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Small and medium-size businesses have struggled with a change in tax rules on R&D expenses. Lawmakers may soon repeal it, but the effects will linger.
Companies are hoping they can soon deduct research expenses as they used to after a more than two-year change to a tax law led to layoffs and reduced research investment. For some U.S. firms, it may be too late to unwind the adjustments they have made.
Lawmakers this week advanced an agreement that would restore immediate domestic research deductions rather than requiring companies to spread them out over years. But they didn’t enact it ahead of the beginning of tax filing season, and it’s not expected that they will consider the bill before the Senate takes a two-week recess starting Feb. 12. As the law is now, it’s costing large public companies hundreds of millions or billions of dollars up front, and for some small and medium-size enterprises, the personal and financial pain may cut deeper.
Business owner Jacek Zagorski, founder of healthcare information technology firm Shasta Networks in Ashland, Ore., laid off five people in the past year, in part because of the tax rule, which requires companies to spread deductions for research costs over years rather than taking them immediately to reduce their taxable income. The worker cuts, a roughly 50% head count reduction at the software creation business, are meant to bring down the innovation budget, which has been slashed by around 80%, Zagorski said.
This approach will likely remain even if the law is changed. “If it gets repealed, I don’t know if I’d go back to investing as much money into research and development as I used to,” he said. “Once I move past a certain point, and diversify into other lines of business, development and innovation are difficult.”
The problem for Zagorski and other businesses stems from part of a tax law that went into effect in 2022. Businesses for decades were allowed to deduct certain research expenses immediately to reduce their taxable income. But under a provision of the 2017 Tax Cuts and Jobs Act designed to generate revenue to help pay for cutting the corporate tax rate, costs associated with research and development activities are spread over many years, five for domestic research costs and 15 for those incurred overseas.
The 2022 start date has been on the books for years. But many companies, accountants and business owners assumed Congress would change it before it took effect, and then held out hope for its repeal. Lawmakers on both sides of the aisle have been in agreement that it should be reversed, and this week the House passed a bipartisan agreement that would restore domestic research deductions retroactively from 2022 and extend them through 2025. Deductions for foreign research would remain spread across several years.
Businesses of all sizes have been urging Congress to change the law. Small and medium-size firm owners are watching closely to see if lawmakers repeal the law and if they will get refunds for tax payments already made, which some delayed to late last year. For now, many are running their businesses as though the law will impact their 2023 tax bills that will start to come due in the next few months.
Whether the law is repealed, and regardless of any refunds, some will remain cautious about their research and development investments.
Founder Jeff Gunther is among them.
Gunther, chief executive of research and innovation company Metaform, sent an email to his five-person team on Dec. 15 indicating that the firm needed to reduce head count because of the law. He held off sending the message until the last minute while waiting to see if Congress would repeal the research and development law last year. Dec. 14, the last day many lawmakers were in session last year, came and went with no action. The next morning, Gunther sent the message to Metaform staff.
“The reality is stark—continuing our operations under these conditions is simply unsustainable,” he wrote, adding that the Charlottesville, Va.-based company would immediately stop all software development. Three people would need to find new jobs.
Even if the law is repealed, Gunther isn’t planning to resume the same level of spending on research and development without more certainty about what is ahead. “I don’t see us investing a lot more and making any changes from what we’re doing right now until we know what’s beyond 2025.”
For larger companies, the change that went into effect in 2022 has created cash flow challenges. Aerospace and defense technology company
Northrop Grumman’s estimated tax liability for 2023 because of the law change was approximately $500 million, for instance, and aerospace and defense company
Lockheed Martin said its 2023 cash tax liability increased by roughly $560 million because of the law, according to regulatory filings. Some small and medium-size businesses owners, meanwhile, are not only laying off workers and slowing growth, they are having to cut costs closer to home, selling houses or dipping into personal savings to cover tax bills.
Dawn Cartier, the founder of CivTech, a Scottsdale, Ariz.-based consulting engineering firm focused on traffic design, stopped hiring and filling empty roles in September of last year. Cartier had just learned her tax bill was around $300,000 because of the law change. Her company, which has around $5 million in revenue a year, now has 26 staffers, down from 30 four months ago.
The company is paying off the tax bill through a payment plan. If the law isn’t repealed soon, Cartier said she would refinance her house. But a reversal won’t mean business immediately goes back to where it was, she said. It will take time to ramp back up. Cartier estimates it will take three to four months to fill open spots after the business files taxes for 2023 later this year.
A repeal also wouldn’t clear up all the uncertainty tied to future research investments, according to Cartier. “I just don’t have my game plan totally together, because the current bill only pushes this to 2026,” the founder said. “It doesn’t really give me a lot of time to get back and do all of this over again just to wind it back down.”
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This article by Jennifer Williams originally appeared in the Wall Street Journal on February 2, 2024.