december2022january2023 - 30

FEATURE
Unprofitable Startups May Owe 2022 Taxes
By Vanessa Kruze, CPA
A LARGE NUMBER of unprofitable startups are going to have a surprise
tax bill on April 18. A little discussed provision in the Tax Cuts and
Jobs Act (TCJA) changes how tax law treats research and development
expenses, dramatically reducing how cash expenses are
accounted for - pushing many money losing startups into
owing taxes. Ernst & Young estimates that this will reduce
U.S.-based spending on R&D by $4.1 billion in the first few
years.
MANY VC-BACKED STARTUPS WILL
OWE TAXES - EVEN THOUGH THEY
ARE LOSING MONEY
My firm works with 750+ venture-funded startups
and our data suggests that 10% to 20% of revenuegenerating
startups that are losing money will
end up showing positive net income on their tax
return - thus having to pay federal taxes! This will
have a disproportionate impact on startups that
are generating revenue, yet investing heavily in
research and development. (We analyzed moneylosing,
VC-backed startups generating over $1
million in revenue to get the 10% to 20% estimate.)
The TCJA forces companies to capitalize their
R&D expenses, recognizing them over a five-year
schedule. The way the calculation will work is
even more punitive in the first year, when only
one-tenth of the first year's R&D will be counted.
It's even worse for a company that does some
innovation outside of the U.S., as the amount
that can be recognized is even lower. Because
many VC-backed startups invest heavily in R&D,
many startups that are generating revenue will be
caught in a situation where their cash expenses
are meaningfully higher than their tax expenses.
Let's take a look at how this might impact a
hypothetical startup aggressively investing in
R&D. Imagine a startup generating $2 million in
revenue, spending $500,000 on non-R&D expenses,
and another $5 million on R&D expenses. This
company is losing $3.5 million a year - a healthy
burn rate for a VC-backed company. Ordinarily
it would not owe any taxes, because it has negative
net income.
Of course, the TCJA changes that. In 2022,
this hypothetical company would only be able
to deduct one-tenth of its $5 million in R&D
expenses - that's only $500,000. That means that,
for tax purposes, the company will generate $1
million in pre-tax profit and will end up owing
over $200,000 in federal taxes. That's enough
for the business to hire one additional software
engineer! Assuming the company's financials are
stable the subsequent year (not a good assumption
for a VC-backed startup, but good enough for this
exercise), the startup deducts one-fifth of its R&D
expenses, $1 million, leaving it with $500,000 in
taxable income and just over a $100,000 tax bill.
The most exposed category of startups to this
change are largely software businesses ranging in
size from 10 to 1,000 employees. With the recent
slowdown in venture funding and the looming
recessionary environment, these surprise tax
bills could not be coming at a worse time. These
types of startups tend to lead on many of the tech
innovations in development right now, providing
a disproportionate amount of the competitive
advantage to the U.S. There are thousands of
revenue-generating startups heavily investing in
R&D in the U.S. that will now have to consider how
their research spending impacts their tax position.
DOES CONGRESS WANT TO PROMOTE
INNOVATION - OR TAX IT?
Recently Congress passed the Inflation Reduction
Act, which doubled the R&D tax credit, in
an attempt to promote innovation in the United
States. The R&D tax credit is a powerful incen30
DECEMBER 2022/JANUARY 2023 ■ www.CPAPracticeAdvisor.com
tive that helps money-losing startups spend on
U.S.-based research. But the TCJA clearly moves
against this incentive - Ernst & Young estimates
that the TCJA will reduce employment in the U.S.
in R&D by over 23,000 per year.
Moreover, according to the Information
Technology and Innovation Foundation (ITIF),
the U.S. is now one of only a few countries that
doesn't allow immediate expensing for R&D costs.
As of 2020, the ITIF noted that tax support for
research and development in the U.S. ranked
24th out of a comparison group of 34 countries
in the Organization for Economic Cooperation and
Development (OECD), along with China, Russia,
India, and Brazil. The ITIF notes that this new
R&D amortization rule (assuming that states
follow the federal government's lead) will bring
the U.S. ranking down to 32 out of 34 countries.
There are currently Senate and House bills
with significant bipartisan support that would
eliminate the R&D amortization requirement.
If Congress really wants to promote innovative
research, canceling the R&D capitalization rule
is a good first step. ■
Vanessa Kruze, CPA, is the founder and CEO Kruze
Consulting, providing startup CFO consulting, including
accounting, tax and HR services, to startups in San
Francisco, Los Angeles, and New York City. Prior to
establishing her firm in 2012, Kruze began her career
with Deloitte Tax and is a University of San Francisco
alum.
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