Why is this startup slashing its R&D budget? Taxes

Law requiring R&D expenses to be spread over 5-15 years has CTM pulling back on innovation initiatives

Congress has two main powers granted by the U.S. constitution: to tax and to declare war. Little did the founders know that, someday, these powers would be combined, using taxation to declare war on American innovation.

Section 174 of the tax code did exactly that.

Previously, companies that innovated through research & development were able to deduct expenses incurred to offset revenue and pay tax on their actual profits. But the law was changed as part of the “Tax Cut and Jobs Act of 2017”; effective tax year 2022, money actually spent on R&D cannot be “expensed” — it has to be spread (amortized) across 5 to 15 years.

The effect of this is to lower costs and inflate paper profits to tax. Even though the money has actually been spent on engineers and patents, companies have to pretend they kept most of it as profits and pay taxes on cash they don’t have. Expenses like advertising can be immediately deducted, but not R&D. Eventually, they catch up with Year One’s expenses and can work on Year Two. Until then, it’s an artificial tax bubble for the government.

Companies that invest a large amount in innovation relative to their revenue can actually owe more in taxes than their cash profits. This is especially true for small companies that are inventing new technologies.

CTM Insights is one such company. We don’t sell products; we are a research lab that invents new ways to defend against cyberattacks. Our largest costs are R&D. As a result, in 2022, almost every dollar made was paid back out in taxes. When people ask me what I do, I now say “I work for the government.” CTM always has focused on our mission over profits, but the risk of paying more in taxes than we actually bring in makes this a charity.

You might think this can’t be correct — that the government didn’t intend to discourage American innovation by making it unprofitable. You might further think innovation in areas like protecting against artificial intelligence-generated identity theft, ransomware, fraud and securing cloud data are examples of things it would want to encourage. At the very least, maybe not discourage. Apparently, you (and I) would be wrong. The Tax Cut and Jobs Act is taxing American innovation out of existence.

Some in Congress, from both political parties, realized that this might have been a mistake. In late 2022 and early 2023, they tried to amend the law to roll back this provision. Their efforts failed because neither political party would work with the other. Twice. A third attempt is now underway, but polarized partisan politics, combined with an election year, makes success unlikely.

One “solution” proposed was to shut down CTM as a U.S. company and reopen it in another country. If the new company never hired U.S. engineers or generated U.S. income (only licensed innovations to non-American companies), it wouldn’t be subject to gimmicks in the U.S. tax code. U.S. jobs would be shifted offshore.

We could rename the law the “Tax Increase and Jobs Elimination Act.”

The other solution is to simply stop investing in new innovation. CTM has a portfolio of patents and other intellectual property that we’ve created over the years. We can shift our focus from invention to licensing. Sales costs can still be expensed.

So, that’s the plan. Effective Jan. 1, we are slashing our R&D budget. We will focus instead on licensing IP we’ve already created. If Congress ever decides to revisit its decision, we will do the same. Until then, let’s talk if you are interested in completely new ways to secure software supply chains, identify manipulated images, stop ransomware from encrypting files, protect against AI creating interactive deepfakes or anything else we’ve been working to solve.

Congress may have declared war on American innovation, but we can unilaterally freeze our innovation work to create a cease-fire.

Lou Steinberg is the founder and managing partner of CTM Insights.