They have the $200k they pulled from their startup, far more than what most people earn. If you make enough to pay yourself $100k then you make enough to pay taxes.
Which is what's happening.
I don't think these two are unrelated.
I also don't understand the objection. It's not like anyone's getting away from taxes due to this rule. This is about a temporary exemption from company income tax IF AND ONLY IF companies have someone pay income tax on that money (and only up to the point where that keeps makes sense). This "exemption" lets you not add 15%-20% tax on top of 40-55% income tax just to try a new business as a company.
It makes it substantially more cashflow intensive to build a new software business, which entrenches incumbents and reduces competition. It favors companies who have the cash to wait for the full 5-year depreciation cycle, i.e. the opposite of most bootstrapped startups.
Quick example:
$10,000 revenue
$8,000 paid to software developer
$1,000 paid to AWS
leaves $1000 in profit.
You received $10,000 into your business account, but spent 8000+1000 = $9000. Your business account has a balance of $1000 at the end of the year.
Section 174 means you can only deduct 1/10th of the $8000 in the first year, $800. Your total deductible business expenses for the year will be 800+1000 = $1800.
Your taxable profit for the year is 10000-1800 = $8,200. If your effective tax rate is 25% (generously low), you owe $2,050 in taxes.
You pay your $2,050 tax payment and your business account is overdrafted by $1,050. You need to add $1,050 from your personal funds to the business to cover the shortfall.
Your business was cash flow negative for the year. This makes it extremely difficult to bootstrap a software company.
If you give the company more money to use to cover its tax bill, then that further increases the company’s taxable income.
Clearly if two software engineers build a product that brings in $10M, and each pay themselves $5M, it doesn't seem so outrageous that the can't really claim they're running "a business that made literally no money." Clearly in this second example the problem is that the engineers are paying themselves way too high given the return on their efforts.
What this means is that software engineers will be required to bring in more value to justify their high pay. In your example, it simply means that a software engineer that brings in $100,000 of value to the company, probably shouldn't be paid $100,000.
This seems entirely reasonable to me, and doubly so when I consider how many large corporate teams (who I think will ultimately be impacted more than startups) has huge numbers of highly paid engineers not doing all that much.
In most startups I've worked in it was pretty common for engineers to be delivering multiples of their cost in value, and in every big company I've worked in, it was very common to be delivering fractions of one's cost in value.
So with your suggested tactic the engineers get $2.55 million each. The rest, $4.5 million, is tax.
If those 2 engineers paid themselves $0, and instead paid the $10 million as dividends, they'd get 4.25 million each, and only 1.5 million would be paid as tax.
(Yes, this is a simplification, both situations are artificial and in both cases there'd be other taxes to pay, however, they'd be similar in both cases)
Although for a startup it might be least bad, because for their first few years, their revenue might well be closer to zero; they tend to burn money, sometimes for quite a while.
Revenue: $200,000 Expenses: -$200,000 Assets: $200,000
Net income: $200,000
You’re allowed to say ‘ah, but over the year the value of that $200,000 asset actually fell by 1/5’:
Asset depreciation: -$40,000
So your net income is now $160,000
You owe taxes on that income.
How does it work when a company uses salaried employees to build a structure. Are the salaried employees not deductible at all?
https://www.irs.gov/pub/irs-drop/n-23-63.pdf
To answer your question, the following are software development activities that are capitalizable (and instead of quoting the notice itself, I’m quoting from a better written blog post by accountants:
https://www.cohnreznick.com/insights/additional-guidance-irs...
> Section 4.03(1) of the Notice clarifies that labor costs – including those for contract employees and independent contractors – related to those who perform, supervise, or directly support SRE activities are considered Section 174 expenditures. All elements of compensation are to be included with the exception of severance, which is excludable and deducted by taxpayers in the period paid or incurred. SRE-related labor costs expenses included in the Notice expenses related to pension costs and stock-based compensation.
Section 4.03(1)(e) provides guidance pertaining to certain costs related to operation and management (i.e., rent, utilities, etc.) activities. Specifically, in addition to items such as rent, utilities, and insurance, expenditures such as taxes (i.e., property), repairs and maintenance, and security are now considered SREs subject to Section 174.
So what software development activities don’t count as “Specified Research Expenditures” (SRE)”?
> Training of employees in the use of the software
>Maintenance activities after the software is placed into service that do not constitute upgrades or enhancements (i.e., corrective maintenance to debug, diagnose, and fix programming errors)
> Data conversion activities (except activities to develop computer software that facilitates access to existing data or data conversion)
> Installation and other activities related to placing the software into service
> Marketing and promotional activities
> Distribution activities
> Customer support
If you’re a startup and you have a software developer doing the above activities as well as SRE work, then in order to expense the SRE parts of their job you either have to estimate (and be able to defend) the estimations, or your employee needs to track their time for each type of activity they do.
As an example, A two person software startup; both drawing a salary, each making $100,000 per year. Each doing things related to software development.
Startup brings in 200,000K in revenue.
Under pre Section 174 changes, the profit is zero. Both salaries are expensible in the year they were incurred.
Post Section 174, the profit is now $160,000 each year. Now they pay taxes on $160,000, even though they literally have no money left over because revenues equaled expenditures.
At 25% tax rate, that’s $40,000 in taxes, for a business that made literally no money.
That’s why this is so devastating to small software businesses; unless you’re highly profitable and have cash reserves, this change hits hard.