Start-ups with Grant Funding Face Additional Tax Burdens Due to the TCJA’s IRC Sec. 174 R&D Capitalization

Start-ups that have secured funding from grants have been hit with additional tax burdens due to the changes in the Tax Cuts and Jobs Act’s (“TCJA”) IRC Sec. 174 related research and development (“R&D”) capitalization.

In short, IRC Sec. 174, which first became effective for tax years beginning on or after December 31, 2021, requires taxpayers who incur research or experimental expenditures to capitalize and amortize these costs rather than deduct them as incurred. Now, almost three years since the law took effect, EisnerAmper has heard from many tax practitioners, clients and other individuals that this change was contrary to the historical U.S. position of encouraging innovation and advancement through favorable tax laws, yet any hopes for U.S. Congress to act to rescind it before the end of the 2023 extended tax filing season have faded.

 To specify the tax burden for startups, both with and without grant funding, IRC Sec. 174 requires any costs incurred by a taxpayer as research and experimental ones to be capitalized and amortized over five years for those incurred in the U.S., or 15 years for those incurred outside the U.S. The mechanics of the amortization rules require that the costs are treated as placed in service halfway through the tax year, allowing for only six months of amortization in the first year and six months of amortization in the last year, which effectively extends the amortization into an additional tax year.

For example, ABC Corporation is a pre-revenue start-up developing a new drug and expects to spend $900,000 in Year 1 to perform research through various clinical trials performed in the U.S. and $200,000 in other expenses for administrative and overhead costs. For taxpayers funded through equity or debt, this essentially means that there is a $1.1 million loss generated in Year 1 for book purposes.  For tax purposes, this loss will be reduced significantly as most of the costs are primarily related to R&D and must be capitalized. In our example, the $900,000 of costs directly related to the clinical trials would be included under IRC Sec. 174, and assuming $100,000 of additional overhead costs, we will assume that $1 million of the total costs in Year 1 are treated as IRC Sec. 174 expenses.

However, for taxpayers that receive grants from the Small Business Innovation Research (“SBIR”) or National Institute of Health (“NIH”), for example, that funding is considered income, whereas taxpayers funded by debt record a payable on the balance sheet. Grant-funded entities must include 100% of the cash income in taxable income in the year the grant income is expended for R&D. Due to the fact that the R&D expenses are not immediately deductible, these start-ups are left with taxable income and a cash tax liability in the early years. If the company is a C corporation, it would pay income tax at 21% in Year 1 on the $800,000 of taxable income and with the inability to carry back net operating losses to earlier tax years. Eventually, ABC Corporation will get the deductions for the R&D expenses and create losses in Years 2-6. However, they will never recoup the cash tax paid in Year 1 as illustrated in our example below.

Additionally, for start-ups that are funded with grants: If ABC Corporation paid for the R&D though debt or equity funding, the company may also be able to claim an R&D credit, which could be applied against the future Federal Insurance Contributions Act (“FICA”) payroll tax liabilities or future income tax liabilities (assuming they qualify). Also, if the R&D is funded by a grant, no R&D credit is available since the R&D was “paid for” with grant income.

Further, if the company was taxed as a flow-through entity such as a limited liability company (“LLC”), the tax burden is even greater for companies that received grants since the taxable income in Year 1 flows out to the unit holders and if those unit holders are individuals, such as the founders who participate in the business activity, they will not only have to pay individual income taxes on the income, but also be subject to self-employment taxes on the income as well.

However, in September 2023, the IRS did issue Notice 2023-63 and Notice 24-12 which clarified that if a research provider that bears no financial risk under the terms of the contract with the research recipient and had no rights to the intellectual property created, then the R&D costs incurred by the research provider were not expenditures subject to capitalization under IRC Sec. 174. This was a break for all the contract research organizations (“CROs”) who are hired to perform clinical trials as a third-party service provider, but for taxpayers with SBIR or NIH grants, the notice does not apply since these grants typically allow the company to keep any intellectual property created under the grant.

Besides the tax burdens that start-ups face from grants, there are other limitations. Funds from grants typically cannot be used to pay for patent or licensing expenses, so companies are required to have non-grant funds to pay for these costs, along with paying their income tax.

Until or unless IRC Sec. 174 is changed or reversed, start-ups who received grants will likely still need to secure additional outside equity or debt funding through either convertible notes, SAFE loans or venture capital transactions if they anticipate using grants to fund their research.