'd have bigger control of Congress and could control the tax package in a bigger way. So another year has gone by without any relief. I'm tagging his chief of staff - Susan Wheeler - because it's an election year and it's absolutely insane that this is still a problem.

Why This Hurts Software Startups

1. Cash Flow Constraints: Startups typically operate on razor-thin margins and rely on immediate tax deductions to stay afloat. Under the new rule, the delayed tax benefit reduces liquidity, which means less cash available for reinvestment in product development, hiring, or marketing.
2. Increased Tax Burden: Even if startups are technically unprofitable, they may still owe taxes on paper under this new treatment. In the early years of amortization, only a fraction of the R&D expenses can be deducted, leading to a higher taxable income than the actual cash situation justifies.
3. Risk to Innovation and Competitiveness: In the software world, speed matters. Startups must innovate quickly to remain competitive. But limited cash flow means less investment in engineers, testing, and product iterations. Over time, this may lead to slower product development and stifled innovation.
4. Disproportionate Impact on Small Startups: Larger tech firms with deep pockets can weather these changes, but early-stage startups—the backbone of the tech ecosystem—are hit hardest. These companies often rely on heavy R&D investments during their first few years to build and launch viable products.
5. Real taxes on paper profits: Let's use a simple example. A software startup makes $1,000,000 in total revenue, and breaks even with no profit. Let's also pretend that 80% of the expenses are people (typical in many businesses), and in a small startup, Section 174 would say that everyone who does direct R&D, or manages the R&D, or supports the R&D, needs to have their salaries amortized.

Prior to 2022, this example company would owe 20% (corporate tax) of $0 profit, or $0 in taxes. That's real, because there is no money in the bank account, as they broke even.

Since 2022, with the lapse in the Section 174, the company must amortize the $800,000 in salaries and expenses that were spent on R&D. Which means that - on paper, for tax purposes - the company owes taxes on $800,000 in "profit". Or, $160,000!

But how will this business pay this bill ... they have no money in the bank account? According to my amazing CPA? What has she seen the past two years?

Her customers are setting up payment plans with the IRS. Because the money is not real. It doesn't follow cash flow.

So these businesses are going into real debt to pay an IRS bill for something that isn't real.

A Call for Reform: What Needs to Change

The current tax policy is a misstep for a country that prides itself on being a leader in technology and innovation. By treating R&D costs as long-term capital expenditures, the government unintentionally penalizes the most innovative companies, particularly those in software development.

There is growing bipartisan support for repealing or modifying Section 174. Proposals include reinstating the full expensing option or at least introducing temporary relief for startups and small businesses.

What Startups Can Do Now

Until reforms are made, startups should prepare by:

• Consulting with tax professionals to optimize their R&D reporting under the new rules. Frankly, you may need to stop doing R&D.
• Exploring R&D tax credits that can offset the amortization burden. These help, but they are minimal.
• Engaging with advocacy groups that push for legislative changes, such as the National Venture Capital Association (NVCA). Call your Congressional representative, and governor. Write them about this mess.

Conclusion

Innovation drives growth, but Section 174 slows that momentum by introducing unnecessary financial hurdles for software startups. If we want to foster entrepreneurship and maintain a thriving tech sector, it’s critical that policymakers rethink Section 174. Startups operate at the bleeding edge of technology, but they shouldn't be cut by the very tax policies intended to encourage their growth.

Let’s advocate for change before more promising companies find themselves burdened by outdated policies that stifle their potential.

Some Other Resources

Here are a few other links for you:

• https://www.dhirubhai.net/pulse/strategic-maneuvers-gops-inside-battle-over-vital-174-tax-legislation-wm19c/
• https://existek.com/blog/section-174-capitalization-things-to-know/
• https://abgi-usa.com/section174/latest-and-greatest
• https://www.usa.gov/elected-officials

#software #taxpolicy #startups #innovation #section174 #R&D

Some of my representatives and their staff ... maybe you all can answer what is being done?

Ted Cruz Brian Flores Adam Lester Susan Wheeler