I'm having a hard time understanding how this leads to lay offs. Software engineering salaries being amortized over 5 years leads to an increase in yearly taxable income for the company. So what makes this a bad thing for the company? Are they doing the layoffs just to reduce total income to bring taxable income back down to (or closer to) 0? I.e. is this all just to avoid paying more taxes?
Imagine you're a small business that makes $1m ARR and you employ 5 software engineers at $200k per year. Your net income is 0.
Prior to this change in the tax code, your software labor costs for that year would all count against your income so you'd be taxed on $0 in profit.
With this tax code, you can only amortize 10% of software labor in the first year so now your business just had $900k in profit as far as the IRS is concerned. You now have to pay ~200k in taxes. You have to come up with that money somehow, and for most businesses the only short-term option is a combo of reducing costs (layoffs) and loans.
Tech Companies that are not making profits are the most affected.
Let’s say you have $100 in revenue, $100 in salary expenses and $50 in other expenses.
Pre 174 you would be considered to have a loss and wouldn’t pay taxes on profits since you don’t have any.
However, post 174, since you’re amortizing salary expenses, you can only deduct $20 out of that $100 (actually the scaling is a little weird I believe, so it’s even worse and the first year you can only set aside 10%), so as far as the IRS is concerned you made $100 in revenues and $50 + $20 in expenses, so you had a profit of $30. So somehow you now need to find actual cash to pay for the $30 in profits when in reality you’ve paid out more than you’ve made.
This just means you have to raise more funds for something that is not returning any value to you.
Your competitors abroad don’t need to do this. Your deep pocketed large competitors don’t need to do this. They have cash to pay and they will get the money back in 5 years, a time which you may not even survive to receive that set off.
This is the worst kind of policy because it doesn’t even make the government more money (the overall tax deduction is still largely the same) but it makes things way worse for companies.
The weird scaling is what's called in accounting the "half-year rule." Any depreciable expenses are assumed to have been incurred halfway through the year, so the first year you can only deduct half of the normal amount (and the other half of that is in the last year + 1 of the depreciation period).
To take a simple example under Section 174 rules let's take a bootstrapped business with one US-based developer developing a SaaS product. If you pay them $100K and also bring in $100K revenue, prior to Section 174 the taxable revenue was 0. Under section 174 the business now can only claim $20K and the taxable revenue is $80K. Your tax bill is some fraction of that after you get done applying credits of various sorts.
The problem with the Section 174 change is 2-fold. It was unexpected--most people assumed it would be corrected. It also hits bootstrapped businesses hardest, which are exactly the sort of businesses we should be encouraging. VC-backed businesses have less of a problem early on because their expenses tend to be so high that even with Section 174 they aren't profitable. However even there as a founder there can be a substantial impact, because the Section 174 charges eat up your Net Operating Losses (NOLs) which you can use to offset the profit from selling the company or future tax bills.
Edit: as others have pointed out the amortization schedule is apparently not linear, so 20% might not be right. The other complication is that there are many deductions and adjustments that affect your taxable revenue. NOLs are the biggest in my experience but there are others.
Actually, this has the most impact on startups that are close to break even or barely making profit. Let's say you make 1m ARR and have 5 software engineers at 200k/year. Prior to this tax code, you had $0 in profit to be taxed. With this change, you can only amortize 10% of software labor in the first year. Now, the IRS treats you as having 900k profit so you have ~200k in taxes to pay.
All other factors being the same year to year, this accounting change will suddenly show the company making a sizable profit. Because the R&D cost (engineer salaries) can no longer be expensed.
Exactly. How we've thought about what 'profit' is has changed.
When I bought a laptop for my business, it was amortized over... 3 years I think. Kinda nuts but, whatever. It's a couple thousand dollars.
But the example above (somewhere) with the 5 employees at $200k/each... only being able to deduct $100k of that, even assuming $1m in revenue... meaning 'profit' of $900k.... it's just crazy.
