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Tax Incentives for Biotech and Medtech Startups

12/04/20 | 5 MIN READ

Federal & state tax incentives that biotech & medtech startups can take advantage of.

Any measure that can help a biotech or medtech startup to slow their burn rate is worth their attention. Tax deductions and credits are the government’s way of encouraging certain business activities and can assist companies in slowing their burn rate. The federal research and development tax credit, for example is a US government-sponsored method of saving a company money for specific activities. This credit rewards companies for doing their research and development within the United States. Prior to 2015, this credit was only applicable to companies that already had income. Now, pre-revenue companies such as biotech and medtech startups can take advantage of these tax credits too.

The federal government is not the only entity that offers tax incentives—states also offer tax incentives for startups, biotech, and medtech companies to conduct their activities in those locations. Life sciences companies tend to employ a range of salaried workers, from Ph.D. level scientists to skilled technicians to janitors, which make them attractive to governments as engines of economic development.

Read on to learn more about some of the common federal and state tax incentives that biotech and medtech startups may be able to take advantage of. This article should not be construed as professional tax advice. Seek the assistance of a qualified tax professional to understand how this information may apply to a specific business.

Federal Taxes

Startup Tax Deductions

Some of the costs associated with opening a business can be deducted by startups when they file their taxes. The federal government allows companies to deduct the costs for the following startup activities:

  1. Costs associated with creating or investigating the creation of a business can be deducted. This might include market research, finding a location, or researching the competition. It should be noted that this tax deduction only applies if the business is actually started.
  2. Costs incurred while preparing the business to open can sometimes be deducted. Equipment is not included in this, but employee training, consultant expenses, and advertising expenses generally are.
  3. Organizational costs, such as the fees paid for filing documentation related to the creation of a legal business entity can be deducted. These costs must be incurred during the first year of business.

Startups may take up to $5,000 in organizational costs and $5,000 in business startup costs, so long as the total cost to start the business is less than $50,000. If the cost is over that amount, the amount over is subtracted from the total that may be deducted.

Companies should be aware that these tax deductions only apply to activities prior to the business “opening.” For a retail establishment, this probably means anything prior to the grand opening, but for a biotech or medtech startup the “opening” may be more difficult to determine. The government considers a business to be “open” if it is performing the function for which it was created. Therefore, a biotech or medtech startup that is conducting business virtually is probably open, but if the only activities are fundraising related, that is probably not considered to be open.

Federal R&D Payroll Tax Credit

The Federal Government offers startup companies that are engaged in research and development a payroll tax credit. This credit is based on qualified R&D expenses and usually adds up to 8-10% of credit for every qualified dollar spent.

Only qualified small businesses can utilize this credit. The qualifications are that the company has less than $5 million in current or credit year gross receipts and that it hasn’t earned revenue for more than 5 years total. For biotech and medtech startups, these qualifications are usually easy to meet.

Qualified expenses include wages, costs for prototyping, costs for supplies, and research-related consulting fees. These costs have to be based in the U.S., meaning the work which these expenditures support must be conducted in the United States. For consulting and contractors, “A contract research expense equates to 65% of the wages paid to a contractor,” according to Titan Armor, a tax software.

The specifics of exactly which expenses are considered qualified can be complex, and generally require a CPA who specializes in these tax credits. For example, the wages of a biologist who is working on a research project are likely qualified expenses, but their supervisor’s wages are probably not. Administrative expenses are similarly not qualified.

The qualified expenses top out at $250,000 per year per company and can be claimed for up to 5 years.

California Tax Credits

California Research Tax Credit

The State of California offers a research tax credit that is based on the Federal R&D Payroll Tax Credit, but with some modifications. The California credit is similarly based upon qualified research expenses such as related wages, supplies, prototyping, etc., but the credit rates are different. The following are some of the differences between the federal and California tax credits:

  • The California credit rate is 15% as opposed to the Federal Government’s 20%
  • California does not have an Alternative Simplified Credit (ASC) method
  • California allows the Alternative Incremental Research Credit
  • The research must take place in California in order for it to qualify
  • This tax credit in California is a permanent research and development tax credit
  • While federal credits which can be carried back one year and carried forward twenty, unused California research credits can be carried forward indefinitely
  • Service-based companies in California use a different definition of gross receipts

California R&D Sales Tax Exemption

California also provides a sales tax exemption for equipment used in manufacturing and R&D. This exemption applies to companies doing R&D and/or manufacturing in the life sciences, physical sciences, and energy generation. The purchases that qualify include tangible personal property such as machinery, equipment, devices/equipment used to operate, control, maintain, or regulate other equipment, equipment used in pollution control, special purpose buildings, and more. This property must be used in “a qualified manner at least 50 percent of the time,” according to Miles Consulting Group. A qualified manner means R&D, manufacturing, maintaining equipment used in R&D and manufacturing, and more.

Tax Incentives in Other States

Many states utilize tax credits and deductions to entice companies to locate there. These incentives may be geared toward the specific industries an area wants to attract. As most states offer some kind of tax incentive for research and development, it would be exhaustive to list here. Luckily the Biotechnology Industry Organization (BIO) published a list including which states offer which types of credits and incentives. In some states, these tax incentives even include angel investors and investors in early stage investment funds. Please note, this information is from 2013-2014, so be sure to double check this information via each state’s tax board website. This document can be found here.

How to Take Advantage of Tax Incentives

The best advice for biotech and medtech startups to take advantage of federal and state tax credits and deductions is to work with a qualified CPA who has experience in this area. The process for filing to get credits can be complicated. Plus, taking tax credits can increase the likelihood that the IRS will decide to audit a company. Below find the steps involved in taking the Federal Payroll Tax Credit, as a broadly applicable example.

The steps to claim the Federal Payroll Tax Credit involves the following:

  1. The company must conduct a research and development tax credit study, in which an experienced CPA determines which activities are qualified expenses. The CPA that performs this study likely won’t be the same CPA that does the tax preparation, but it is still essential that both tasks be completed by CPAs. Qualified activities fulfill these requirements:
    1. The activity must be technological in nature, meaning it is related to physics, chemistry, biology, computer science, engineering, etc.; in other words, the “hard” sciences.
    2. The activity must be for a permitted purpose, which according to KBKG means “an attempt to improve the functionality, performance, reliability, or quality of a new or existing business component.” This does not include unstructured activities such as tinkering. The activity must be purposeful.
    3. The activity’s purpose must be to eliminate uncertainty in the technological development or improvement of a product. In conversations regarding funding, these activities are often referred to in terms of risk reduction.
    4. The activity must involve experimentation, including modeling, testing, simulating, or systematic trial and error. This experimentation must be documented in such a way that it shows the purposeful experimentation. (Thus, biotech and medtech companies’ research and development activities almost always fulfill this requirement.)
  2. The tax CPA will then take the results of the research and development tax credit study and use them to determine what can be claimed on the company’s annual tax return.
  3. With R&D payroll tax credits, the goal is for the company to pay less in payroll taxes. Therefore, the next step is for the company’s payroll department or provider to reduce those taxes. This should undertaken by payroll professionals who are experienced with these tax credits.

Another reason to employ an experienced CPA to determine a company’s tax credits is that some research and development expenses do not qualify, and they may not be obvious to someone new to R&D tax credits.

Expenses that do not qualify for the Federal payroll R&D tax credit include but are not limited to:

  1. Research that takes place after commercialization
  2. Adaptation of existing business components for use in a new product
  3. Duplication of existing business components
  4. Reverse engineering of an existing component or product
  5. Computer software for internal use
  6. Research that takes place outside the United States
  7. Research that eliminates uncertainty, involves experimentation, and is for a permitted purpose, but is in the social sciences, arts, humanities, etc.
  8. Research funded by government grants

Again, the best way to be sure your company is taking advantage of the right credits and doing so correctly is to work with a qualified, experienced CPA.

Complex, but Worthwhile

Tax incentives can sound like the type of thing that only large established companies take advantage of, but there are many that are designed specifically for startups, and specifically for biotech and medtech companies. Especially for companies that are strapped for cash, tax credits, deductions, and exemptions can be a great way to preserve hard-earned funding. It’s also a good way to demonstrate to investors that a young company is able to spend their investment wisely.

 

 

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