One of the least talked about tax code blunders S174 could derail Silicon Valley ($COMPQ).

What happened?

Basically, all costs related to R&D cannot be expensed, including labor for software development.

These costs have to be capitalized and amortized over 5 years – or 15 if labor is done outside of the US.

This is a massive game changer that makes IT salaries substantially more expensive on paper.

This topic has come up a few times in private conversations that I have had, even though startups are arguably the hardest-hit companies of all.

What’s the fallout?

An unexpectedly high tax bill out of nowhere.

Many US software businesses amassed surprisingly high tax bills in 2023, seemingly out of nowhere, due to a tax change that took effect in July of the previous year, which many small companies knew nothing about until finalizing their 2022 returns.

The change was expected to be repealed (reversed) in December 2022, so many accountants didn’t inform customers for that reason. So, businesses got a surprise when the first tax payments fell due last April.

The amendment to S174 means employing software engineers can no longer be accounted as a direct cost in the year they are paid – unlike the norm, globally. Here’s a simplified example of the change from the final tax year before the change.

Here is how amortization works:

1. 10% amortized for the first year
2. 20% amortized for years 2 to 5
3. 10% for year 6

Less hiring of software engineers and more software engineering layoffs are already happening at smaller US tech companies.

This could slash around 100,000 software developers at small companies.

One of these changes was Section 174, set to come into effect 5 years later, in 2022. These parts deliver the blow by making it clear that software development costs need to be amortized over 5-15 years.

What’s the damage?

Microsoft: $4.8B additional tax paid in 2023. The company generated a $72B profit that year, so this tax increase was manageable. It’s still a very large amount!

Netflix: around $368M in additional tax paid – also manageable with $4.4B annual profit.

What’s the key takeaway?

Innovation across all US software companies will take a hit if Section 174 isn’t repealed.

The tax change incentivizes software companies without large cash reserves to invest less in research and development. Or they can just move abroad.

But the change isn’t just bad for small software companies; it hurts even the largest ones – it is why Microsoft and Amazon are also advocating for its reversal.

I won’t pretend that Silicon Valley is full of little companies because it’s not.

I can easily see many firms like Google and Apple offshoring more jobs abroad for lower wages if they cannot amortize the full amount of wages in one year.

It puts American tech at an acute disadvantage, but I do believe US tech is so far ahead of its peers than in the long term, it won’t matter too much.

Just take Europe, many of the backwater countries are just a fraction of the size of Apple or Microsoft.

US tech is gargantuan and we forget that sometimes.

In the short term, the pressure is squarely asserted on the balance sheet. How will Silicon Valley nudge up the EPS with even more expenses coming down the pipeline?

The solution is clearly firing more American developers and reallocating the workload to other colleagues and a partial workload will go to AI.

US tech is famous for working smarter and this is just another hurdle to jump over.

In the first part of the year, this puts a lot of pressure on external tailwinds mainly the Fed pivot to power us through to new highs.

Buy the dip in tech.

In December, the US economy and the American tech sector ($COMPQ) showed who is boss in the world economy by blasting past employment expectations.

This comes at a time when every professional economist is calling for a gloomy outcome in the short term.

From the tech side of the equation, remote jobs are rebounding at a blistering pace.

Full-time workers plunged by 1.5 million in just one month to the lowest since February 2023.

Part-time workers made gains of 762,000 the highest on record.

Multiple jobholders hit a time-high 8.56 million.

What does this tell us?

Work from home can do more than one job and those are mainly tech jobs. A lot of the time they are IT and software engineering jobs as well.

The other group this could have affected is the group affected by Bidenflation which has crippled the budget of many low-income workers living in the US and this cohort needs two low-paid jobs.

The reality is that these multiple job holders are a mix of each group.

It’s now highly common for remote workers to work 3 or 4 jobs at once because these workers don’t need to be physically present in any office.

They can simply clock in and clock out when they choose to and this has been a boon for tech companies who have taken advantage of this trend and fired many full-time workers who became too pricey.

For the past year, Silicon Valley has taken a machete and chopped off the fat from its business model.

Their leanness was a massive reason for the overperformance of tech stocks last year and even though that same boost won’t happen to the same extent in 2024, it has given the blueprint to management on how to run a tech company.

The largest economy in the world saw the addition of 216,000 new jobs in December 2023, surpassing projections of a decline from the previous month, as per data from the Labour Department.

The joblessness rate remained steady at 3.7 percent, a figure that is notably low historically and counters predictions of a slight increase.

These impressive job market statistics arise amidst the context of rising interest rates. The Federal Reserve has aggressively raised and maintained high rates for the benchmark lending rate to moderate demand and control inflation.

In terms of wages, December witnessed a consistent rise, with a 0.4 percent increase from November 2023, according to the Labor Department. Year-over-year, average hourly earnings went up by 4.1 percent.

Tech jobs are evolving into a different type of existence with agility becoming more important and that is highly positive for tech companies.

Silicon Valley was at the forefront of the firing spree last year, but job numbers were more than compensated by the additions in government, health care, and services.

The strength of the US economy means that it’s painfully obvious that traders are still too early betting that the Fed will drop rates by 1.5% by the end of 2024.

My belief is that we will end up with a drop of .5%-.75% of Fed Funds rate cuts which means we have a little ways to go to reverse from this overshoot.

This idea that the economy is stronger than people think is verified by rising wages and lower unemployment.

I do believe that high inflation and high rates are here to stay and the 0% rate of yore was just a weird anomaly that defied historic data.

Delaying the “recession” yet another year means once we absorb this pullback, tech stocks will be off to the races again.