R&D Expenditures for Early Stage and Life Science Start-ups

Could your startup benefit from research and development (R&D) tax credits? Have you explored whether or not you qualify? Are you prepared to navigate tax strategies that could ease financial pressures on innovation? For early-stage and life science startups, R&D drives progress and lays the foundation for growth. However, recent changes to tax law—specifically Section 174 of the Tax Cuts and Jobs Act (TCJA)—have introduced new complexities. These updates affect how R&D expenses are treated for tax purposes, often creating unexpected financial challenges for emerging businesses.

What is Section 174?

Section 174, which went into effect in 2022, requires that R&D expenses be capitalized and amortized across five years for domestic costs and 15 years for foreign costs as opposed to being fully deductible in the year incurred. This change affects a wide range of expenses, including lab equipment, supplies, and overhead, which may strain cash flow for startups already managing limited resources. For early-stage start-ups and life science firms, this rule is particularly significant as it affects substantial investments in research equipment, lab supplies, physical space, refrigeration, and other critical resources needed for scientific innovation. By understanding these changes and planning effectively, businesses can address these challenges and potentially reduce the financial burden on their path to innovation.

How 174 Differs from R&D Tax Credits

While Section 174 is a major change, it does not alter the availability of the R&D tax credit, which remains an important tool for reducing tax liability. The R&D tax credit offers a dollar-for-dollar reduction against taxes owed based on eligible expenses like labor, supplies, and contract research. These expenses must meet certain criteria to qualify for the credit, making it a powerful way to reduce your tax burden. For eligible businesses, the R&D credit may also be applied against payroll tax if certain requirements are met, providing an additional avenue for early-stage companies to realize benefits.

Though the tax credit remains, the relationship between Section 174 and the R&D tax credit is important. This is because a business cannot claim the R&D tax credit without including expenses that fall under Section 174. This creates a complex intersection between the two provisions, requiring precise accounting along with the right strategy to maximize benefits. While Section 174 may increase the tax burden, the R&D tax credit can help in offsetting it and potentially reduce your overall tax liability.

What Does This Mean for the Life Sciences?

This shift can be particularly challenging for startups or smaller firms relying on immediate deductions to cut costs. The new rules may affect your financial position by limiting short-term deductions and altering cash flow projections. As a result, life science clients must be proactive in developing tax strategies to manage changes effectively.

Planning Opportunities to Mitigate the Impact

At AAFCPAs, we understand the specific challenges early-stage start-ups and life science firms face including the need to optimize credits and incentives. While Section 174 is here for now, there are strategies you may implement to help mitigate its effects. This might include more effective allocation methods for R&D expenses. AAFCPAs understands the nuances of both R&D tax credits and the 174 provisions and can help you identify opportunities to optimize your tax strategy and reduce your financial burden.

Maximizing the R&D tax credit alongside new rules may help in offsetting some of the impacts of capitalizing R&D expenses. Through careful planning and the right allocations, you can still benefit from the R&D tax credit while complying with the new tax requirements. It is important to find the right balance to ensure your business remains financially sound during this period of transition.

If you have questions, please contact Bella Amigud, CPA, MST, Tax Partner at 774.512.4060 or bamigud@nullaafcpa.com—or your AAFCPAs Partner.