In the third week of June, I had an opportunity to pay a visit to Washington, DC with the Greater Austin Chamber of Commerce. Our purpose was to meet with members of Congress to discuss, among other things, initiatives to spur small business (and particularly small technology business) growth.
On the table was a piece of draft legislation called “Startup 2.0,” championed by U.S. Senator Jerry Moran (R-Kansas). Among the items in this plan are R&D tax credits, exemptions from capital gains taxation for startup businesses, and revisions to the system by which H-1B visa status is granted to immigrants in STEM (Science, Technology, Engineering, and Math) fields to allow the US to retain more of the top foreign-born talent that often gets its education at U.S. universities (and at US taxpayer expense) and then returns home to work for foreign competitors to US industry.
On the opposite side of the political aisle, Senator Chris Coons (D-Delaware) was also floating out suggestions for a number of possible ways in which to grant “tradable R&D tax credits,” the notion behind which was that companies running at a loss (which most startup companies do in their early years) would be able to sell the unusable “tax breaks” they accrue from startup costs to larger, established firms that would need tax breaks and could directly provide working capital to small businesses when they need it most. Dollar amounts would be discounted in any exchange such that the total revenue lost to the government would not be so great as to impact federal deficits significantly.
Both plans are laudable, yet both are coming under the same legislative fire that ultimately they reduce the government’s tax receipts and therefore fail to meet budget hawks’ demands of “deficit neutrality.”
The original Coons plan (the tax credit exchange) also faces criticism that it may be somewhat unwieldy or open to fraud. This complaint comes from both the IRS, which would have to administer it, and small business itself, which would have to bear the additional accounting costs. A number of similar exchanges have been attempted at the state level (in those states with corporate income taxes) with mixed results. In some cases the exchanges were well structured and did manage to get working capital to companies that needed it. But in others, the exchanges ended up being somewhat ad hoc and administered as much by the CPA firms doing everybody’s tax returns (who had clear visibility into everybody’s individual situation) as anybody else. And this cost had to be borne somewhere in the private sector – usually in accounting fees paid by the businesses doing the exchanging. The result was that the overhead to get money (or tax credits) ultimately made the getting of it cost-prohibitive.
Focus Embedded’s role in these discussions was to offer firsthand testimony as to the trials and tribulations of being in the technology startup business. Our compatriots for the trip included members of Samsung Semiconductor and senior executives of Freescale Semiconductor and Dell Computer. And to be sure, they all had valuable input on the subjects H-1B visas as well as R&D tax credits for large, established technology firms. But we were somewhat singular in being a small company in the tech sector. As is so often the case, small companies don’t have the money to make trips to Washington, and often they don’t have the kinds of contacts that’d get them into the offices of people in charge. We were somewhat lucky in the respects that we could find the cash to go (yes, we turned over a lot of sofa cushions looking for loose change) and that the Austin Chamber of Commerce recognizes that it’s the small technology startups that really drive the economic engine of central Texas. Thus the Chamber is a lot more proactive in engaging small businesses than other large industry organizations might be.
On the subject of H-1B visas, we at Focus Embedded were more “disinterested observers,” since we understand the problems and frustrations of people looking to hire for high-tech companies, but we don’t have nearly as much demand for foreign-born talent. Since most of our work requires such an extremely high level of industry experience on top of good education, we’re not in the market for the kinds of recently minted foreign-born talent coming out of US universities. And the indigenous technology infrastructures of a great many foreign countries have not evolved to a point where they’re capable of providing the environment in which the best of locally born (and possibly later US educated) talent can get the critical on-the-job training it’d need to be of use to us.
Additionally, because we do work in defense/aerospace, where US citizenship is often required, we’re less of a buyer of H-1B talent simply because of the needs of our customer base. Nonetheless, we are keenly interested in the H-1B question, since having enough talent to fill positions in the US – and keeping it in the US so that that talent doesn’t become a part of the machinery of a foreign competitor – keeps the US technology infrastructure healthy enough to support much of what we do, even though we may not hire any H-1B visa candidate directly. Also, simply for having been engineering students ourselves, we’re aware of the emerging patterns in technology education and the creation of additional human capital in STEM fields. Presently about half the graduate degrees in engineering given in the US today go to foreign nationals, and three quarters of all patent filings by universities have at least one foreign national on the list of inventors.
On the subject of R&D tax credits, we had a lot more to say, precisely because those credits impact us far more directly. The crux of our message, however, was this:
Most small businesses get no break whatsoever as far as their initial investments in R&D materials or labor. Usually such businesses are operating in the red and have no offsetting revenue in those first years, so any tax credit for investment is automatically lost. This intrinsically stacks the deck against the small startup shop with the great new idea and favors the large, established corporation with current profits that can be offset with credits that’d be useless to the little guy. The result is a lot less innovation overall, since it’s the small shop that frequently will take the kind of risks that the big shop won’t.
However, should one of these small businesses be fortunate enough to be that one out of ten technology startups that survives infancy, it can count on being taxed on the back side of success for any “capital gains” – on top of the regular income tax it pays annually for any profit it might make. The result is that the financial disincentives to innovation in small companies created by the tax code are staggering.
We’ve been exploring several possible remedies. One idea on the table is to allow carry-forward of expenses in non-profitable years into future years where the startup company has begun running in the black. This is perhaps the simplest to implement and the least likely to encourage fraud, since all transactions stay on one company balance sheet, even if deductions may end up spanning several tax returns. It doesn’t solve the immediate short-term cash flow problem (particularly for the bootstrapped startup), but at least it eases the pain of capital gains taxation and removes one more disincentive to new venture creation.
To be sure, there may be additional complications with carry-forward brought about by the fact that a company may change its tax status as it grows. (Did it start as a sole proprietorship and file everything on a 1040, or was it an LLC with returns also filed via Form 1065 and pass-through to Schedule K? Or at some point did it make a Subchapter S election, and is a carry-forward crossing that change in status? As companies grow and do become profitable, their tax status almost always changes.)
Another possibility for alleviating the tax burden on technology startups is reducing FICA liabilities for those early stage companies making R&D investments – but not yet having offsetting revenues against which they can claim a credit. The obvious problem here, however, is that the vast majority of self-funded bootstrapped startups aren’t using salaried W-2 labor, they’re renting their help via Form 1099 “nonemployee compensation.” So the question becomes, “How do you reduce a FICA liability to somebody who doesn’t have it in the first place?” And if you do reduce the FICA payment of somebody who does have to make it, are you tilting the tables in the marketplace in favor of the venture capital funded company that’s more likely to be making outright hires of salaried employees at the start. (After all, people buying 1099 labor, in spite of not paying FICA, are buying labor at a higher hourly rate generally, since they’re “renting” it.) If you tilt the tables to the benefit of the company with W-2 employees, you’re asking every Jobs and Wozniak working in a garage to compete on an uneven playing field as they contract out work whose volume doesn’t yet justify doing it in house. Do that, and the next Apple Computer might never happen. Finally, there’s the problem that FICA wages are paid in regularly over the course of a year, and if you’ve got a company that’s not making money but is claiming an R&D credit, the government would have to pay them back at the end of the year. And if there’s one thing Uncle Sam really doesn’t like to do, it’s refund money he’s already been given (and likely already spent). Better it never go to Washington in the first place than to try to ask Uncle to give you some of it back.
All in all, there are any number of thorny questions buried in the tax and H-1B visa questions. But it’s clear that there’s at least some impetus in Washington to try to do a few things to fix problems with both immigration law and the tax code. Immigration law may come sooner, simply because it’s intrinsically deficit-neutral – and because there’s a growing chorus of people in Congress who want comprehensive tax reform but aren’t going to try to tackle it in this Congress (and certainly not before November). And R&D tax credits would have to be considered in the context of standalone tweaks to the current Internal Revenue Code or as part of what’d be the first dramatic overhaul to tax law in 30 years.
But the rumblings are that this will eventually somehow happen sometime.
And we’re very open to anybody’s suggestion on how to do it.
(If you’d like to offer up any thoughts, feel free to drop us a line at email@example.com.)