Last Updated on
June 13, 2023
By
Excedr
Biotechnology and the Life Sciences industry are extremely capital-intensive. The ongoing costs of lab equipment, lab space, supplies and materials, hiring and wages, multiple clinical trials, and FDA approvals (hopefully!) continue to rise and time horizons for getting a product to market remain significant.
All of these expenses, which are part of your research and development (R&D) costs, can make quick work of the capital you raise, making it hard to fund R&D for multiple years. Funding R&D is a huge challenge biotech companies face considering it can take several years or more and millions to billions of dollars to bring a new product to market.
To make matters more difficult, developing a new biological product is a risky endeavor. Many drug candidates and medical devices never see the light of day, due to preclinical-, clinical-, regulatory-, or patent-related issues.
Because of these factors—time, costs, and risks—properly funding R&D projects can be extremely difficult. Despite all this, research and development (R&D) has been and remains a significant driver of economic development and growth in the United States and around the world.
To ensure R&D activities continue, the federal government created the Research and Development tax credit, which provides businesses with qualified R&D expenditures the ability to save money at tax time. There are also a number of tax incentives provided by state governments that make it easier for laboratories to fund their research and development.
However, despite significantly high R&D costs, there are far fewer life sciences companies taking advantage of tax credits and incentives in the US than you think.
It’s important that businesses conducting R&D, especially small businesses and startups, know their options. If you qualify, claiming the R&D tax credit can help you decrease your tax liability over multiple years. Decreasing how much you pay in taxes can directly support your research, helping you increase R&D spend, hire more researchers, and more.
In this article, we’ll review the federal R&D tax credit and some of the state-level tax incentives available to startups and small businesses.
Although the R&D tax credit can be complicated to claim, having a general understanding of these topics can ultimately help you identify whether or not you’re eligible for the credit or other state tax incentives.
Simply put, a tax credit decreases the amount of income tax you owe, as well as your overall tax liability as a taxpayer or business owner. Compared to a deduction, which deducts your overall taxable income, tax credits directly reduce the amount of taxes you owe.
The federal R&D tax credit is a specific type of tax credit designed to support and encourage the research and development of new technologies and products.
Many types of businesses in a wide range of industries can qualify for it, as long as the company and its R&D activities meet certain requirements. However, it is highly relevant to startups and small businesses in the life sciences, such as biotech and biopharma startups.
If your R&D activities and expenses qualify, you can file IRS Form 6765 to claim the credit for increasing research activities, electing the reduced credit under section 280C, and, if your business qualifies, file Form 8974, electing to claim a certain amount of the credit as a payroll tax credit against the employer portion of social security taxes.
An additional feature of the credit allows life sciences startups that are not generating taxable income to apply up to $1.25 million—or $250,000 each year for up to five years—of the federal R&D credit to their employer portion of social security taxes, giving non-revenue generating businesses that perform qualifying R&D a way to lower costs at tax time.
The decrease is a dollar-for-dollar reduction, and applies to a certain percentage of your total qualified research expenses (QREs) for the current tax year.
Qualified R&D expenses usually include your company’s researchers’ wages and salaries, the cost of supplies and materials, as well as prototype costs and any amounts paid to consultants or organizations for research services. Furthermore, these costs must all be based in the US.
The R&D tax credit applies to a broad range of research and development activities and operations, including the development or improvement of new products, manufacturing processes, techniques, formulas, and computer software.
You can take the time to determine your lab’s eligibility using the four-step process established in the Internal Revenue Code (IRC) and Treasury Regulations:
Going through these steps will give you an idea of whether or not your company may be eligible for the R&D tax credit. If you choose to file the 6765 form (used to claim the credit for increasing research activities, to elect the reduced credit under section 280C, and to elect to claim a certain amount of the credit as a payroll tax credit against the employer portion of social security taxes), be prepared to document and support your qualifying R&D activities.
This form will also provide a list of R&D activities that do not qualify, as defined by the IRS. For example, research performed after commercialization, research adapting an existing product or process to a particular customer’s need, surveys and studies, and duplication of an existing product or process do not qualify as R&D activities.
New businesses that have a lot of research costs and little or no income tax liability have an alternative that can help them reduce their tax liability, thanks to the Protecting Americans from Tax Hike (PATH) Act of 2015.
The law allows startups and small businesses to apply the R&D tax credit against their payroll tax (FICA) for up to five years. However, there are requirements you must meet in order to apply the payroll tax offset. Qualifying companies must:
If eligible, you can apply $250,000 of your available R&D credit to your payroll tax each year, adding up to $1.25 million in total. However, you cannot claim the credit more than five years in a row.
The PATH Act also allows eligible companies to use the R&D tax credit to offset the alternative minimum tax (AMT). Qualifying companies must:
The percentage of QREs you can apply the credit to—if you’re eligible to receive it—can be calculated using two different methods: the regular research credit (RRC) method or the alternative simplified credit (ASC) method.
The RRC method calculates your credit rate using your company’s average, annual gross receipts for R&D of the previous four tax years, as well as a fixed-base percentage. The credit equals 20% of your current-year QREs over a base amount, which is determined by applying your historical percentage of gross receipts spent on QREs to the previous four years’ average gross receipts.
In contrast, the ASC method doesn’t require gross receipts to calculate your R&D tax credit rate. Rather, it takes into account your QREs over the previous three-year period, making it easier for you if you don’t have the historical records necessary to document your base amount to establish eligibility and file for the R&D tax credit.
At a high-level, the ASC method calculates your rate using a four-step process:
That said, if you don’t have any QREs for the previous three years, your tax savings will potentially end up at 6% to 8% of total QREs for the current year you’re filing.
Lacking historical qualified research information or having never filed for a tax credit will make the RRC calculation method less suitable than the ASC method. However, the ASC method may not produce the maximum benefit.
Startups with low base amounts typically elect to rely on the RRC method, while companies with high base amounts or incomplete base period records use the ASC method. However, one size does not fit all, which is why it’s important to consult with your tax advisor.
To claim the federal R&D Tax Credit, you need to fill out IRS Form 6765 along with your income tax return. The credit can be claimed for prior tax years as well, so it’s important to document your R&D activities and expenditures for evaluation. Doing so will establish the amount of QREs you have for each qualified R&D activity.
It is prudent to let your accountant know ahead of time that you plan to claim the R&D Tax Credits as it will allow them to track each qualifying expenses in the normal course of business. If you delay informing your accountant, it may become impractical to claim the credit timely at tax time. This may result in additional tax preparation expenses and require your business to amend its filings.
Additionally, they will be able to help you prepare and collect all the documentation you’ll need when filing for the credit for the current and previous tax years.
Some examples of the documentation you may need to include are:
Each of these items can include a number of documents. For example, the documentation regarding the wages you paid employees may need to include employee W-2 forms, payroll registers, and oral testimonies. Supply expenses documentation can include purchase orders, invoices, and general ledger expenses.
Furthermore, the IRS will ask you to provide specific information to prove whether or not your business qualifies for the tax credit, such as the product, process, technique, or formula the claim relates to, a list of the research activities performed, who performed them, and what results they were after.
Providing the proper documentation to the IRS can help you increase your chances of successfully claiming the R&D credit claim.
Besides being able to take advantage of the R&D tax credit at the federal level, there are a number of tax credits and similar incentives available at the state level as well. Not every state provides R&D tax credits or incentives, however.
The map below shows which states offer an R&D tax credit or incentive.
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If you’re located in a state that provides a credit or incentive, there is a chance you can offset against taxes owed at the state level as long as your research is conducted in that state. If you also conduct research in other states, you may be able to claim tax credits in every one of them.
Most states conform to the federal rules and regulations for qualifying research activities, however, the credit calculation method, as well as some other factors, may vary significantly based on the state. Let’s review some of the credits and incentives that states provide. These states are well known for their biotechnology and life sciences hubs, and include California, New York, Texas, Maryland, Connecticut, and Massachusetts.
California provides a Research Credit for businesses that perform qualified R&D activities and expenditures. The business entities that are eligible for these incentives include C-corporations, S-corporations, LLCs, and partnerships.
The research credit applies to taxable years beginning on or after January 1st, 2000, and equals 15% of QREs that exceed a base amount for the tax year you are filing for. The credit may also include 24% of basic research expenses in the given tax year. The credit cannot be carried back, it can be carried forward.
If you’re planning on filing in California, it’s important to review and understand the regulatory differences between California’s research credit and the federal tax credit. For example, California does not adhere to the ASC method of calculating your credit rate. Instead, it allows the election of the alternative incremental credit method.
New York provides businesses with an R&D tax credit similar to the federal tax credit. It also offers several tax incentives associated with R&D activity, job creation, and investments in the life sciences.
Some of these incentives include the New York Excelsior Jobs Program R&D Tax Credit, New York Qualified Emerging Technology Companies (QETC), and the Life Sciences Research & Development Tax Credit, all of which provide different benefits but have varying requirements.
For example, the Life Sciences Research and Development tax credit provides qualified businesses with a refundable research credit. To qualify for the credit, your business must be certified by Economic Development as a qualified life sciences business, paid or incurred R&D expenses within the state, and received a certificate of tax credit issued by Empire State Development (ESD).
The credit equals 15% of the company’s R&D expenditures in New York if the company has 10 or more employees, and 20% of QREs if the company has fewer than 10 employees. You can claim the credit for up to three years in a row, and is limited to $500,000 per year.
Although Texas does not have a traditional income tax; it does offer some tax incentives to life science companies. C-corporations, S-corporations, LLCs, and partnerships in Texas can use the state’s R&D tax credit to reduce the company’s sales tax liability and/or to reduce its franchise tax credit for QREs that take place within the state.
The sales tax exemption applies to depreciable, tangible property that’s been purchased, leased, rented, stored, or used in qualified research.Texas gives a sales tax exemption either at the time a business purchases a taxable good/service or the business can claim a refund on purchases it was incorrectly charged tax at the time of purchase. A taxpayer cannot claim both the sales tax exemption and the franchise tax credit in the same year.
There are some key differences between the Texas R&D tax credit and the federal credit, such as the definition of qualified research expense. However, there are similarities between the two as well. This is another situation where it’s important to understand the differences between state and federal law regarding the R&D tax credit.
The credit typically equals 5% of QREs that exceed the base amount in the current period. If you don’t have any QREs in one or more of the three preceding tax years, the credit will equal 3.125% of all QREs incurred during that period. It’s possible to carry forward unused credits for up to 20 years.
Small businesses in Maryland that conduct qualified research and incur QREs within the state can qualify for the R&D tax credit. Maryland defines a small business as a for-profit corporation, LLC, partnership, or sole proprietorship with net asset values totaling less than $5 million at the beginning or end of the tax year for which the qualified R&D expenses are incurred.
Maryland’s Department of Commerce adheres to the same regulations and definitions the federal government sets for qualified R&D and qualified R&D expenses, as outlined in IRC Section 41, meaning your R&D can qualify if you already qualify for the federal R&D tax credit.
The Maryland credit is equal to 10% of qualified R&D expenses that occur during the tax year in excess of a base amount, as defined by the state. You can’t claim more than $250,000 per tax year.
Additionally, Maryland is a good example of a state that provides biotech investors with tax incentives for investing in a qualified Maryland biotechnology company (QMBC).
The credit, referred to as the Biotechnology Investment Incentive Tax Credit (BIITC), provides the investor with a refundable income tax credit that equals 33% of the eligible investment in a QMBC up to $250,000 in tax credits, or 50% of the investment up to $500,000 in tax credits if the company is located in Dorchester, Garrett, Somerset, or Allegany County.
Connecticut recognizes and provides two R&D tax credits, the Research and Experimental Expenditures Credit (RC Credit) and the Research and Development Expenditures Credit (RDC Credit). The difference between these two credits is that the RC is an incremental credit, while the RDC is a non-incremental credit. The RC and RDC credits are available to C-corporations that conduct qualified research.
The RC credit equals 20% of QREs that exceed the base amount for the current claim year over the QREs during the prior year. If there is any remaining credit balance that exceeds the credit you apply for or exchange, it can be carried forward for up to 15 years or exchanged for a refund of up to 65% of the value of the credit in some cases.
The RDC credit equals 6% of the research and development expenses for qualified small businesses (QSBs), however, it can be calculated using the same information the RC credit uses to calculate the credit rate. Any business other than a QBS must use the tentative rate outlined in Connecticut’s Department of Revenue Services Form CT-1120 RDC.
Massachusetts also provides a research credit similar to the federal R&D tax credit, which companies can claim against excise tax due to the equal sum of 10% in credit for QREs that exceed a base amount for that given tax period. In addition, companies can also claim 15% of the basic research payments determined under IRC Section 41.
The credit amount is limited to the first $25,000 of corporate excise due, as well as 75% of any excise due in excess of $25,000, and is only applicable if the research activities or services were performed in Massachusetts. The business entity must either be a C-corporation or an S-corporation.
There are many companies that can take advantage of federal- and state-level R&D tax credits and similar tax incentives. However, the research credit is often most relevant to life sciences companies performing R&D projects with the goal of creating a new healthcare-related product or technology.
If you qualify for the research credit, you can directly reduce the amount of income tax you pay, leaving you with more cash in your pocket at tax time. This can give you the ability to increase R&D activity, hire more researchers, and more.
What makes the credit beneficial to startups and small businesses is that, regardless of the amount of taxes you owe, you can still receive a refund on credit. Even if you owe nothing in taxes. This is in contrast to a tax deduction, which would reduce your taxable income and help you owe less in taxes.
While filing for a claim can be a great idea, it may increase the risk or chance of getting audited. The best course of action you can take is to consult with a tax advisor, who can help you identify and document QREs and calculate the specific credit rate, as they will be able to do the best possible calculation of the credit.
That all said, there are a number of aspects to the federal and state R&D tax credits that we did not explore in this article, as well as various changes that have been made in recent years.
If you’re interested in reading more, here are some resources that provide further information on the various biotech R&D tax credits and incentives and the recent changes:
This article is informative and is not meant to represent legal advice. It is best practice to consult with a CPA or tax advisor to determine if you qualify for a federal or state credit. Before making any tax decisions, you should consult with a professional CPA who can advise you based on your individual situation.