Although it’s late-June and the sky is a velvet dusk until 9 pm, our hearts are still in tax season! For this article, we wanted to review our biggest learnings from the 2023 tax season, from pesky Proconnect bugs to Section 174 theory. It was the first time Hash Basis offered tax services including return preparation/filing and the R&D tax credit. And as we’ve written a few times on LinkedIn and our newsletter, we love tax. 😌

But first, some quick stats on our 2023 filings:

• # of returns filed (so far): 14
• # of R&D tax credits filed: 4
• Average R&D credit amount: $80k (the client gets this money back through payroll refunds)
• Average # of state returns: 3
• Most common states: New York, Delaware, California
• Most common entity formation: C Corp in Delaware

We chose Intuit Proconnect software to file the returns because nearly 100% of our clients use Quickbooks for accounting. It’s easy to port data across systems and their UI is similar enough that retraining was minimal. Their support team is also stellar - I called Intuit several times between March & April, and although I spent ~45 minutes on average with a support agent, we were always able to problem-solve (and I learned valuable tax insights through this debugging process).

One of our main takeaways was the importance of having clean, accurate accounting data before attempting to file a return. We were fortunate to complete the books for all of our tax clients, so the normal scrambling and adjusting entries were minimized since everything was squeaky clean. We simply took the financials, layered in the book-to-tax-differences, compiled a few tax schedules, and we were done! Great tax returns can be reduced to detailed & correct books, something we think that Luca Pacioli would’ve agreed with. See below for our other learnings!

Digital Asset Question on Form 1120, 1120-S and 1065

Our clients spanned the whole crypto industry, from DeFi protocols to DAOs and NFT platforms. Inevitably, these clients received income in crypto, paid expenses in crypto or participated in on-chain platforms to earn returns on their treasury. Starting in 2023, the IRS wants to know which entities (specifically those that file Form 1120, 1120-S and 1065) are transacting in crypto. Nestled deep within the “Other Information” schedules on those various returns, the IRS asks,

“At any time during this tax year, did the corporation (a) receive a digital asset (as a reward, award, or payment for property or services); or (b) sell, exchange, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”

This wasn’t totally unexpected since the IRS requested that same information for individual 1040s starting in 2020. But it was new enough that we had to consciously remember to seek out the question in Proconnect and check the box (if you forget to check it, Proconnect defaults to “no”).

Section 174 Expenses

Section 174 has been all the rage amongst both trad tax accountants and crypto folk that have startups as customers. This provision deals with “research and experimental expenditures,” and it affects when companies can deduct those expenses on a tax return.

Before the Section 174 changes (which were included in the 2017 TCJA), companies could deduct 100% of their R&D expenses in the current year, aligning their tax schedules with their GAAP books. However, starting in 2022, companies no longer had that option. Qualified Section 174 expenses now have to be capitalized and amortized over 5 years (for domestically incurred expenses) or 15 years (for foreign expenses). The TCJA amendment also expanded the definition of “research and experimental expenditures” under Section 174 to include “any amount paid or incurred in connection with the development of any software.” 

This majorly impacted our crypto customers since most of them are building software (i.e. protocols, DEXs, DApps) using non-US labor. These startups often accumulate net operating losses (NOLs) in the early years before the revenue machine turns on. Section 174 significantly lowered the NOLs in 2022 and 2023, reducing the available bank of losses to draw upon when net taxable income is eventually generated.

Common Section 174 expense buckets for crypto startups include:

Costs from these three buckets are then split between US and foreign sources and the % of time spent in qualifying R&D activities is applied against the employee and contractor wages. The sum of these figures is the total Section 174 intangible asset that is capitalized and amortized, starting at the midpoint of the tax year in which the cost was incurred (i.e. so 7/1 for current year expenses). And unfortunately for startups, indirect labor costs such as overhead, taxable benefits, and payroll taxes paid for R&D employees are also factored into this figure.* See our example Section 174 template here.

However, there are a few categories of excluded costs such as admin costs, marketing, interest on debt that services R&D activity, and costs associated with “research conducted after the beginning of commercial production.” This last item is particularly fuzzy since startups need to track which components of their business are on the market and which ones are still being tinkered with (there’s often a gray line between the two). We’ll cover this more in the R&D section, but the IRS plays around with this concept of “technological uncertainty.” R&D activities must be undertaken to eliminate uncertainty and build a new/improved concept or product. Imagine scientists in a laboratory or programmers whizzing away in Github - those are the types of costs we’re talking about here.

* severance costs are excluded

R&D Tax Credit

Section 174 costs go hand-in-hand with a discussion on the R&D tax credit. Section 174 capitalization & amortization isn’t great for startups, especially if they were planning on huge net operating losses in the early years. To relieve some of this tax burden though, startups can (and definitely should) take the R&D tax credit.

How is the R&D Tax Credit (Section 41) different from Section 174?

A credit reduces your overall taxes owed $1 for $1. In the case of startups that don’t own any taxes (because they’re running net losses), they can realize the benefits of the credit by offsetting payroll taxes owed $1 for $1. It’s basically a rebate from the government to incentivize economically beneficial activities and to encourage more innovation in the United States.

Contrast that with Section 174 expenses, which are not a credit and affect the timing of when deductions can be taken on a business tax return. While these expenses are often the same ones used to calculate the R&D tax credit, Section 174 expenses lead to a tax intangible asset that is slowly burned down over time as the deduction is taken:

I loved going through the R&D tax credit process with customers because I learned oodles about how their core technology worked and how they were thinking about product development. To be a qualified R&D expense for purposes of the credit, it must pass a four-part test (very similar to a Section 174 expense):

I walked our customers through this four-part test, and we discussed their different product lines, technical challenges encountered and solutions during these interviews. We went deep into the programming weeds and looked at example code that was tested and/or deployed into a live product.

Qualified research expenses are the foundation of the R&D credit. Specifically, these buckets of expenses contribute to the credit:

The R&D credit and Section 174 expense buckets are substantially the same, but the IRS’ intentions are clear in the subtle differences between these two. Section 174 is broad and intends to scoop anything that smells of research into its’ brittle embrace. The R&D credit, on the other hand, is a watered down version and features exclusions like foreign labor costs and indirect costs (i.e. overhead, depreciation). The actual calculation on Form 6765, "Credit for Increasing Research Activities,” is also a sad whittling down of percentages. For example,

The other component to claiming the credit is gathering the requisite support. The IRS doesn’t ask for support when you file the return, but there better be adequate documentation in the event of an audit. There’s online tools like TaxCredit.AI that analyze Github/Jira logs to determine qualified percentages, but we used a more manual process including the interview, input from the customer on employee/contractor time, org charts, payroll registers, job descriptions, Jira/Notion tickets, etc. The more support, the better! A few pro-tips for the R&D tax credit:

• Expenses incurred after the point of commercial production are disallowed - so be sure to check if a customer’s product was available for the sale in the current year (+ dates of marketability).
• For startups without gross receipts, the credit can be used to offset up to $250k worth of payroll taxes - these are claimed directly through your payroll platform (i.e. Gusto, Rippling). Be sure to select this option on Form 6765:

• If claiming the full credit (and not the reduced credit), be sure to reduce your current year deductions for the full amount of the credit claimed - the IRS doesn’t like double dipping. 🍦

How to Enter the R&D Tax Credit in Proconnect:

Common Book-to-Tax Differences

Traversing from book income to tax income can be a long and winding road. What’s required for GAAP is often wildly different from the tax code, which can spin the brain of the best accountant. Here are the most common book-to-tax differences we encountered:

Common Proconnect Bugs & How to Fix Them (+ Random Tax Things) 🐛

And there you have it! We had a wonderful time learning this tax season and helping our customers feel good about their financials and their taxes. It was awesome jumping between these two worlds that seem so different, but they are really intimately connected. Tax and accounting, accounting and tax: they are two sides of the same double-entry coin. We already can’t wait for tax season 2024! 🎉