Comment by vessenes 8 days ago
Thanks for working on this guys. The current tax code is fairly crazy: you could spend a few million in salaries, sell 200k of software in a year and possibly owe taxes on that. Even if the company would otherwise be shutting down.
The traditional capital asset treatment applied to software leaves a lot to be desired. Some software is a capital asset, but much just isn’t. Or at least should be considered to depreciate rapidly.
Salaries are not generally considered “capital” - HR wording aside, you do not own your employees. It’s an immediate expense that may, or may not, produce something of value.
The IRS is using a theory of value where software (1) is a capital asset (okay, sure), (2) has a six-year deprecation schedule (uhhh why not 5 like everything else?), and (3) is valued at the exact cost of all inputs to it, including salaries (uh oh).
This is unlike how capital assets are valued for any other industry! And it has the effect that hiring a second lawyer is “cheaper” (for five years anyway) than hiring a second developer.
There could be a distinction between creating new value (greenfield), and maintaining existing value (brownfield). Most of my work is green field and I do consider it to be a capital asset, it's sweat equity as I don't pay myself, but I can't deduct my non-salary either. Others estimate the most of the software work is 95% brownfield.
An other issue is competitiveness with other jurisdictions that don't have these tax laws, but even if that were normalized there are jurisdictions that are far lower tax in general regardless of the classification.
Imagine if secretaries' salaries were applied to the "capital asset" of the well-organized file cabinets they create. Or if janitors' salaries were applied to the "capital asset" of a clean workspace. This whole quagmire is far more insane than anyone is giving it credit for.
Straight no. That’s why they had to put in line 3, “clarifying” the intent, because it’s not done anywhere else.
> This is unlike how capital assets are valued for any other industry!
Is your dismay that it's unfair compared to other industries or that the policy doesn't reflect reality that software is a capital asset that has a lifetime longer than 6 years for many companies?
It's that it doesn't reflect the reality that the value of software is not remotely correlated with the salaries that were spent building it. It could be valued much higher or much lower, spanning a huge range.
Using salaries as a proxy for value of the asset encourages only the safest shovelware bets, discouraging risk taking lest your asset be taxed at substantially higher than it's worth.
Avoiding that risk-adverse dynamic is why Section 174 was written the way it was since the 50s to encourage R&D, and it's paid off in spades.
Shorter is better here — it means you’re able to take the deduction up-front. The issue is that salaries should not be included as part of a capital asset, as this precludes any other deduction for the same salary. You don’t do this for accountants or lawyers, even at a software firm, but you now have to for your developers. It makes a particular role of employee more expensive!
It’s this absurdity I’m upset about. Six year vs five year is weird but meaningless. Internal software not being sold can be a capital asset, or at least I can point to examples of it (MSFT Hyper-V, ex). But the valuation process is both arbitrary in both directions, and discourages companies from hiring software developers as a policy effect.
Software just isn't a "capital asset" in the traditional sense. It might have a multi decade depreciation in real life, or it might be worthless shortly after writing. I mean, we live in a tax regime where a jet is 100% depreciable in the year its purchased. Srsly.
> you do not own your employees
Well, that framing is just wrong. The companies are paying taxes over what those employees created, not over the employees. Does the company own the software?
> The IRS is using a theory of value where...
Notice that all of your 3 points are exactly like any other kind of capital.
Most countries exclude salaries from the income calculation because it has good practical consequences (both on making accounting cheaper and on incentivizing companies to hire), not because of any theoretical problem.
If you're ripping off a competitor, sure, the salaries of your engineers roughly translates to the value of the resulting capital asset. But the most valuable work that software engineers do is the stuff that has never been done before. The salaries of your developers and designers and your product managers go first towards figuring out what a valuable capital asset would look like. Only after that can you start investing in the actual asset.
The same is true for all true R&D, which is why historically the government has tried to provide protections for R&D work to incentivize people to not just churn out the safe bet over and over again. Patents fall into this category, but software patents are (rightly) hard to come by. Through 2022, the risk of software development was offset by the ability to expense the costs and avoid a tax bill, and this was good policy if your aim is to encourage innovation.
The capital asset theory could still work if there were some way to appraise the value of the actual asset you created. But absent such a way, this thinking is deeply flawed for all but the most shovelware of jobs.
> If you're ripping off a competitor, sure, the salaries of your engineers roughly translates to the value of the resulting capital asset.
I don't think this comes close to being true. It would make ripping off a competitor pointless.
I don't think that framing really tells us much, because there could be many reasons not to release that code that don't indicate it's an asset, such as (A) worries it might have still-relevant security issues, (B) costs of scrubbing other information like employee PII, or (C) the code is too useless to be worth the effort.
If the goal is to measure retained value, I'd ask how much a competitor would pay to acquire your 5-year-old code (for direct use, not for hacking you) without feeling cheated afterwards.
Even if true, a small fraction of engineering time on a project is actually developing that asset. The rest is maintenance and support. The tax code does allow for this distinction, but only if you track hours associated with each kind of work, which basically no one does. And even if they tried, it's difficult because that line is blurry. Tasks are rarely 100% one or the other. Ever fixed a bug by refactoring to make something better? Which kind of engineering is that? Can you justify that to the IRS accountant auditing you?
Isnt this just false? I thought corporate taxes are levied on net income?
Not when it comes to capital assets. The full cost of a large capital asset is generally not allowed to be treated as an expense for tax purposes.
It's technically correct that tax is levied on "net income", but that's an accounting term which means something different from "money_in - money_out" when there are capital assets.
One justification for this is, although you spent the cost, you received equivalent value in the form of the asset itself.
This means if it costs $100k in salary to make software this year, and you get $30k in income from the software this year, your bank balance will lose $70k (which is expected) and you'll have negative income in the ordinary way of thinking, but you'll be charged income tax (which is new) despite losing money, as if you gained (almost) $30k instead of losing $70k.
Your tax accounts will show an increase in net assets, despite the decrease in your bank balance, because they will show the software as being "worth" (almost) $100k, regardless of what it's really worth right now.
This is particularly hard if you're a small company or (non-VC-funded) startup that's already stretching to cover the cost of speculative software development. Being charged income tax even while you're losing money developing software (in the ordinary way of thinking about money) is what's new in the tax code. It makes it harder than before to do speculative developments, making some kinds of development non-viable that were viable before.
Corporate taxes are indeed levied on net income after expenses. Trading money for capital assets is not considered expense.
If you start the year with 0$ in your bank. After the end of the year you have made $200k in revenue. However you "spent" $200k on software salaries. However, because these are software costs, they must be depreciated over 5 years, so only 20% of that $200k software cost can be applied as depreciation cost which is considered an expense. So your net income for this year is $200k revenue - $20k depreciation expense = $180k. Your 15% tax on this is $27k.
So you made $200k and spent all of it on software, so your bank account is 0, but you owe $27k in taxes.
You do, however, have $160k worth of software that is generating ~$16k/mo in revenue (or more since you presumably did not make that $200k evenly spread out across year 1 while you were developing the software), so in year 2 you could halt further development, use a loan to get through the 2 months it takes to make the money to pay your taxes, and then make $176k profit. Then you pay your taxes on year 2 and walk away with $152k in the bank along with $120k worth of software asset.
(Of course an asset that generates $200k/year is actually worth far more than $200k, so in that case 20% depreciation seems even more absurd)
> You do, however, have $160k worth of software
That is a huge assumption that is probably not true.
> in year 2 you could halt further development, use a loan to get through the 2 months it takes to make the money to pay your taxes, and then make $176k profit.
This is almost certainly not true.
Correct but the point is that the salaries of the developers are not treated as an expense to net out, they are treated as an asset that depreciates over some period of time. (Even though some "developer" work might be day to day maintenance, rather than building a new feature.)
I would be surprised if nearly all software companies wouldn't consider their code to be a valuable capital asset. For example, do you think your company would be okay with releasing commits/snapshots of their source code and design docs into the public domain once they hit 5 years old? Or do they currently depreciate too quickly?