The Unintended Consequences of the Tax Cuts and Jobs Act on Startups
The Tax Cuts and Jobs Act (TCJA) of 2017 was heralded as a significant overhaul of the tax code, aimed at stimulating economic growth and making the U.S. business environment more competitive globally. However, even though most of the Act helped stimulate economic growth, one of the provisions within the TCJA has begun to cast a long shadow over the vibrant startup ecosystem that drives innovation and job creation in the US.
The R&D Amortization Rule
Starting in 2022, a new rule from the TCJA came into effect, altering the way companies handle their research and development (R&D) expenses. Previously, businesses could deduct R&D costs in the same year they were incurred, providing immediate financial relief and incentivizing investment into innovation. The TCJA changed this by requiring companies to amortize these costs over five years, or even more challenging, fifteen years if the expenses are for R&D conducted overseas.
Impact on Startups
US startups, notoriously known for their fragile cash flow and rapid innovation cycles, today are feeling the brunt of this change. The immediate expensing of R&D costs was a lifeline for young companies, many of which operate at a loss in their early years as they invest heavily in development, personnel, and intellectual property. The shift to a five-year amortization schedule means that startups now face larger taxable income figures in the short term, leading to higher tax bills that in turn stifle growth and further investment in innovation.
A Real-World Scenario
Consider a startup with $1.5 million in revenue and $1.4 million in R&D expenses. Under the old rules, it would pay taxes on a $100,000 profit. Now, it can only deduct one-fifth of the R&D expenses per year, resulting in a taxable profit of $1.22 million vs. $100,000. This increase in taxable income can be the difference between survival and closure for a startup operating on thin margins. And as the vicious circle continues the start-up is forced to go into greater debt by borrowing at the current high interest rates
Long-Term Effects
The long-term effects of this provision are potentially dire. It’s projected that after a decade, the U.S. GDP could be reduced by $45 billion, with more than 48,000 direct start-up jobs lost according to the ITIF, one of the world’s leading think tanks for science and technology policy. Moreover, the U.S. risks falling behind in the global R&D race, with several countries offering far more generous tax benefits for R&D, potentially luring away innovation and talent.
Some other examples of generous R&D tax incentive countries according to the OECD include:
- Iceland: In 2023, Iceland offered one of the most generous R&D tax incentives for small and medium-sized enterprises (SMEs), regardless of their profitability.
- Portugal: Portugal provided high R&D tax subsidy rates for both SMEs and large firms in 2023. It was particularly favorable for large profitable firms, as well as loss-making firms.
- France: France has been known for its substantial R&D tax incentives, offering significant subsidies for both SMEs and large enterprises.
- Poland: For large profitable firms, Poland was among the countries with the highest R&D tax subsidy rates in 2023.
These incentives can include direct subsidies, tax credits, or deductions that reduce the overall tax burden for companies engaging in R&D. The aim, at the end of the day, is to encourage businesses to invest more in innovation, which can lead to technological advancements, more jobs, economic growth and in the end, pretell, more sustainable tax revenue.
The OECD also reported that a total of 33 out of 38 member countries offered tax relief for R&D expenditures in 2023, highlighting the global competition to attract R&D investment. Such competitive tax landscapes can influence where companies decide to locate their R&D activities and where talent chooses to work, potentially drawing both away from countries with less favorable tax treatments.
The Path Forward
There is a growing consensus among industry leaders, economists, and policymakers that the current US R&D amortization rule is counterproductive to the goals of fostering innovation and competitiveness. What will happen is that many entrepreneurs will go to the bank, borrow at high-interest rates, or incur penalties because they don’t have the money to pay the tax bill.
But repealing this provision has stalled in the Senate putting at risk efforts to reinvigorate the startup sector and ensure that the U.S. remains at the forefront of technological advancement for years to come. It’s imperative for the long-term health of the innovation economy that this rule be re-evaluated and, ideally, repealed, to allow startups, many of which are not venture-backed, to continue being the engines of growth and innovation they are meant to be.
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This blog post reflects the current state of affairs based on information available up to early 2024. For the most current and detailed information, readers should consult a tax professional or refer to the latest legislative updates.
