The Tax Cuts and Jobs Act (TCJA), passed in December 2017 made significant changes to Internal Revenue Code (IRC) Section 174 – Amortization of Research & Experimental Expenditures.
The effect of this change to IRC Section 174 can be devastating to the cash flow of a small business that invests in R&D including most SBIR/STTR-funded companies.
R&D costs were previously considered an ordinary business expense, immediately deductible for tax purposes. The TCJA completely eliminated the ability to currently deduct R&E expenses. Instead, taxpayers must now capitalize and amortize these costs – typically over a 5-year period. This change went into effect for taxable years beginning after December 31, 2021, and small companies are now seeing large tax bills for 2022.
To make matters worse, Congress has discussed and acknowledged the issue, but failed to codify its intentions. In this blog, we will explore the issues and give you our non-authoritative thoughts on the matter.
Who Will This Affect? Section 41 QRE Considerations
The TCJA included a conforming amendment to Section 41 to align with Section 174. In our opinion, this effectively ties Section 41 (the calculation of the R&D credit) to Section 174.
Under Section 41, taxpayers are permitted to include certain R&D costs as QREs. However, there are several types of expenses that were carved out that specifically do not qualify for the R&D credit – critically, exclusions for funded research.
From the IRS’s Audit Techniques Guide: https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-i-e-research-tax-credit-irc-41-qualified-research-activities
Exclusion for Funded Research
The exclusion for “funded research” under section 41(d)(4)(H) provides that the credit shall not be available for qualified research to the extent funded by a contract, grant, or otherwise by another person (or governmental entity).
All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons are to be considered in determining the extent to which the research is funded. As a result, the examiner should request a complete copy of all contracts (including modifications), agreements, letters of understanding or similar documents where funding is an issue. These contracts and similar documents will need to be reviewed to determine whether, and to what, extent the research is to be considered funded. A “fixed-price” contract, where the customer agrees to pay a set price for a deliverable, and a “cost-plus” contract, where the customer agrees to pay the actual costs incurred by the contractor in acquiring/constructing the deliverable plus an additional amount for profit, are examples of the different contracts you may encounter. Counsel can be helpful in securing and interpreting these agreements. In the case of documents that are “classified” by a government agency, contact the Classified Contract Technical Advisor or a Research Credit Technical Advisor for further assistance.
In order to determine if the contractor’s research expenditures are “funded”, you must resolve the following issues:
- Is payment for the contractor’s research activities “contingent upon the success of the research” under Treasury Regulation section 1.41-4A(d)(1)?
- Does the contractor retain “substantial rights” in the results of the research activities within the meaning of Treasury Regulation section 1.41-4A(d)(2)?
If the answer to either question is no, then the research is treated as funded.
This leads us to believe that cost-reimbursable type SBIR/STTR funded awards will generally not be subject to the devastating effects of Section 174, though there can be exceptions where the company faces financial risk, and this is not specifically spelled out in any regulations. We have had dozens of conversations with our client’s tax preparers, and most reasonable CPAs agree that without risk of payment tied to risk of performance, a government-funded award is merely “fee for services.”
But where does that leave DOD and NASA SBIR/STTR awards – which are often fixed price-type (FFP) funding vehicles?
Example Shows a 17.5% Initial Negative Cash Flow
Kevin Burns, the CEO of Precision Combustion, Inc. and the Co-Chair of SBTC.org https://sbtc.org/about-us/who-we-are/ took a crack at the cash flow effects on a Phase II FFP which would be subject to R&E expenses being deferred. Kevin assumed a 10% capital amortization in year one, then 20% for each of the next four years, then 10% sixth year. He assumed a 25% combined state and federal tax rate, and it calculated that the deferral will drive cash flow negative by 17.5% by the end of year two. So, in addition to working capital and other capital expenditures, this tax change would require an SBIR company winning a $1 million two-year Phase II award to come up with an added $175,000 in taxes by the end of year two. This is a huge barrier for a small company!
Kevin acknowledged the counterargument that the company may lose cash to the deferral but will be able to claim the R&D tax credit, which can be worth 6-8% of FUTURE corporate earnings. However, that requires the company to make it to profitability.
Companies fail because they run out of cash, and this deferral will cause more companies to run out of cash, or simply not be able to afford to participate in the SBIR program because of the imposed tax burden.
Congress wants to incentivize small business innovation to continue to propel our country, and it knows that small SBIR-funded businesses don’t have the cash that larger ones do. There should be a way to tailor an exception for the SBIR program, so it doesn’t bankrupt these early-stage government-funded companies.
Please add your name to the National Small Business Technology Council letter to Congress. This is a simple, effective way to take action!
Ed Jameson, CPA