More US tech layoffs are coming or why abroad software vendors are a way out for tech startups: nitty-gritty of Section 174

Behind all these frustrations are the changes (which, spoiler alert, should have never been passed) to Section 174 of the US tax law. They kicked out few years ago and changed one crucial thing for US businesses – from now on, all R&D costs including labor for software development cannot be expensed, but need to be capitalized and amortized over 5 years. In case, you have engineers from other countries on your team – amortization of software development costs from abroad should performed over 15 years.   

Simply saying, now US tech startups will have to pay taxes on every software engineer hired. It becomes even worse when we look at actual numbers and examples.

So, let’s discuss the example provided by Pragmatic Engineer:

Let’s imagine, there is a Company A that gets $1,000,000 of revenue which is fully spent to pay salaries to its software engineers. In 2021, it meant that Company A didn’t get any profit, so they needn't pay any taxes in 2022. 

The changes to Section 174 interpret the situation differently. In 2022, if you’re a company A which spends all its revenue, let’s take the same $1,000,000, on software engineering labor, it would mean that your profit equals $1,000,000.

As the new tax changes deduct only 10% of the profit, it means that Company A now needs to pay taxes on its $900,000 profit, which is $189,000 to be paid in 2023. So, the fictional Company A which has no actual profit has to pay $189,000 of taxes from the costs it doesn’t have.  

There are just few options left for companies like ours: 

• Take a loan to pay taxes (which is crazy, because you have to return it somehow with obviously high interest rates).
• Fire the engineering staff to cut on research and development costs, as well as the taxes calculated and issued. 

Evidently, the massive tech layoffs are not such a big surprise, after all. 

Do you see the problem now?

As the new tax bills started to come only in spring 2023, businesses had been silent till that time. But now the reality has already struck, and tech startups are fearing even bigger damages from the 2024 tax round. 

US businesses from the smallest ones to the biggest corporations all around the country are commenting on their losses and future tech layoffs. Here are only some of the cases described by Pragmatic Engineer:  

• A business posted a $90K loss in 2022 by the old rules, but is taxed on a $1M profit.
• Infra startup Gruntwork is hiring software developers less in 2024 because of the change.
• A startup that raised $1.25M and hired five employees, is likely to face a $150,000 tax bill it did not account for.
• A seed-stage startup that raised $3M and was operating at a loss became profitable due to the S174 change, so must budget for higher taxes. Another US company let go of 23 engineers employed in India because of the tax change.

Software engineers abroad can be amortized only over 15 years. The changes did not affect only small startups, as big and well-known tech ‘whales’ also suffered from the new taxation in 2023. Thus, Microsoft paid almost extra $5 Billion of taxes in 2023, while Netflix faced additional $368 Million in taxes. Yet, these huge tax bills are still manageable for the tech giants, although certainly painful.

Let’s start from the very beginning – when and why the changes were introduced, first of all. It all tracks down to the 2017 Tax Cuts & Jobs act signed by then-president Donald Trump. As the act itself reduced tax, it also caused a reconciliation process. Simply saying, the need to introduce changes that delayed tax increases in order to balance back the reduction. 

Among these changes were IRC Section 174, which claimed that software development costs need to be amortized over 5 years (for engineers hired abroad - over 15 years) and became effective 5 years later - starting from 2022. 

These changes were expected to be reversed by the end of 2022, that’s why most accountants rest assured that new tax legislation would not work and they didn’t prepare their management and businesses for the possible outcomes. 

Although Congress worked on three bills which would retroactively revert IRC Sec. 174 to its pre-2022 status, the amendments are still not passed and the new taxes remain intact and might hit businesses even harder up early in 2024.

While the majority of the businesses are staying positive and believe that the government would revert the damaging tax changes, entrepreneurs and tech leaders start to act and raise awareness about the possible damage using all available channels. Some of the tech corporations, including Microsoft, Amazon, Intel and others even created the US R&D coalition to advocate in reversing Section 174. 

Yet, while paperwork and bureaucracy is to be done, tech companies need to react quickly to stay afloat and find the ways to save their businesses.

So, what are the options for US tech startups? There are actually several ways for businesses to go: 

• Introduce layoffs to reduce the number of software engineers. It’s a pretty tough, but obvious one, considering that most US companies are already cutting down their engineering staff. Yet, companies still need someone to develop and support their software, let’s not forget about that.  
• Part with non-US software engineers working with US companies.
• Painful, but also an obvious way to cut down on taxes and 15-year amortization of software development costs.  Increase vendor spend and buy (not build) software. The new taxation put software vendors back in the game, as the purchase of the software does not necessarily fall under Research & Development costs.
  Here's simple math: let’s take the average salary of a software engineer in the US – according to Indeed, it’s somewhat around $120,000 a year. In 2021, businesses needed to pay just the engineer’s salary. After the tax change, companies will now be required to cover over $20,000 of taxes for each software engineer hired. Option with an outsourcing vendor seems much more appealing. With an average engineer salary of $50,000-60,000 per year in, for example, Eastern Europe, businesses don’t need to cover any additional taxes or worry about extra HR expenses, as they do not hire people but buy ready software from them. 
• Move to more business- and tax-friendly environments. Unfortunately for the US economy, moving to the country with less challenging tax policy might be an answer for many businesses.
• Look for some ‘workarounds’ and gaps in the legislation. With a team of professionals, businesses probably will be able to find some ways how to cope with the new tax changes and make them less painful for everyone.

As the year unfolds, there is no time or resources to just wait and watch how Section 174 will or will not be reversed. Owners and CEOs need to prepare their companies and businesses for the new tax challenges and mitigate the risks of their own future.

There is a strong belief that IRC Section 174 will be reverted and US tech companies could continue working and creating awesome things under business-friendly conditions. Yet, it’s essential to be always armed with the information and plan any possible ways out to save your business.

We, as an outsourcing partner, would be happy to help you find more business-friendly options for your digital products to grow, aspire, and make people happy all around the world.