We are pleased to present a unique feature on our blog today. The following post comes courtesy of a guest contributor, Collective 54 member Robin Way, CEO of Corios, who brings a fresh perspective and expert insight on a recent change to the tax code affecting boutique professional service firms. We are honored to share his knowledge and viewpoints with our readers. Enjoy this unique piece that broadens the horizons of our usual content.

What is this IRS Section 174 thing?

Sure, the title of this article probably made you flip to the next page. Few stories are less sexy than tax regulations and Congressional legislation. But, if you are a professional services firm who invests in research and development of any kind, you should be paying attention.

Greg Alexander, Founder of Collective 54, has shared a lot of perspectives about productizing your services, diversifying your sources of revenue, and creating mechanisms to earn fees that are not dependent on billable hours. If you have done anything with this advice, chances are you have probably made an investment in R&D whether you knew it or not.

Does this apply to you?

If your firm delivers technology, engineering, design, architecture, or IT services, chances are good that you will incur R&D oriented expenses, whether you know it or not. (This little condition will come back around later, wait for it…)

Here is some good news that you have potentially already been taking advantage of, under the federal government’s R&D tax credit program: you can deduct some of these costs from your tax liability as a tax credit.

The US federal government has provided R&D tax credits since 1986, under what is called IRS Section 41 “Credit for increasing research activities”. Corios has benefitted from this program for about 5 years, and it has taken some of the sting out of our federal tax liabilities, depending on how much we spent on qualified R&D.

To meet the standards of a “qualified research and development expense” under IRC Code Section 41, these R&D expenses need to meet all the following criteria:

• • The costs for in-house or (domestic) contract labor and supplies.

  • Associated with experimental development processes.

  • Associated with improving the functionality, quality, reliability, or performance of a business component.

  • Where there was some technical uncertainty about the outcome of the research.

What is interesting about the “experimental” and “technical uncertainty” clauses is that, if your staff are performing fixed price work for your clients, and this work contributes to building a technical product that your firm owns, then you can also take credit for the labor costs of performing that work. Note that this only applies to fixed price contracts, since under that approach, your firm holds the risk of performance, and this cannot be a work-for-hire where the client owns the deliverables and/or the intellectual property. Your auditor will read all the contracts to ensure these projects meet those criteria.

So, yes, those R&D tax credits sound rather good! Stay tuned for the bad news…

What is different this time?

I mentioned IRS Section 41 above, which defines expenses subject to the tax credit. There is another section of the federal tax code, called Section 174. This (previously) defines how firms can deduct their R&D expenses in the year in which they were incurred. For comparison’s sake, other countries offer manufacturers and other companies investing in R&D a “super deduction” that is vastly preferable to what we have here in the US. In China for instance, firms can deduct 200% of their R&D expenses in the current year.

A major amendment to IRS Section 174 was introduced 5 years ago as part of the Tax Cuts and Jobs Act (TCJA), passed in 2017. It amended the way that Section 174 expenses were deducted, by making business amortize those expenses over a 5-year period. When this was signed into law, there was a 5-year delay in its implementation, so it only affected business taxes starting after Dec 31, 2021.

Section 174 is entirely different than Section 41 tax credit. From my vantage point, you can think of Section 174 treatment of R&D expenses as a penalty. Section 174 makes your firm amortize your expenses over a 5-year period, rather than allowing you to deduct these costs in the year in which they were incurred as a normal expense. (If that sounds boring, it should not. I will clarify this with a simple example a little later…)

Section 174 qualified R&D expenses include everything under the Section 41 definition, and now they add on the following additional categories of expenses:

• • Non-qualifying software development and related expenses

  • Non-taxable benefits costs

  • Foreign research expenses (note that Section 41 only gives you credit for domestic expenses)

  • Depreciation

  • Overhead

  • General and administrative costs

  • Utilities

  • Rent

  • Securing (but not acquiring) a patent

You might be thinking, “OK, so the R&D expense category is larger now, is that a good thing?” Nope. The 5-year amortization requirement is going to really be the part you end up hating. Let us compare your new R&D deductions rate (20% per year) with China’s (200% per year). Big difference.

Why should you care?

Usually, your firm pays taxes based on your EBITDA. The more income you make, the more taxes you pay. Well, Section 174 is completely different. It is not tied to how much profit you make, but to the costs you incur. The more R&D costs you incur, the larger the penalty will be, because your effective current-year R&D OpEx costs now go DOWN, and hence your implied (but not actual) income goes up, and hence so does your tax liability.

Here’s a (relatively) simple example:

Before Section 174 phased in, assume your firm earns $100 per year in income, less $40 for COGS (mostly, the salaries and benefits of staff who are not in R&D), leaving $60 in gross margin. Now come the operating expenses. As a tech-investing firm, you have $30 in R&D expenses each year and another $20 in all other expenses. This leaves $10 in EBITDA, and if the effective tax rate (note: Corios is based in Portland, Oregon, the home of high taxes) is 40%, then your annual tax liability is $4.

Now let us run the very same simple scenario but add in Section 174. The only difference is that R&D expenses need to be amortized over a 5-year schedule. Hence you can only claim 20% of the year 1 R&D expenses in year 1. Your actual OpEx is unchanged, as is your actual EBITDA. However, your effective R&D expenses in year 1 become only $6 (instead of $30) because you can only deduct a part of the first year, making your “effective” EBITDA $34, and now your tax liability is $13.60–more than triple your “Before Section 174” taxes! (Yeah, “holy crap!” is right.) Note that you do not actually earn any more EBITDA, and there is not more money in your bank account; actually, there is less of it, namely $9.60 less of it, due to the increased tax liability. By the end of year 5, your amortization schedule has caught up and now your effective OpEx and effective taxes are back to normal, but in the meantime, you are getting screwed. Royally.

What to do about it

There is some promising news on the horizon, but it needs your help to push it into reality. You too can act and make a difference.

The Senate has introduced a bipartisan bill called the American Innovation and Jobs Act (AIJA), which will repeal the previously amended Section 174 to go back to the way it was before the TCJA. Democratic Senator Margie Hassan introduced the bill in the Senate in March 2023, with co-sponsorship from Senator Todd Young of Indiana on behalf of the Republicans. Support is broad on both sides of the aisle, but the bill needs to be attached to an omnibus spending bill to get adopted. There is a corresponding bill in the House, called the American Innovation and R&D Competitiveness Act, which enjoys a similar bipartisan support.

Despite this bipartisan desire to get this bill passed, many Democrats want to pair the AIJA with a reinstatement of the Child Tax Credit. This is where progress on the bill has stalled a bit (do not take my word as gospel, I am not an expert on the back-room conversations here, but I am passing along what I have heard from the lobbyists).

Several weeks ago, through Corios’ membership in the Technology Association of Oregon, I was invited by Yelp and their lobbyist, Dentons, to visit Washington DC and tell our story to several US Senators. Specifically, two weeks ago we visited the offices of four US Senators: Senator Todd Young (Indiana), Senator Chris Murphy (Connecticut), Senator Ron Wyden (Oregon), and Senator Mazie Hirono (Hawaii).

My role was to tell the story of the “little guy”, namely, the pull-up-by-your-bootstraps entrepreneur who is struggling to get by and for whom the impacts of this Section 174 provision are a big punch in the jaw (or insert a more colorful metaphor, which works just as well). The goal of the lobbyists is to build momentum for both bills in each house of Congress and to get them attached to the major spending bills. To reach this objective will take a journey, not a one-day meet-and-greet.

So, here is what you can do, and it is simple: write to your Senator and House representatives, telling them your story. Here was my story:

“I’m the founder and CEO of Corios. We are not a large company like Google, Amazon, or Netflix, but we employ Americans and pay them a good wage and strong benefits. I believe in innovation, and I actively invest in our software products so that we can stay as competitive as possible in a very tough industry. So now, given the implications of Section 174, my tax liability has skyrocketed, and the incremental taxes are equal to an entire month’s cash flow. That means I cannot pass along pay raises or bonuses to my team members or hire more members of our team to grow. Meanwhile my offshore competitors are enjoying tax incentives that dramatically outpace our own, and meanwhile I am being penalized for trying to invest in my company and my team. Bear in mind, our R&D investments are really an investment in hiring Americans to build our products and paying their salaries. We are not hiring ChatGPT or something, these are real jobs and good salaries. But now that I have less to pay for everything else, I am faced with the decision of paying offshore developers to do the work that ought to stay onshore in the US. But when offshore developers cost $30 per hour and onshore ones cost $100 per hour, that is a very tough decision to support. I need you to get this amendment to Section 174 repealed. “

You can put this story however you would like, but I encourage you to tell your story, and do it today.