Through advancements in technology, collaboration, and continual research, development, and discovery efforts, the life sciences industry pushes the boundaries of innovation at a rapid rate. This innovation drives research and development (R&D) and stimulates economic growth.
Life science companies have opportunities to claim R&D tax credits and orphan drug tax credits (ODC) to reduce certain tax liabilities. However, these benefits come with varying rules, applications, and qualification criteria that a company must meet to be eligible.
Furthermore, there are potential risks associated with claiming these tax credits that require proper documentation and substantiation to support the qualified research expenses claimed as part of these tax credits.
This article will:
- Introduce components of the R&D tax credit and ODC
- Provide updates to recent guidance that impacts the determination of qualified research expenses that are a key element of the tax credits
- Provide insight into the IRS’s audit guidelines for life science companies
Available Credits
The R&D tax credit is available to life sciences companies that develop new pharmaceuticals, biologics, devices, diagnostics, delivery systems, and any other new products, processes, techniques, formulas, or inventions that result in new or improved functionality, performance, reliability, or quality.
The credit is available at the federal and state level, with over 30 states offering a credit to offset state tax liability.
R&D Payroll Tax Credit
Qualified small businesses may be eligible to apply up to $250,000 of the R&D tax credit against their payroll taxes for up to five years.
The following qualification criteria apply:
- The company must generate less than $5 million in worldwide gross receipts during the current tax year
- The company can’t have any gross receipts before the five-year period ending with the current tax year—interest income counts toward gross receipts
For answers to common questions about the R&D tax credit, please see our article How the R&D Credit Can Help New Companies Offset Payroll Taxes.
Read our article for help to Avoid Delays and Added Costs when Claiming the R&D Payroll Tax Credit.
Orphan Drug Tax Credit
The ODC is a federal tax credit available to pharmaceutical companies working to find cures for certain rare diseases that affect small populations.
Much like the traditional R&D tax credit, the ODC provides pharmaceutical companies an opportunity to increase cash flow and reduce the cost of their development operations. The ODC is generally more generous than the traditional research credit.
Eligible pharmaceutical companies have potential for higher tax credits on their orphan drug clinical testing expenses, which provides a tax credit of 25% of such expenses, as opposed to the non-ODC credit that utilizes a lower R&D credit percentage.
It’s crucial to understand the different qualification requirements between the ODC and non-ODC R&D tax credits to substantiate the credit claim. To learn more about eligibility for the ODC and how much your company could potentially save, please see How Companies Can Claim the Orphan Drug Credit.
Learn more in our article on Key Differences Between the ODC and the R&D Tax Credit.
Should You Expense or Capitalize R&D Expenditures?
Prior to 2022, IRC Section 174 provides taxpayers with the option to either deduct R&D expenditures immediately or defer the expenses and amortize the costs over time—five years or longer. This gives companies the flexibility to deduct expenses in the current period if it’s more beneficial to offset taxable income.
Under existing law set forth in the 2017 tax reform law, commonly referred to as the Tax Cuts and Jobs Act (TCJA), companies will no longer be able to immediately deduct costs that are treated as IRC Section 174 research expenses starting in 2022.
Instead, they’ll be required to charge US-based research expenses to a capital account and deduct them over a five-year period. Expenses incurred for research performed outside of the United States will be charged to a capital account and deducted over a 15-year period.
With some tax planning, companies might want to consider bringing offshore R&D spending to the United States to capitalize and amortize R&D expense over five years rather than 15 years.
Pharmaceutical Industry Research Credit Audit Guidelines
The IRS has an Audit Techniques Guide for IRS agents and managers examining the R&D tax credit claimed by taxpayers in the pharmaceutical industry.
In the guide, four stages compose the product development life cycle:
- Preclinical and Discovery Research
- Clinical Development
- Regulatory Review
- Post-Marketing
Each development stage is generally categorized as low-risk, medium-risk, or high-risk with a range of considerations reviewed by IRS agents. Taxpayers should be prepared to demonstrate how their research costs are allocated to each of these stages and understand the specific risk considerations outlined by the IRS.
Directive Methodology
With respect to the R&D Tax Credit, the IRS issued a Directive for Large Business & International (LB&I) examiners with guidance to help determine qualified research expenses in an efficient manner.
An original Directive issued in September 2017 provided a safe harbor for determining qualified research expenses; however, a revised and clarified Directive issued in September 2020 outlined additional processes and eliminated the safe harbor protections.
The Directive methodology isn’t an official pronouncement of law. It’s intended to provide an efficient methodology for determining qualified research expenses (QREs) for LB&I taxpayers that meet the requirements of this Directive and to more efficiently manage LB&I's audit resources.
Taxpayers who use the Directive methodology to determine their QREs must follow US Generally Accepted Accounting Procedures (GAAP) and disclose the total R&D costs charged to expense in the income statement or a separately stated note within the Certified Audited Financial Statements as a starting point with guidance on specific expenses that may or may not be included.
Additional Resources
We have an abundance of resources related to the R&D tax credit. Please see our R&D Tax Credits Services page and the articles below:
- R&D Tax Credits: How to Navigate the Claims Process Step by Step
- 5 Common Misconceptions about the R&D Tax Credit—and Whether You Qualify
- 3 Key Attributes to Look for in an R&D Tax Credit Service Provider
- A Closer Look at R&D Tax Credits for Technology Companies
- How Software Companies Can Claim R&D Credits
In addition to the articles, please see our Guide to Claiming the Federal R&D Tax Credit.
We’re Here to Help
If you have any questions about claiming either the R&D tax credit or the ODC, please contact your Moss Adams professional.