Optimizing Tax Credits for Life Science & Biotechnology Companies
By Christopher Abad, Director, Tax & Business Services
Companies in the Life Science & Biotechnology space are at the center of innovation. Innovation requires research, which stimulates job growth and capital investment. Due to its positive economic impact, Congress and 36 state governments incentivize research to be performed within the U.S., offering tax credits which may offset tax liability and, in some cases, generate refund opportunities.
The Research and Development (R&D) tax credit and Orphan Drug Credit (ODC) are two excellent tax planning opportunities for businesses to substantially reduce tax liability. For what amounts to regular business activity, biotechnology and life science companies can qualify for substantial federal and state tax savings, helping fund the hiring of new employees, investments in new products and service lines, and growing existing operations.
FEDERAL AND STATE RESEARCH AND DEVELOPMENT TAX CREDITS
The federal R&D Credit was created in 1981 to keep technical jobs in the U.S. by rewarding companies for conducting R&D domestically. The credit is fairly robust as it applies to businesses of all sizes and is not limited to major corporations with research labs. Many states have significant credit opportunities too, which follow the federal program in qualifying activities but have unique computational and application methodologies.
The research credit applies to a broad range of life science/biotechnology activities. If a company does any of the following, it likely qualifies for the R&D credit:
- Development/design of new products or processes;
- Development/design of new manufacturing processes;
- Enhancement of existing products or processes;
- Development of prototypes and software;
- Clinical trials;
- New product manufacturing trials;
- Development of technology to comply with regulatory agencies; and
- Core R&D direct support activities.
In order to claim the credit, a life science/biotechnology company must contemporaneously document its research activities to establish the amount of qualified research expenses paid for each qualified research activity. It is permissible to estimate some expenses, but taxpayers must have a factual basis for the assumptions used to create the estimates. Some examples of pertinent documentation include:
- Payroll records;
- General ledger expense details;
- Clinical trial documents;
- Project lists; and
- Project notes.
FEDERAL RESEARCH AND DEVELOPMENT TAX CREDIT – PAYROLL
The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) permanently extended many expiring tax laws, including the R&D credit. The PATH Act allows startup businesses with no federal tax liability and gross receipts of less than $5 million to take the R&D tax credit against their payroll taxes (employer-paid FICA – 6.2%) for tax years beginning in 2016, essentially making it a refundable credit capped at $250,000 for up to five years.
To offset the FICA portion of payroll tax, a qualified small business (QSB) is defined as a business with less than $5 million in annual gross receipts and having gross receipts for no more than five years (for 2020; not available to companies with gross receipts prior to 2016). The election to offset payroll taxes must be made on a timely filed income tax or informational return, including extensions. In the case of a QSB that is a partnership or S corporation, the election must be made at the entity level. For corporations and partnerships, the gross receipts and the credit limitation apply on a controlled group basis.
ORPHAN DRUG CREDITS
The Orphan Drug Credit Act was adopted in 1983 and gives drug companies incentives to develop treatments for rare diseases. The Act has led to approvals for more than 780 products to treat in excess of 250 rare diseases. Half of the approved treatments are for cancer.
To be eligible for the ODC, a life science/biotechnology company must receive the orphan drug designation by the U.S. Food and Drug Administration. This means the company is developing a treatment for either:
- A rare disease that affects less than 200,00 persons in the U.S., or
- A disease affecting over 200,000 persons in the U.S. but for which there is no reasonable expectation that the cost of developing and making available a drug for such disease will be recovered from sales in the U.S.
The ODC applies to medications and treatments for rare diseases that affect small populations. As originally established, the credit was for 50% of qualified clinical testing expenses. However, with the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, the ODC credit was reduced from 50% to 25%, beginning in 2018. Other incentives include a rebate on application fees and a seven-year window of drug exclusivity. The ODC may be claimed whether the company performs clinical tests itself or contracts out to a third party.
The qualification requirements for the ODC are similar to traditional R&D credits, as both seek to incentivize research activities that address technical uncertainty through iterative experimentation efforts. However, both credits must be separately calculated, and there are some key nuances to understand.
Typically, eligible companies see better return on their clinical testing expenses (CTE) under the ODC regime than with the R&D credits for qualified research expenses (QRE). While the federal gross R&D credit typically results in a tax credit of 10% of QRE, the ODC provides a rate of 25% of CTE. Another distinction is that the ODC allows for 100% of qualified contractor expenses to be included as CTE, while the R&D credit caps at 65% the amount of these costs includible as QRE. Also, in most cases testing must take place in the U.S., but CTE activity outside the U.S. can uniquely qualify for the ODC.
It is possible to claim both credits in the same tax year. However, a company cannot receive both credits on the same expenses. Because it is possible for many expenses to qualify for both credits, proper cost allocation is necessary to minimize overall tax liability. As with the R&D credit, proper documentation of the qualified nature of expenses is key in the event of an IRS examination.
Marcum will continue to keep you updated about further developments with respect to Tax Credits & Incentives. Contact your Marcum professional for questions and assistance in optimizing life sciences and biotechnology tax credits for your company.