NC business leaders warn new federal tax rule will harm innovation, reduce growth

North Carolina business leaders are urging Congress to halt a new federal tax requirement they say will hamper company growth by suppressing research and development investment.

In a Nov. 27 letter to North Carolina’s 16-member congressional delegation, state Commerce Secretary Machelle Baker Sanders implored the delegation to block a change in Section 174 of the Internal Revenue Code.

“Failure to act would result in a ‘tax on innovation’ that would stifle entrepreneurship and growth across the state,” Sanders wrote.

Established in 1954, Section 174 had for decades enabled businesses to deduct many of their research and development (R&D) expenses immediately, affording them a greater tax break upfront rather than have that tax relief spread out over a number of years. Startups and small businesses especially desired the early one-time break as they seek to stretch their limited capital.

“Firms would always want to recognize the full expense today in their tax returns,” said John Gallemore, an accounting professor at the UNC Kenan-Flagler Business School. “They would then get the full benefit of reducing the taxes today, rather than having to wait 10 years to get the full value.”

However, the 2017 Tax Cuts and Jobs Act passed under President Donald Trump changed Section 174. Starting in 2022, it required businesses to amortize domestic R&D expenses over five years and overseas R&D expenses over 15 years — meaning the tax relief would no longer all come upfront.

This accounting structure allows the government to raise more revenue in the short run. But critics contend it will ultimately curb tax-generating growth overall.

Oct. 16 was the deadline for companies to file for their 2022 tax returns. That is the day many first felt the ramifications of the new rule, says Eva Garland, a financial consultant in Raleigh who works with businesses on their R&D initiatives. Bankruptcy became a concern, she noted, as early-stage firms with little to no revenue faced a steeper tax bill.

“It was just horrific because everybody thought Congress would take care of it, and they didn’t,” Garland said.

With the Section 174 rule change, Gallemore said, businesses may be deterred from spending on research and development overall. Sanders concurred in her letter to North Carolina’s congressional delegation.

“This is creating an insurmountable financial strain and bankruptcy for many innovators,” she wrote.

According to the National Association of Manufacturers, an industry group, 60,000 jobs will be lost over the next decade due to the new tax rule. The new tax burden will be felt by many startups and small businesses, said Krista Covey, president of First Flight Venture Center, a science-focused startup incubator in Research Triangle Park.

“The current tax implications associated with Internal Revenue Code section 174 pose a significant interference to innovation and entrepreneurship,” she said in an email.

Attempts to delay the new federal rule have fallen short. An early version of President Joe Biden’s Build Back Better Act included a deferment. Earlier this year, a Republican representative and a Democratic senator introduced legislation to postpone the tax change. Each bill has stalled.

In her letter this week, Sanders called on Congress to address the Section 174 requirement before the end of the year.

This story was originally published December 1, 2023, 1:58 PM.