For many startups, this year’s taxes will reflect a detrimental change to the treatment of research and development (R&D) thanks to a bill Congress passed in 2017. Without a Congressional fix, small businesses and startups without deep pockets will be less able to weather the cash flow burdens resulting from the change, and some companies may be facing hefty tax bills and will table plans for future R&D.
Generally, the R&D tax code incentivizes companies to conduct costly research and development activities by allowing them to deduct certain R&D expenses from their taxable income. Up until 2022, companies taking advantage of the tax credit were permitted to immediately expense R&D—but after 2017’s Tax Cuts and Jobs Act (TCJA), companies are now required to amortize, or spread deductions for R&D expenses, over five years. And for research conducted outside the U.S., the deductions must be spread over fifteen years. Despite lawmakers’ stated intentions and bipartisan efforts, Congress failed to undo the 2017 change in recent years, leaving many startups unable to effectively plan for the increases in their tax liabilities.
The change to the tax treatment complicates R&D for many startups. R&D is costly, and immediate expensing helped to offset the investment for small companies—many of whom may have a large amount of R&D expenses relative to their size. Businesses are already feeling the crunch, and some companies that had been expecting tax refunds or low tax bills, are facing significant payments that could amount to more than the founder’s salary. It will be significantly more challenging for startups to balance the cumulative burden to cash flow of only being able to deduct a fraction of its R&D expenses each year, instead of the previous 100 percent. They will be forced to use more of their vital cash for increased tax payments instead of for more research or basic operating costs like rent or salaries. The end result is likely an overall net reduction in innovation, slowed economic growth, and decreased ability for our innovation ecosystem to compete with other countries—many of which welcome innovation through favorable immigration policies and broad tax incentives for R&D.
Policymakers from both sides of the aisle support a fix to the tax treatment of R&D, including reverting back to immediate expensing. The American Innovation and Jobs Act, for example, sponsored by Sens. Hassan (D-N.H.) and Young (R-Ind.), would both expand the R&D tax credit and allow businesses to fully deduct R&D expenses each year. And organizations like Engine, have argued policymakers should broaden the R&D credit even further, for greater accessibility for startups. However, even with bipartisan support for an R&D credit fix, policymakers failed to reach a deal last year in an end-of-year tax package, to pair the fix with an expanded child tax credit. While the timeline for a fix is unclear, policymakers must act so that startups do not continue to face yet another barrier to growth. Without a return to full expensing, startups will have less incentive, and ability, to conduct cutting-edge research, risking U.S. innovation and competitiveness.
