Understanding How New IRS Rules Can Impact Your SBIR/STTR Award and R&D Expenses

March 29 | insights

Every April, early-stage companies with Small Business Innovation Research and Small Business Tech Transfer (SBIR/STTR) awards face a daunting task: understanding the tax implications of their research and development funding.

To help entrepreneurs make the most of their awards and stay ahead of recent changes in tax law, The Corridor hosted Lynn Mucenski-Keck, National Lead for Federal Tax Policy at Withum, for a webinar about tax laws affecting small and innovative businesses receiving SBIR/STTR funds. Mucenski-Keck monitors and provides commentary on federal tax policy for Withum clients. She has also appeared in front of the House of Representatives Committee on Small Business.

Mucenski-Keck provided insights on the tax implications of research and development spending. Recent changes and new proposals have made it even more important for entrepreneurs to understand their funding, where it came from, what it was used for, and how that will affect their taxes come April 15.

Section 174: Research & Experimental Development

Section 174 is the primary part of the tax code that addresses what is called “research and experimental development” (R&D) and was the focus of Mucenski-Keck’s presentation. Section 174 was designed to help grow innovation by allowing companies to deduct R&D expenses in the year they were incurred. The section defines who is eligible to receive an R&D deduction and what items are deductible under the R&D guideline. While it is a useful tool for small businesses to consider this year, Section 174 is constantly changing, so it is important to understand its current definition, shortcomings and anticipated changes before applying it to your business tax return.

Criteria for Qualifying R&D Deductions

To qualify for the Section 174 R&D deduction, projects must meet four criteria:

  1. Serve a business purpose, or serve to benefit your business, like the development of a new product or the streamlining of a process.
  2. Be technological in nature or based on hard science.
  3. Eliminate uncertainty or be used to discover new information to improve a product or process.
  4. Involve the process of experimentation, or the systematic evaluation of multiple options to eliminate uncertainty.

Identifying Section 174 R&D Expenses Eligible for Deduction

Any salaries, supplies, research, overhead expenses or patent costs associated with an R&D project are tax deductible through Section 174. Mucenski-Keck also advises companies to identify less obvious costs that could affect your R&D tax burden, like employee benefits and retirement contributions.

On the other hand, some expenses associated with your research are not deductible, such as costs for land and depreciable property. Costs endured after R&D has been conducted, like market research and commercialization, are also excluded.

Assessing Business Eligibility for Section 174 Deductions

Businesses of all shapes and sizes can qualify for deductions via Section 174, as long as your research meets the qualifications set out in the tax code. Corporations and LLCs use the same methodology for determining, capitalizing and paying using Section 174, but the tax rate can be different between the two ownership models.

Maintaining the Required Documentation

Documentation is crucial for tax filing. It is recommended to keep all documents pertaining to your R&D. This includes payroll records, receipts, contracts, research plans, patent paperwork and even meeting notes.

Section 174 Deduction Limitations

Research and development expenses have always been eligible for tax deduction, however, recent changes have forced businesses to capitalize their deductions or spread them across several years (five years for domestic research).

Previously, if you secured a $1 million SBIR award and spent that $1 million within the year, you could claim the entire $1 million as a deduction. Under the current format, however, you can only claim $200,000 as a deduction, while the other $800,000 would be calculated as taxable income.

Recent discussions have included removing the capitalization requirement of Section 174, retroactively effective to 2022. The U.S. House of Representatives has progressed this bill, while the U.S. Senate has yet to take up the proposal. Removing the capitalization requirement would benefit businesses that earn awards or grants for R&D and help them avoid unforeseen income tax liability.

Combining Section 174 With Other Tax Incentives or Credits

The Research and Development Tax Credit is for domestic expenses that are used to develop or improve products, processes, formulas, techniques or software, and can help small businesses lower their tax liability. To be eligible for the tax credit, you must meet the same R&D requirements of Section 174. The total amount of your credit is calculated based on those expenses, which can include salaries, contracts and expenses. Section 174 and the R&D Tax credit can be used in concert with each other, but the R&D Tax Credit is not available when funding was provided through some government contracts.

For more information, see form 6765 – Credit for Increasing Research Activities. Instructions for completing that form are available here.

Section 174 Alternative: Section 162

Section 162 also addresses R&D-related business expenses, including “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”

To qualify for deductions under Section 162, your business must not bear any financial risk for the research; you must receive funding whether the project succeeds or not. Most SBIR/STTR awards qualify under this stipulation.

Additionally, you can only “maintain an excluded product right.” This means it does not retain full ownership over any technology developed as part of the project. This would apply if you either bargained with a contractor for the research or if continued use of the innovation is contingent upon a relationship with the original contractor. If the related R&D meets both these requirements, it is 100% tax deductible under Section 162.

Seeking Business Tax Support

Tax codes and credits surrounding R&D income and expenses are complex, guidance around R&D taxation is dynamic, and negotiations at a federal level can create confusion. It is always advisable to consult with your legal team or a certified tax accountant before filing your taxes.

The Florida High Tech Corridor’s Cenfluence and SBIR/STTR program teams can help you identify an accountant familiar with tax filing for R&D businesses. Contact us for help.