Hash Basis 2023 Tax Season Learnings

Mackenzie Patel
Mackenzie Patel
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June 24, 2024

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Hash Basis 2023 Tax Season Learnings

June 24, 2024
Crypto Tax

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:

  • Salaries & wages for W-2 employees
    • This is the cost of full and part-time employees that perform, directly support, or supervise research activities.
  • Contract labor
    • Cost of contractors (domestic & foreign) that perform qualified research activities.
  • Cloud costs
    • Cost of renting cloud compute (i.e. AWS, Ankr, Google Cloud).

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):

  • Business Purpose
    • Improved function, performance, product
  • Technological in nature
    • Uses engineering, computer science, life sciences, etc. (excludes social sciences)
  • Elimination of uncertainty
    • The R&D process is intended to discover information that eliminates uncertainty
  • Process of experimentation
    • The business engages in experiments, trials, prototypes, proof-of-concepts, etc

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:

  • W-2 wages (grabbed from Box 1 of the W-2) for technical talent
    • This number is multiplied by the % of time the employee spends in qualified R&D work.
    • Note: If an employee spends 80% or more of their time on qualifying R&D, 100% of their wages can count towards the credit (“substantially all” rule).
    • Qualified employee services must either engage in, directly support or directly supervise R&D activity.
  • 1099 wages (applicable only to US contractors → no foreign contractor wages can be claimed here)
    • 65% of 1099 contractor wages count towards the credit for applicable R&D hours.
    • Qualified contractor R&D wages = wages paid * % of time contractor spends on R&D work * 65%.
  • Supplies & Materials
    • For crypto startups, this includes cloud costs.

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,

Credit for startup with $0 gross receipts = Total Qualified Expenses * 50% * 20%

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:

  • Meals & Entertainment
    • Entertainment is generally 0% deductible, but meals can either by 0%, 50%, or 100% deductible - this Perplexity article breaks down the different categories.
  • Net Capital Losses
    • This is relevant for crypto startups since they typically have on-chain activity that leads to realized capital gains/losses, defined as the difference between the fair market value of the crypto asset being disposed of and its cost basis. For companies that have net capital losses in a current year (so realized gains + realized losses = net capital loss), they can’t actually use them on the tax filing. Instead, these capital losses accumulate and are carried forward to future years to offset any net realized capital gains.
  • Non 501(c)(3) Donations
    • I’ve had several customers make donations to various web3 projects. Unfortunately, most of these projects aren’t qualified charities as defined under section 501(c)(3) in the tax code. These donations show up as expenses on the financials, but they are disallowed for tax purposes.
  • Depreciation
    • Book versus tax depreciation has been a hot topic among accountants for decades! For financial statement purposes, equipment/furniture/other fixtures are normally depreciated straight-line over the useful life of the asset (i.e. laptops are depreciated over 60 months). Tax-wise, assets can take advantage of accelerated depreciation under methods like MACRs and bonus depreciation (note: bonus depreciation is phasing out due to the TCJA. Starting in 2023, the bonus depreciation percentage decreases by 20 percentage points each year.
      • 2022: 100%
      • 2023: 80%
      • 2024: 60%
      • 2025: 40%
      • 2026: 20%
      • 2027: 0%
  • Section 174 Expenses
    • Similar to depreciation, Section 174 expenses generate book-to-tax variances due to timing differences between expenses on the financials versus deducting on the return. As we can see in the schedule above, the expenses are amortized (spread out) over time, leading to differences for the full life of the tax intangible assets.
      • Deductions not Charged Against Book Income - capitalized expenses that are being amortized in the current year (but they were incurred on the financials in a prior year).
      • Expenses Recorded on Books not Included on this Return - current year research expenses that are being capitalized and not deducted in the current year return.

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

  • Importing Realized Gain/Loss Data for Schedule D / Form 8949
    • When compiling realized gain/loss data for crypto transactions, your crypto subledger will likely export the data in the correct format for the return. Namely, the csv will include the date acquired, date disposed, description and # of units, cost basis and proceeds. This data (which can be thousands of individual lines) can be uploaded directly into Proconnect to fill out Schedule D and Form 8949. A few words of warning here - if you incorrectly upload the data (i.e. if you entered a 1 for “basis reported” instead of 2), you have to scrap the return and start over. I called the Proconnect team on this, and they confirmed this bug. 🐛 Luckily, there is recourse if you already paid for the return. It’s easy to request a refund here by filling out the webform at the bottom and selecting “Duplicate Charge” under Reason for Refund.
  • Attaching a PDF
    • When filing the full R&D tax credit, Proconnect requires the practitioner to upload a separate schedule showing where the credit amount reduced the allowable deduction for the year. Other schedules (i.e. New York depreciation schedules) may also have to be attached separately. To file a PDF with a tax return, do the following:
      • File Return
      • PDF attachments
      • Manage PDFs
      • Upload your applicable PDF and name it
      • Select the form & line # you’d like to attach it to
      • Note: if you don’t see the form you need in the dropdown, select 0 = Form 1120 for C corporations
  • Intangible assets & amortization on schedule L
    • The Section 174 expenses keep on giving! As we wrote above, Section 174 expenses give rise to book-to-tax differences. However, Proconnect doesn’t realize this and creates an intangible asset representing unamortized expenses on Schedule L. This schedule shows the balance sheet as per the financial statements filed under GAAP (not the tax balance sheet). Schedule M-1, which is under Schedule L, lists out the book-to-tax differences and reconciles taxable income (loss) per the tax return to the books - this then flows into the retained earnings figure showing in Schedule L (so you can always tell if you’re accurate or not).
    • For some reason, when creating Section 174 expenses under the Depreciation section in Proconnect, it creates the intangible asset on Schedule L when it doesn’t exist on the GAAP books (since we directly expensed them in the current year). This messes up the debits & credits and breaks the [assets = liabilities + equity] formula. To fix this, head to:
      • Balance Sheet
      • Assets, Liabilities and Capital
      • Under the Ending column, add in “-1” for “Intangible assets” and “Less accumulated amortization” → this will clear out the phantom intangible created by Schedule L!
    • In general, entering a “-1” in Proconnect renders a field moot, so it can be used for other sections as well (i.e. for state apportionment factors).
  • Texas webfile number
    • This last pro-tip was such an unexpected doozy! One of my clients has employees in Texas, so we filed a Texas state return. In order to e-file in Texas, entities need to have a Texas webfile number. The client didn’t have this number on file (they hadn’t even heard of it!), so I was on the hunt for something other than their EIN. Note: if you e-file with the EIN as the webfile number, the return will be rejected.
    • I ended up calling the Texas state comptroller, who was able to help me locate the number. To grab this number:
    • I knew the client had a webfile number because their previous accountants had e-filed in Texas the previous year. If it’s the first year filing in Texas, the client will need to obtain a webfile number (and don’t forget to record this number somewhere).

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! 🎉

Mackenzie Patel

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