Developing new biotechnology products requires significant financial and human capital. The pace of discovery in this industry is extraordinary and the risk of failure is high. Securing financial backers early in the process is critical in order to meet the considerable equipment and infrastructure costs needed to launch product development efforts. Even if your company is fortunate enough to begin its research and development in earnest, the road to product viability is a long one. Technological setbacks, regulatory approvals, patent issues, clinical trials, and market demand are all headwinds that must be weathered in the early stages of a company’s life cycle.
Recognizing this daunting landscape, federal and state governments have designed numerous tax incentives to encourage biotech investment, both at the company level and at the investor levels. These benefits can help offset your tax liability, which could help you free up cash flow and maximize investment funds.
Credits for research and development (R&D) activities
R&D-related tax credits have long been available to companies to encourage technological advancement. However, many of these credits are based on income tax liability, which is not very valuable to biotech startups, since such companies often generate tax losses and therefore do not have income tax liability. Indeed, the likelihood of an early-stage biotech company turning a profit for tax purposes is exceedingly rare. However, early-stage companies with losses can now realize immediate cash tax savings at the federal level by using their R&D credits against their payroll taxes.
The federal R&D payroll credit
The federal R&D credit rewards companies that create and improve products involving technical uncertainty and a process of experimentation, and biotech companies are prime candidates for claiming this benefit. In general, the credit equals somewhere between 8% and 10% of credit benefit for every dollar of qualified expense. Qualified R&D expenses generally include wages, supply and prototype costs, and amounts paid to outside consultants for research-related services. However, these costs must be based in the U.S. — foreign costs do not qualify for the R&D credit.
The federal R&D credit was historically based on income tax. Recognizing the shortcomings of an income tax credit for a startup company generating tax losses, in 2016 Congress provided an entirely new means for capitalizing on the R&D credit. The legislation now allows startups to apply their R&D credits against federal payroll taxes on a quarterly basis. This benefit applies to “qualified small businesses,” which are companies that:
1. Have less than $5 million in current/credit year gross receipts, and
2. Have not been earning revenue for more than five years in total.
The amount that may be elected against payroll tax is capped at $250,000 per year and a company can claim the credit for up to five tax years. Thus, the maximum benefit a company can claim against payroll taxes in total is $1.25 million.
The payroll tax credit can mean substantial savings for biotech companies paying large amounts in payroll. The credit specifically offsets the employer’s portion of Social Security taxes (6.2%) beginning with the first quarter after the company’s federal income tax return is filed. Additionally, the credit carries forward to successive quarters (subject to an overall 20-year life) until fully exhausted.
Assume your company has $1.5 million in qualified R&D expenses for tax year 2019, resulting in a $150,000 credit. You file your 2019 corporate income tax return on March 15, 2020. Assume further that your payroll beginning in 2020 is $250,000 per quarter, resulting in $15,500 of quarterly employer-paid Social Security taxes. Beginning in the second quarter of 2020, your R&D credit would start offsetting the $15,500 of employer payroll taxes. Thus, after the second quarter, your credit remaining would be $134,500, which would carry over to offset your third quarter payroll taxes. This carryover would continue until the credit is fully exhausted.
While the payroll tax offset election has created new opportunities for startups, there could still be value in having the R&D credit available for income tax purposes. This is so because unused credits carry forward up to 20 years and could be available to offset tax upon the sale of the company at a future date. This should be a careful analysis, however, since there could be limitations upon the future utilization of the credit.
Refundable state R&D tax credits
The majority of states now offer R&D credits; however, most of these state-level credits are based strictly on income tax liability and, therefore, offer no immediate benefit for a startup generating losses (although most states provide generous carryforward periods for future use against income taxes). There are some states, though, that offer refundable credits, which translate into cash. For example, Arizona, Iowa, and Virginia all offer refundable credits for in-state R&D activities and costs.
Massachusetts, which has long been a hub for biotech, offers a host of tax benefits through its Life Sciences Investment Program and the Life Sciences Tax Incentive Program. Under the tax incentive program, several refundable credits are offered, including an R&D credit, an investment tax credit for the acquisition or construction of qualifying property, and a credit for user fees paid to the Food and Drug Administration.
Other state R&D incentives
Sales tax exemptions
Many states provide full or partial sales tax exemptions for purchasing equipment or other tangible personal property used in manufacturing or R&D operations. For example, New York state exempts purchases of tangible personal property for the use or consumption “directly and predominantly” in R&D in the experimental or laboratory sense. R&D “in the experimental or laboratory sense” means research that has as its ultimate goal:
- Basic research in a scientific or technical field of endeavor;
- Advancing the technology in a scientific or technical field of endeavor;
- Development of new products;
- Improvement of existing products; or
- Development of new uses for existing products.
California also partially exempts equipment used in R&D activities. This is done through a sales tax rate reduction of 3.9375% (California’s sales tax rate is generally 7.25%). A number of other states also offer some form of manufacturing or R&D-related exemption, including biotech-centric states such as Washington, Texas, New Jersey, North Carolina, and Arizona.
Angel investor credits
In an effort to encourage investment in technology startups, several states have enacted angel investor credits, which may be refundable to the investor. New Jersey, for example, offers a robust credit through its Angel Investor Tax Credit Program, administered by its Economic Development Authority. The credit, which may be refundable, is available to investors in an emerging technology business (which includes biotech) in New Jersey that:
- Employs fewer than 225 full-time employees, at least 75% of whom work in New Jersey;
- Does business, employs or owns capital or property, or maintains an office in New Jersey; and
- Incurs qualified research expenses in New Jersey, conducts pilot scale manufacturing in New Jersey, or commercializes an eligible technology in New Jersey.
Maryland’s Biotechnology Investment Incentive Tax Credit is encouraging seed capital by providing investors with income tax credits equal to 50% of their investment in a Qualified Maryland Biotechnology Company (QMBC). A QMBC is company that:
1. Has its headquarters and base of operations in Maryland;
2. Has fewer than 50 employees;
3. Is in active business no longer than 12 years; and
4. Is certified by the Maryland Department of Commerce as a QMBC.
New Mexico also encourages early-stage investment with its angel investor credit. Qualified investors may take a maximum tax credit up to $62,500 for an investment made in New Mexico companies that are engaging in qualified research (as defined by the Internal Revenue Code) or manufacturing. While the credit is nonrefundable, any portion remaining unused at the end of a taxable year may be carried forward for five consecutive years.
State tax laws are always changing, so be sure to consult with your tax adviser before applying for or claiming any state tax credit or incentive.
How CLA can help
While the cost of launching a biotech company is significant, there are numerous tax incentives to help encourage investment and defray costs. CLA’s national team of R&D credit practitioners and state and local tax professionals can help you determine the tax incentives available to your company and work with you to claim and support those incentives.
To discuss how your business can benefit from these opportunities, please contact one of our practice leaders: