‘A life and death scenario’: Small businesses say they’re paying more than 100% of profits to Uncle Sam after tax-law change

Small businesses in sectors like software and manufacturing are panicking over the expiration of a critical tax deduction that they say could lead to mass layoffs and business closures, unless Congress acts quickly to amend the law.

“This is a life-and-death scenario for small software companies,” Michelle Hansen, co-founder of the geocoding company Geocodio, told MarketWatch.

The tax change that Hansen and other software executives are taking issue with was signed into law by President Trump in 2017, as part of a larger tax overhaul that slashed the top corporate tax rate from 35% to 21%.

But in order to satisfy Senate budget rules and pass the law with only Republican votes, the bill could not increase the budget deficit over a 10-year window.

So lawmakers included a provision that, beginning in 2022, drastically reduced how much research-and-development spending a business could deduct from their annual revenue to determine taxable income.

The change penalizes certain industries like software and information technology — where engineer salaries are often classified as R&D expenses — as well as manufacturing and pharmaceuticals

IntervalZero CEO Jeff Hibbard, whose Massachusetts-based company designs and sells software for installation on precision machines like semiconductor manufacturers, told MarketWatch that he has had to tap into company savings for the past several years in order to avoid laying off engineers.

He said that his firm brings in about $9 million in revenue annually with expenses of $8 million — but 60% of those expenses come in the form of engineer salaries, which can only be deducted from taxable income over a five-year period because the IRS treats it as R&D.

He said that after taxes consumed all his profits in 2022, he had to pay an additional $800,000 to Uncle Sam, and an additional $600,000 for the 2023 tax year.

“We’ve had to do a hiring freeze and postpone projects” in a cutthroat industry where technology progresses rapidly, Hibbard said. “We’ve been in existence for 15 years. For the first 14, we always hired additional people. Now we have a hiring and salary freeze.”

The House of Representatives voted last week 357-70 to restore full expensing for R&D as part of a $79 billion tax package that boosted the child tax credit and extended other business tax breaks.

The bill now heads to the Senate, which already has its hands full debating immigration and national-security issues, and analysts say election-year politics could thwart its passage in 2024.

Henrietta Treyz, director of economic-policy research at Veda Partners, gave just a 10% chance of the bill passing the Senate in a recent note to clients.

“This year’s effort to pass a tax package has been more robust than the effort we saw in 2022 and 2023,” she wrote. Treyz added, however, that “the competing need to pass border reform and Ukraine/Israel aid, and general dysfunction in Washington keep us pessimistic that we’ll see a bipartisan economic-stimulus package come out of Congress this year.”

 On top of Republicans not wanting to give President Joe Biden a victory that would provide tax relief for businesses and families, Senate Republicans could decide to drag their feet on the bill in the hope that they’ll retake the chamber next year and can play a bigger role in the process, according to Owen Tedford, policy analyst at Beacon Policy Advisors.

“The critical member to watch is Senator Mike Crapo [of Idaho], the top Republican on the Senate Finance Committee,” Tedford wrote. “Crapo has not outright opposed the bill but has raised policy concerns and has expressed a desire to have a chance to amend it.” 

Political considerations may be dictating the bill’s fate in Washington — but some business owners fear they don’t have the wherewithal to wait until next year for the problem to be fixed.

Benjamin Bengfort, co-founder and CEO of Iowa-based software firm Rotational Labs, told MarketWatch that he had to lay off workers last year after his 2022 tax bill rose by 438%.

He noted that even demand for his products has taken a hit because of the change in the law, because his services can count as an R&D expense for his customers, too.

“So it is [between] a rock and a hard place for us, no matter how you look at it,” Bengfort said. “This is an existential threat for software engineering companies.”

Andrew Keshner contributed

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