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The tax savings available through the Federal Research & Development (R&D) Tax Credit rewards businesses that invest in research and innovation. The misconception that only large biotech companies can claim the credit has led many small-, medium-sized, and family-owned biotech businesses to dismiss this opportunity. This assumption is simply untrue. Any company that invests in the identification, evaluation, testing, and improvement of instruments, products, processes, or methods, often qualifies for tax savings. There are numerous situations in which biotech companies, or testing services that have undertaken certain research activities, may qualify. Unlike other incentives, there are comprehensive guidelines that must be followed when claiming the R&D Tax Credit (26 U.S. Code § 41). To maximize this opportunity, biotech companies may want to revisit the immense tax savings program available. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
How Does the R&D Tax Credit Benefit Biotech Companies?
Under current law, taxpayers can apply the credit against current Federal tax liabilities for a dollar-to-dollar reduction. Any unused Federal credits can carry forward for up to 20 years or can be used to offset payroll taxes owed in certain circumstances. Beyond this, if an amended return is filed then the taxpayer can also receive a tax refund up to three years back. In addition to offsetting income tax owed on the entity level, certain states, such as California also allow taxpayers to offset personal income tax owed to the owners of passthrough companies.
Numerous start-up companies can elect to use the R&D tax credits identified to offset current payroll tax liability. Beginning in 2016, eligible taxpayers can apply $250,000 towards the employer’s share of social security tax owed. With the Inflation Reduction Act, beginning in 2023 qualifying companies can offset up to $500,000. Eligible taxpayers must use the credit against social security tax first and then the remainder can be applied against Medicare tax. Any unused credits can then carry forward into the next quarter. Qualified companies can elect the payroll tax offset on the originally filed return on Form 6765 and then would need to complete Form 8974 and attach the form to the employment tax return.
For eligibility, an organization must be a Qualified Small Business meaning that the taxpayer must have less than $5M in gross receipts in the current year and no gross receipts in a five-year look-back period ending with the current year. It is important to note that this option cannot be elected on an amended tax return and the R&D Credit cannot be claimed against wages that were already covered under COVID-19 relief funding such as the Employee Retention Tax Credit or the Paycheck Protection Program. In addition, for related entities and controlled group companies, the sum of the gross receipts from all entities must be used in calculating the current year’s gross receipts.
Generally, any project or activity is considered eligible if it satisfies the criteria laid out in the four-part test (26 U.S. Code § 41(d)). This test examines four key areas including (1) permitted purpose, (2) uncertainty, (3) technological in nature, and (4) the process of experimentation. A detailed explanation of each is outlined below.
- Permitted Purpose – The purpose of the research must be towards the creation of a new or improved product, process, technique, invention, software, or formulation (or “business component”) resulting in increased performance, quality, or reliability. Concurrently, research activities undertaken for aesthetic reasons (e. g. style, taste, cosmetics) are not eligible. It is important to note that success in a project is not necessary to meet this criterion.
- Uncertainty – The research must eliminate uncertainty about the capability, design, or method related to the development of a new or improved product, process, or component. Since regulations do not require that the taxpayer be successful in eliminating the uncertainty, proof of resolution is not required to meet this test. Concurrently, it can be demonstrated that uncertainty existed if the information readily available to the taxpayer did not allow for the development of an improved business component. Finally, it is important to remember the Patent Safe Harbor rule (Treasury Regulation §1.41-4(a)(3)(iii)), which states the issuance of a patent means information that the research is technological in nature, and the elimination of uncertainty relating to a new business component has occurred.
- Technological in Nature – The research must demonstrate the process of experimentation relies on the principles of “hard” science, examples include those found in biology, chemistry, engineering, physics, or computer science.
- Process of Experimentation – The research must eliminate uncertainties through a process of experimentation. This may include an iterative process of trial-and-error, the use of the scientific method, simulation, modeling, or any approach that involves the evaluation of alternatives. The process is not required to be completely academic, but documentation on the alternatives considered, testing methodology, and results, must be performed and documented to satisfy this requirement.
Which Biotech Projects Typically Qualify?
Although any project must pass the aforementioned four-part test to qualify, there are certain biotech projects that are usually eligible. The most common include new and improved designs and redesigns for instruments, technologies, chemistries, kits, reagents, newly designed or designed processing/manufacturing equipment or machinery, and improvements in current processing techniques or protocols. Other projects such as routine manufacturing or testing are more difficult to qualify. Finally, repair, maintenance, or projects undertaken on behalf of another taxpayer where you did not maintain rights to the research or did not fund the research (i. e. contractor research or contract testing) generally do not qualify.
Which Biotech Activities Typically Qualify?
- Instrumentation – These include activities such as examining, and evaluating instrument designs and redesigns in order to improve instrument functionality or quality. Testing of hardware and software is also included. Finally, analysis of testing results may also be a qualified support activity.
- Technologies – These include activities related to new or improved technologies and capabilities such as the development of new chemistries, kits, reagents, workflows, and much more. Eligible activities often include the evaluation and testing of new chemistries and formulations to meet the project scope and the evaluation of alternative solutions to overcome challenges.
- Processing-Related – These include activities related to improvement in the processing of manufacturing. For example, improvements in processing lines in plants or redesigns of equipment to increase production or produce quality would qualify as research activities. Eligible activities often include the evaluation and testing of new facility designs to meet project scope, calculations for conveyor layouts, new design or design of existing processing machinery, and the evaluation of alternative solutions to overcome processing challenges.
There are specific R&D costs that can be claimed including wages, supplies, and certain third-party expenses. For Biotech companies, the most captured expenses include employee wages, supplies, and certain subcontractor expenses related to testing and consulting services.
It is necessary to ensure that proper documentation is available to substantiate expenses claimed. The typical documentation that may be evaluated includes employee rosters, payroll records, testing reports, laboratory design layouts, pictures, analytics reports, and contracts. This is not an exhaustive list and each company may have documentation unique to its processes.
The tax savings potential arising from the Federal R&D Tax Credit can be significant for Texas and California biotech companies and contractors. Due to the complex regulations governing the credit, it is necessary to consult with a qualified tax advisor to determine eligibility. If you have questions about the information outlined above or need assistance with the R&D Tax Credit, JLK Rosenberger can help. For additional information, please call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.