2023 Year-End Tax Planning Strategies for Technology Companies

TIM LSON: Hello, and thank you for joining Cherry Bekaert's latest technology industry podcast. Today we are covering important tax planning matters technology companies should be considering as we move toward the end of 2023. This will include regulatory areas that can trip up finance planners and accountants, as well as credit and incentive opportunities that might benefit companies in 2024 and beyond.

TIM LSON: My name is Tim Lson. I am a tax partner in Cherry Bekaert's Austin practice, and I'm joined today by my colleague Rob Schwarzman, a tax partner in our Atlanta office. Rob, I'm glad we have the chance to talk about tax issues for tech companies as we round out 2023.

ROB SCHWARZMAN: Happy to be here, Tim. Tax planning is especially important this year for early- and growth-stage technology companies. These companies often run large operating losses that translate into tax losses, but recent rule changes have introduced disallowed deductions so operating losses may not convert to tax losses.

ROB SCHWARZMAN: The two primary disallowed deductions I'm referring to are the new rules around research and experimentation costs, often referred to as Section 174 costs, and the interest disallowance rules under Section 163(j). Interest is no longer automatically deductible; there are specific rules to determine deductible interest.

TIM LSON: With respect to interest deductibility, changes began in 2018, but this year we're seeing the full effect in how the deductible amount is computed. You cannot add back depreciation and, importantly for many tech companies, amortization when calculating the base for business interest expense deductibility. That has had a real impact, and the same is true for Section 174.

TIM LSON: These provisions have caused what many describe as stealth tax increases, and while some hope for legislative relief, any change may be prospective rather than retroactive. We have seen clients with book losses from operations end up in taxable positions once tax adjustments are applied, particularly due to required addbacks for R&D amortization.

ROB SCHWARZMAN: It has caught a lot of people off guard. If you heavily use foreign contractors, Section 174 costs capitalized for offshore work are amortized over 15 years rather than five, which can significantly increase taxable income. These two items alone—R&D amortization and interest limitations—can push companies into taxable income.

ROB SCHWARZMAN: The interest limitations under Section 163(j) are harder to address because changing capital structure can be difficult. Converting debt to equity may provide relief in some cases, but it's often not a simple fix.

ROB SCHWARZMAN: For Section 174, clients have approached the computations in two ways. Some apply a pragmatic indirect-cost allocation—for example, adding benefits at an estimated 20–25 percent of direct salaries and allocating rent and other indirect items proportionately. Others drill down to identify actual costs directly associated with R&D to reduce the amount capitalized.

TIM LSON: For those unfamiliar, prior to 2022 companies could generally expense research and development costs as incurred for tax purposes. Starting in 2022, those costs must be capitalized and amortized. The amortization period depends on where the costs are incurred: five years for U.S. R&D and 15 years for offshore R&D.

TIM LSON: It's important to get those numbers right. Our firm has spent significant time on this, and spending a little time now can make a meaningful impact on your tax liability.

ROB SCHWARZMAN: For flow-through entities, if the disallowed deductions result in tax liabilities flowing up to owners, it can be especially painful if you weren't prepared. Also, borrowing costs are higher now than historically, with rates moving up, so interest expense is a larger factor than in prior years.

TIM LSON: Another consideration is bonus depreciation. It used to be 100 percent, but it's phased down—80 percent in 2023 and 60 percent the following year. Losing the ability to immediately expense some depreciation, combined with interest deductibility limits, can create a double headwind for cash tax positions.

TIM LSON: There are still year-end planning opportunities. Some are basic accounting methods and timing techniques that can materially affect cash taxes if properly applied.

ROB SCHWARZMAN: I encourage clients to review their overall accounting methods. If you're a cash-basis taxpayer with substantial subscription revenue that is deferred, moving to an accrual basis might help. Conversely, if you're on an accrual basis, switching to cash basis accounting can be powerful.

ROB SCHWARZMAN: The gross receipts test determines eligibility for cash-basis accounting. For S corporations and partnerships, the average gross receipts threshold is $29 million over the prior three years. If you meet the test, a change in accounting method often requires filing Form 3115.

ROB SCHWARZMAN: On accrual accounting, there are ways to accelerate deductions for prepaid expenses under the 12-month rule, and the all-events test can allow accrual deductions for fixed obligations paid within a short period after year-end. These are standard but often overlooked tools.

TIM LSON: Returning to basics—blocking and tackling—can be very effective. With so much change out there, simple planning techniques can sometimes be overlooked yet have significant impact on cash tax planning.

TIM LSON: State and local taxes are another often-overlooked area. Start by reviewing whether you have nexus in a state and whether you must file there. Since the Wayfair decision, economic nexus thresholds are lower, and apportionment methodologies for service revenue may differ from those for tangible products.

TIM LSON: Reviewing apportionment factors can be an easy way to reduce state exposure. Also, explore state credits and incentives, which vary widely and can meaningfully offset state tax liabilities.

ROB SCHWARZMAN: International and cross-border considerations can be as complex as state and local issues. Reassess choice of entity and whether to operate as a flow-through or C corporation. If you're operating offshore, consider whether foreign entities should be treated differently for U.S. tax purposes than under local law.

ROB SCHWARZMAN: Depending on profitability, you may prefer losses to flow through, or you may want to prevent profitable foreign entities from flowing through. Anti-deferral regimes can create deemed dividend or income inclusions, which affects U.S. tax positions and may prompt a reconsideration of entity structure.

TIM LSON: It's worth considering whether a corporate structure makes sense in the current environment, given the 21 percent corporate rate and potential opportunities such as Qualified Small Business Stock treatment.

ROB SCHWARZMAN: Regarding credits and incentives, if Section 174 is an issue, be sure to evaluate the R&D tax credit. Even in a loss position, claiming the R&D credit can make sense, particularly at the state level.

ROB SCHWARZMAN: Many states allow R&D credits to offset payroll taxes if you are not in an income tax position. There are also state credits for job creation, employee training, and investments. These incentives are effectively free money if you apply and qualify.

TIM LSON: We are seeing tightening liquidity markets and stress on capital structures for many tech companies. The last thing you want is to use capital to pay unexpected taxes. There are planning opportunities to minimize that liability.

TIM LSON: Here at Cherry Bekaert, we can assist clients with these planning efforts. Thank you for listening, and we wish you success going into 2024. Happy holidays.