Changes to Startup Taxes for 2023
Taxes is like the sands on the beach by my house, it is a constantly changing world molded by the tides of public sentiment and the seasons of political changes. Sometimes I walk down and there is a ton of sand and everything is smooth and easy to walk on. Other days the sand is sucked out, leaving rocky crevices where my feet are constantly at risk of a cut. The same thing is happening in the business world regarding the shifting of tax laws. We have experienced a decade of smooth regulations that have eased the way for business development, but the seasons are shifting and we are moving into a period where this may not be the case for long.
IRS Hiring 87,000 New Agents
One of the biggest changes coming that most tax advisors are least prepared for is the massive hiring spree the IRS is currently on. The IRS announced last fall that they will hire 87,000 new revenue agents over the next few years, and by my calculations this means the IRS will be two-thirds new hires by the end of 2025. Why does this matter? From my experience, the new IRS agents are much more likely to fight over every single dollar in an examination, and this makes both the cost of litigation costs and the overall cost of an audit will increase significantly for businesses.
When I first entered the world of taxes in the mid-2000’s business audits were common- over 2% of a firm’s small business clients could expect to be audited annually. That number has since dropped to around 0.2% in recent years. As businesses increase in revenue this percentage increases quickly, but that is who the IRS audits; Fortune 500 companies are almost always defending themselves against audits. But with all these new agents, they won’t be assigned those high profile audits, and auditing individuals is unpopular, so who will they be assigned to audit? Small businesses.
I would calculate the risk of audit for the 2022 tax year jumping up to around 2% again for startups, and for 2023 and 2024 I am guessing this will be more in the 5% range of risk for each year. Therefore, it is more crucial than ever to carefully document your business activities and expenses, as the risk will be substantially higher for every business.
Research and Development (R&D) Credits and Expenditures
In the past two years, there has been a gradual decline of the application and value in R&D expenditures in the US. First, tax court cases and IRS memos have increased the documentation burden for taxpayers when claiming R&D credits. Then the requirement to amortize Research and Experimentation (R&E) costs was quietly included into the Tax Cuts and Jobs Act (TCJA), as activated, will prevent deductions of many costs previously taken by startups.
The increased diligence regarding R&D credits was necessary. The appeal of “free money” back from the government for a credit refunded against payroll taxes is very high, and it can be a very valuable credit for startups when claimed legitimately. However, there are many fly-by-night credit generation mills that have developed software programs to create large credits claims, market their credit services heavily through affiliate programs, and take a big chunk of the credit given.
Sadly, these practices will someday backfire on the many startups who have gone this route and they will owe large amounts of credits back, plus penalties and interest. These credit mills have been playing the “Audit Lottery” for years, and with 0.2% audit risk that made sense. But when the IRS does John Doe summons for their records and goes after these practices, it seems unlikely that these companies will stay in business long enough to support their “Audit Guarantee” schemes. I wouldn’t bet my company’s future on it at least.
The R&E expense amortization changes were expected by everyone in the industry to either be eliminated or at least be deferred for a number of years. They were added as a revenue raiser to the TCJA to make it meet budgetary requirements to get passed, but nobody ever expected them to become reality. But that seems to have happened as it quietly became law for the 2022 tax year, and now all expenditures for research and development costs must be amortized over five years if the work is done in the US, or over 15 years if this work is performed abroad.
The guidelines for what qualifies as R&D under the amortization rules are far more broader than for the R&D credit, and any development cost for a new software must be amortized. Additionally, common activities like feasibility studies or a market research projects must now be capitalized as well, and even overhead costs must be allocated to these expenditures. This will have a major impact on startups, and may decrease investment in US companies going forward.
1099-k Deadline Extended to Start with 2023 Tax Year
The much discussed new $600 reporting threshold will start for payments made in the 2023 Tax Year. This was supposed to start in 2023 for the 2022 tax year, but at the last minute the IRS delayed this requirement until the following year as part of the America Rescue Plan Act enacted during the Covid-19 pandemic as part of a series of tax credit extensions.
The reason for this delay was to allow for a smooth transition to the enforcement of these reporting requirements, which will affect many gig economy workers and marketplaces. The current requirements for the 2022 tax year to report are if payments exceed $20,000 in total value and more than 200 transactions.
It’s important for companies using payment providers like PayPal or Stripe to check for the 1099-k form before filing their taxes, as the amounts listed there typically include certain refunds and chargebacks that may not have appeared on other statements. These amounts typically do not match up with the bank statements and often require additional accounting help in order to reconcile to get the correct numbers for tax filing. With the new guidelines in place next year, it would be wise to seek professional accounting help now for the 2023 tax year to ensure everything is ready for filing and to avoid last-minute adjustments before the tax deadline.
Bonus Depreciation Phaseout
Typically, when a business buys a capital asset, like a vehicle, computer, or machinery, you cannot deduct the full purchase in the year it was bought; instead, it must depreciate over a period of 3 to 15 years. Bonus depreciation is one way to speed up this process, allowing the full purchase amount to be taken in the current year.
Bonus depreciation is a popular tax advantage offered by Congress during economic recessions to encourage business spending that drives the economy. This bonus amount has been at 100% for many years, and the US Chamber of Commerce is pushing to make it permanent. However, under current law, it’s scheduled to be phased out, meaning only 80% of the purchase price can be deducted for purchases made in 2023. It is highly likely that this will be extended, especially as we seem to be entering an economic recession, but like the R&D expense amortization, you just never know.
Global Pressure for 15% Corporate Minimum Tax
There were several times this year where politicians rolled out tax bills that included an increase in the corporate tax rate. Many of my clients were worried this would increase to 28%, but this seems unlikely in the current political climate, especially as we approach an election year with rising inflation and a cooling economy. However, beyond the public pressure to tax the rich, there is also pressure on Washington from the European Union and the Organisation for Economic Co-operation & Development (OECD) to prevent international tax evasion by instituting a global minimum tax of 15%.
This year the US quietly released laws that change how interest can be deducted when related companies are in low-tax jurisdiction, aimed at curtailing profit-shifting by major corporations. However, in the usual fashion of laws written with the input corporate lobbyists (who understand tax law far better than elected representatives), these laws are as full of holes as swiss cheese. As a result, I don’t see them actually applying in enough circumstances to allay the concerns of our European friends. Thus in the coming years we most likely will see increases applied across the board to the GILTI and FDII rates, and we also may see an increase in the US corporate tax rate to 23 or 24%. However, this is unlikely to happen in the next few years due to current political considerations.
1% Excise Tax on Stock Buybacks
Another law that was passed in the last year with much fanfare was the excise tax on stock buybacks. However, this only applies to publicly traded companies and over $1 million in buybacks, so most startups that purchase shares back from co-founders and early investors will not be subject to this tax.
However, this can come into play on mergers and acquisitions, and startup founders should carefully consider the implications of this law when assessing acquisition offers from publicly traded companies. Furthermore, there has been some discussion about how this will affect companies going public using SPACs, and this may curtail the use of this as a listing mechanism, or at least it adds an additional cost consideration when raising money in this manner.
More States Assessing Income Tax for Remote Activities
The Supreme Court overturned all prior state tax precedents in 2018 with the South Dakota v. Wayfair case. Prior to this case, a physical presence in a state was required in order for a business to have any sales tax or income tax calculated. But the Wayfair case changed all this and allowed states to determine what arose to the level of minimum contacts that were sufficient to tax businesses selling to customers who reside in their state.
During the pandemic, many states realized they were losing income from businesses moving out of state, and they created new laws and stepped up enforcement efforts to collect tax revenue they felt they were entitled to. As these laws keep changing rapidly, it is important for startups to review the rules annually in the states they have employees, independent contractors, and even key customers located in, to make sure they are complying. We have created a 50-state nexus guide on this topic to help startups get the most current information about tax matters in the states they have activity in.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.