Software firms face huge tax bills that threaten tech startup survival

Across the software development field, founders are experiencing an income tax season that has become an existential threat to their company’s survival. Software startups say they were blindsided by shocking tax bills as a result of a change in law related to research and development costs, and if Congress does not provide a retroactive fix, business failures will spread throughout the industry.

The root of the issue is the inability of lawmakers to extend a key tax provision that had bipartisan support at the end of last year that allows for full expensing of research and development costs under Section 174 of the tax code. That did not come out of nowhere, and was a big disappointment to major corporations that had lobbied for the measure. But for many small business owners who often wear multiple hats, don’t have lobbying arms or relationships with big four CPA firms, the change to require R&D amortization over a period of five years first became known this spring when accountants showed them the massive tax bills they owed the government. As word has spread throughout the software community, some owners remain too afraid to look at the full tax cost as they file for tax extensions and accountants revise their returns.

The pain is being felt from the smallest software developers of a dozen or less employees to large venture-backed companies sitting on pre-2022 frothy valuations, with tax bills rising to a level where cash flow is being drained, forcing painful financial decisions. Startups need to take out loans or extend lines of credit at a time of tighter bank lending and higher rates, ask VCs for more money during the worst fundraising environment in over a decade, freeze hiring and contemplate layoffs — if they have not started making them already. Many software firms will make it through this year, but if R&D full expensing treatment is not brought back, they say survival will become an issue. 

The software development field is the starkest example of the fallout from the R&D tax change because its biggest expense is software development talent. Developers don’t come cheap, and until tax year 2022, these companies could fully expense those costs as R&D rather than having to amortize them over multiple years. Industry success relies on the contribution of software talent, but when that cost overwhelms cash flow and profits, it potentially makes the business model untenable.

“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.

How bad is it? According to Landon Bennett, co-founder of Georgia-based software firm Ad Reform, which provides automation technology for the advertising industry, his taxable income has gone up by 400%. “It’s been a tough year for the ad agencies, in the five or six toughest years we’ve ever had, so this is like a bomb on top of an already bad year,” he said.

Bennett has already forsaken his entire compensation for 2022 to pay the tax bill and said he considers himself fortunate to be able to put his entire pay towards it. But he added, “I can take that hit this year, but I can’t take it forever.”

He does not have to currently consider any staff changes, and says that is the last decision a software firm ever wants to make, with the cost of finding people and training them on code high, and building up the internal knowledge base among seasoned developers, critical to success and growth. But he did have to put annual profit sharing with employees on hold for now — a decision he recently explained to staff in a video call about the R&D tax issue — and he says the situation is dire for many other small companies and will get worse if no retroactive change is made to tax law. 

“It’s very bad from a cash flow perspective,” Landsman said, who estimates an increase between $140,000-$160,00 in taxes this year. The longer it goes on, the bigger the annual tax bills become. “That’s a humongous change and one we were not expecting. We don’t just have a few million sitting around to write a check and not be too worried,” he said.

Landsman said he is able to tap lines of credit for now, but is paying 9% interest, and he says many other founders he knows don’t have that option. “They will have to mortgage their house … others just wont pay and hope it gets fixed, or just not do taxes correctly,” he said. Landman is already being forced to make decisions that impede the business. Since a software developer left at the end of last year, the position has not been replaced. “Small software companies are just not set up to absorb the cost over five years,” he said. “Everything is structured around revenue in and a lot right back out to employees.”

The legislative effort hasn’t stopped on Capitol Hill, with a bill introduced last month by Republican Senator Todd Young of Indiana and Democratic Senator Maggie Hassan of New Hampshire, and bipartisan House legislation being introduced on Tuesday by Kansas Republican Ron Estes and Connecticut Democrat John Larson, with 60 co-sponsors, evenly split along party lines. 

But the challenges haven’t changed, and there are more of them, highlighted by the debt ceiling negotiations which need to occur before any tax priorities move on the Hill. On Monday, House Speaker Kevin McCarthy brought his message to the New York Stock Exchange, where he stressed the need to cut spending to get a one-year debt ceiling deal done, but conceded in an interview with CNBC he did not even have his own party on board yet for his plan. Negotiations between the GOP and Democrats over the size of any expanded child tax credit to match against the R&D expense price tag, which was the main snag last year, remain a moving target, though more GOP members have expressed openness to some form of the child tax credit and some Democrats’ are said to be willing to accept a lower amount, though there has been no formal offer made 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. Many of us have frozen hiring or suspended projects. Some of us are now considering laying off staff or reducing salaries. 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. Even with the debt ceiling looming, he says there is more time this year to pursue the tax change compared to last year’s rushed effort during a lame duck session of Congress. And lawmakers are coming to understand the economic consequences of letting this tax issue go unresolved.

“It should have passed last year. Everyone liked it and wanted it to, and we ran out of time,” he said. “There is also a lesson learned out of last year by not having it done, and maybe people making the assumption it would be OK if we didn’t pass it. Now they sense this is a real cost and essential for short- term and long-term growth, and a little bit more of a recognition and willingness to focus.” 

That’s a view that is also making small business trade groups that have been on top of the issue for longer than most more optimistic about a fix than they were at the end of last year. “Congress often acts when what we said would happen actually does and it all erupts once the impact becomes real and painful,” said Karen Kerrigan, president & CEO of the Small Business & Entrepreneurship Council. “Congress is beginning to hear from small business owners about the widespread and negative impact of these shocking tax bills, and what it means for innovation and their ability to compete.”

While small business owners like Bennett and Landsman have never had a relationship with big companies on the issue, they recently met with PwC’s national tax services lead Rohit Kumar, a former top aide to Mitch McConnell, who found the grassroots movement on Twitter and reached out to make a connection. Kumar says all the same legislative hurdles remain that killed the effort last year, and on top of that the debt ceiling which must be dealt with first. But he said the “increasing loudness” from the small businesses that are affected and show up to express their view to lawmakers is a notable development. “It’s more persuasive and another reason why Congress can’t just twiddle its thumbs and let the opportunity go by,” he said. “It’s not just big companies writing big checks, where at the margins it means fewer R&D projects, less investment and fewer people hired. That’s an abstraction even if real economic consequence.” 

Landsman says many small businesses “will scratch and get by this year,” but running up an expensive deficit into next year if this tax law is not fixed will lead to many small business failures. “You can only mortgage something or max a line of credit for so long,” he said.

For a business model built on software development talent, a cash flow drain that requires an owner to consider letting all developers go is an untenable position.

“I am super worried,” Landsman said. “Some won’t even make it through this year, and a lot not the next year or two. They are not going to come up with the money, and it doesn’t make sense to fire half your staff. 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. “I think it would be existential for the entire tech start-up community,” he said. “Kind of like the bank run, but for tech.”