Unexpected Tax Bills Hindering Innovation for SBIR Grant Recipients

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced significant changes to the treatment of research and experimental (R&E) expenses for tax purposes. Under the new rules, which took effect in 2022, taxpayers are no longer allowed to deduct R&E expenses. Instead, they are required to capitalize and amortize these expenses over a period of five years (or 15 years if the expenses are attributable to foreign research).

Development stage companies that receive Small Business Innovation Research (SBIR) grants can be significantly impacted by this change in tax law. SBIR grants are competitive programs that provide funding to small businesses in the U.S. to conduct R&E on innovative technologies or processes. SBIR grant recipients should know that grant funds are generally considered taxable income. Thus, they must report their SBIR grant income on their tax returns and pay any applicable federal, state and local taxes.

Additionally, SBIR grant funds must be used for R&E activities related to the specific project described in the grant proposal. They cannot be used for general business expenses not directly related to the research and development of the proposed technology or process, including federal taxes.

Let’s say Company X received an SBIR grant of $150,000 to perform R&E on an innovative product. Company X spends the full $150,000 on approved R&E costs resulting in a net income of $0. However, once Section 174’s new R&E capitalization rules are applied, only $15,000 of the $150,000 in expenditures are tax-deductible in the current tax year. The resulting net taxable income is $135,000, and the federal tax owed is $28,350. Even if Company X did not spend the entire $150,000, they could not use the remaining SBIR funds to pay the tax bill.

Prior to 2022, net taxable income would have been $0 (generally speaking, to keep this simple), and the federal tax bill would have been $0. The new R&E capitalization rules contradict and hinder the government’s goal of stimulating technology and innovation via the SBIR program. Without proper planning and management of SBIR funds, many startups may be forced out of business due to unexpected tax bills.

Looking forward, as the remaining capitalized R&E expenses are amortized, and no additional revenue or taxable grants are received, Company X generates losses, and these losses cannot offset the year one tax bill in the example above. The Tax Cuts and Jobs Act of 2017 eliminated the ability to carry-back net operating losses (NOLs), creating a permanent tax liability for Company X, and implementing yet another roadblock to furthering innovation and technological advancement throughout the U.S.

What if Company X had an NOL carry-forward from the prior year totaling $300,000? Again, the Tax Cuts and Job Act of 2017 limited the utilization of NOL’s generated after 2017 to 80% of taxable income. In our example, Company X could only use $108,000 (80% of the $135,000 taxable income) of the $300,000 NOL, bringing company X taxable income from $135,000 to $27,000.

To navigate the capitalization rules and recommend strategies to mitigate these “phantom” federal tax liabilities, we recommend working with a tax professional who can help you explore opportunities that will enable your business to continue to innovate and thrive in the face of R&E capitalization requirements.

Please note: This article was authored under the current federal tax law in-effect as of May 2, 2023 and was originally published in MassCPA Magazine in July 2023.