Maximizing R&D Tax Credits for Life Science Companies

By Tom Yuen, CPA, MST
Gray, Gray & Gray, LLP

Research and development are the lifeblood of the life science industry. From developing new drugs and medical devices to advancing biomedicine and biotechnology, life science companies pour billions into R&D each year in pursuit of life-changing innovations. However, the R&D process is extremely costly, time-consuming, and risky, with many drug candidates and products failing to ever make it to market.

To incentivize private sector R&D investment and foster innovation, the 2022 Inflation Reduction Act increased the maximum amount that a qualified small business (QSB) can use from the Sec. 41 research credit (R&D credit) to offset certain payroll tax liabilities from $250,000 to $500,000 for tax years beginning after Dec. 31, 2022. The Act also enables taxpayers to use up to $250,000 against the 1.45% employer portion of the Medicare payroll tax liability.

This can be particularly valuable for startup companies that currently have net operating losses for federal tax purposes and would like to monetize the R&D credit in the near term. Yet studies have shown that eligible companies often miss out on millions in R&D credits by failing to claim all their qualified research expenses (QREs).

For life science companies looking to maximize their R&D credits and receive the full benefit, understanding what qualifies as QREs and maintaining meticulous documentation are crucial. Here are some tips for capitalizing on these valuable tax incentives:

Identify All Qualifying Activities & Expenditures

The definition of qualified research is quite broad and covers far more than just product development. Any technical activities undertaken to gain knowledge that could lead to new or improved products, processes, techniques, formulas or software may qualify. This includes:

• Drug development (synthesis, biological screening, animal studies, clinical trials)
• Medical device design
• Process development and optimization
• Formulation studies
• Software development for analytical, scientific or computational purposes
• Quality assurance testing and troubleshooting
• Environmental testing and compliance

Qualified expenditures span employee wages, supplies, contractor expenses, and computer rental/cloud computing fees related to qualified R&D.

Track Project Details & Time Meticulously

Having a standardized process and tools for tracking and documenting all R&D projects, activities, and associated costs is critically important, both for substantiating claims and maximizing credits. Be sure to comprehensively record details such as project background, objectives, technical uncertainties/challenges, experimental protocols, results, conclusions, and hours/wages for all employees contributing time.

This level of detailed, contemporaneous documentation provides the audit trail and credible evidence required by tax authorities. It also ensures no qualifying hours, materials or contractor expenses get overlooked when calculating credits.

Leverage Specialized Software & Expertise

Given the complexity of constantly evolving R&D tax rules and the intricacies of identifying, tracking and calculating qualified expenditures, life science companies are wise to use specialized software and work with expert R&D tax credit firms. These solutions automate time tracking, cost accounting, and QRE calculations, while helping companies remain fully compliant with evolving regulations in all jurisdictions where they operate.

Consider Opportunities for Startups

For pre-revenue life science and biotech companies, R&D tax incentives can provide a much-needed source of capital and liquidity. The federal R&D tax credit is payable for eligible small businesses with no tax liability or that elect to apply credits toward payroll taxes. Many states also offer refundable or transferable R&D credits.

Qualified small businesses can claim up to $500,000 annually for up to five tax years under the federal payroll tax provision. Combine this with state credits and startup companies can receive millions in cash benefits simply for performing R&D. This influx of non-dilutive financing helps sustain operations, accelerate R&D timelines, and reduce future equity financing needs.

With annual R&D costs often reaching hundreds of millions of dollars, leaving R&D tax credits on the table is incredibly costly for life science companies. By carefully tracking all qualifying activities and expenses while leveraging specialized expertise, life science innovators can reap the full benefit of these generous innovation incentives. With so much at stake in the endless pursuit of new cures and treatments, maximizing R&D credits is an opportunity no company in this field can afford to miss.

Watch Out for These Issues

If you are considering using an R&D credit to offset payroll tax liability, you should be aware of some common pitfalls. First, taxpayers must make an annual election on their originally filed tax return (including extensions) to use the R&D credit against payroll tax.

Second, if a taxpayer belongs to a controlled group or a group under common control, the Qualified Small Business (QSB) rules must be met at the aggregated group level to qualify for the payroll tax offset. Taxpayers should carefully review all members of the group, as it may impact their eligibility for the payroll tax offset.

Third, unlike the regular credit rules, there is no exception for a de minimis amount of gross receipts. Even a small amount of income could make a taxpayer ineligible for the payroll tax offset. Gross receipts include various sources of income, such as sales, royalties, and interest. Taxpayers must consider all types of gross receipts when evaluating if they fall below the $5 million threshold.

Fourth, the taxpayer must file Form 8974 with their payroll tax returns to apply the R&D credit against their payroll taxes.

Lastly, if a taxpayer uses a Professional Employer Organization (PEO), they should coordinate with the PEO to claim the payroll tax credit. The PEO is usually responsible for filing the appropriate payroll forms on behalf of the taxpayer, including the amount of payroll tax credit elected by the taxpayer on their timely filed return that included Form 6765. The instructions for Form 8974 provide specific filing requirements for PEOs when their customers claim the payroll tax credit.