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You didn’t found your company because you always dreamed of navigating a constantly shifting tax landscape—but that doesn’t mean you get to ignore it. So, here’s an R&D Capitalization cheatsheet from your tax wonk friends at Neo.Tax.…
Fair question! Capitalization can be understood as a limitation on the timing in which you can take a deduction. There are two different subgroups of capitalization: depreciation (for physical assets) and amortization (for intangible assets). For this post, we only need to worry about amortization.
In its simplest form, a deduction can be thought of as an expense that is subtracted from taxable income. So, if you made $10 mil in revenue and spent $5 mil on R&D, deducting that amount would make your taxable income $5 mil ($10,000,000 minus $5,000,000).
But under the new R&D capitalization rules, the amendment means the deduction must be amortized, or in simpler terms, spread over 5 or 15 years, depending if the expense is domestic or international, respectively. That means only one-fifth or one-fifteenth of the R&D expenses can be subtracted from the taxable income that first year. So, if your company’s R&D occurred in the States, the equation becomes $10 mil minus $1 mil; if it’s done abroad, the equation becomes $10 mil minus $333,333.33. Eventually, over the 5 or 15 years, you will technically be able to deduct the same amount as before, but this obviously increases your tax bill in the near term by quite a bit.
Unfortunately, the amortization amendment hits pre-revenue or early-revenue startups especially hard. Up until now, pre-profit companies used to stack Net Operating Loss deductions up year over year. But the new law changes that, too: from now on, you can only use 80% of your NOLs to offset your taxable income. And, because of the amortization changes to R&D, the amount of NOLs you’re able to claim in those pre-revenue or early-revenue years is very likely to plummet. (More on this in a moment.)
So, let’s say you bring in $5 million in revenue and spend $10 million in R&D expenses. Only $2 million can be deducted in Year 1, which means you’re paying taxes on $3 million, when you’re actually $5 million in the red. Your tax bill is higher, more of your R&D tax credit goes towards offsetting that bill, and you’ve collected $0 NOL for the moment you actually do become profitable. So, you can see how this amendment significantly disincentivizes the companies doing the most innovative work in the United States from spending on R&D.
An NOL or Net Operating Loss means how much in the red you are in a given tax year. So, if your startup is pre-revenue or early-revenue, every dollar you spend on payroll, marketing, R&D, or rent over the amount brought in via sales would be counted as an NOL.
NOLs are a valuable deferred tax asset for startups because they can be rolled over year to year and eventually used to offset taxable income when you become profitable. For example, if you were in the red by $400,000 in Year 1, $250,000 in Year 2, $150,000 in Year 3, before making $1,000,000 in profit in Year 4, you could subtract $800,000 from your taxable income. Thus, you’d pay the 21% corporate tax rate on $200,000 rather than on $1,000,000—that’s $42,000 rather than $210,000 in taxes.
But, the R&D Capitalization amendment will greatly reduce the amount of NOLs for startups. Why? Good question!
When startups have to amortize their R&D expenses, that means the amount they can deduct from income in that first year is only one-fifth or one-fifteenth (depending on if they’re spent in the States or abroad) of the total amount they spend. So, if you were $400,000 in the red in Year 1 and $100,000 of that was United States-based R&D spend, only $20,000 could be counted in Year 1. The result is $80,000 less in Year 1 NOLs. By the time you are able to deduct all the expenses, chances are you’ll be profitable—that means a once-valuable tool for pre-revenue or early-revenue startups has been kneecapped by the new law.
And if your R&D spend is on foreign contractors? Good luck taking advantage of the majority of those NOLs!
Well, here’s the reality: R&D expenses that qualify for the R&D Tax Credit have never been more valuable in this brave new world. That’s because those R&D costs can continue to be claimed in the current tax year against income taxes or payroll taxes—not the taxable income. In other words, your R&D credit gets applied after you apply the corporate tax rate of 21%, not before.
This means that your R&D credit is roughly 6x more valuable than an NOL. (Remember, only 80% of the NOL can now be applied.) So the key now is to maximize your R&D expenditures that qualify (certain US-Based R&D expenditures that meet the Four-Part Test: Permitted Purpose; Elimination of Uncertainty; Process of Experimentation; Technological in Nature) while minimizing those that don’t.
As we’ve discussed before, the R&D Credit was passed during the Reagan Administration as part of the Economic Recovery Tax Act of 1981 (ERTA). The most relevant change for tech companies was the creation of the “Credit For Increasing Research Activities” (R&D Tax Credit), which amended IRC §41 to allow qualified expenses to be claimed as a tax credit. The law was drafted to incentivize innovation within the United States, and the amendment allowed companies to claim 20% of expenses like salaries, research expenses, and some other expenses as credits.
For the first three decades, the R&D credit could only be claimed as a dollar-for-dollar offset of the federal income tax, which meant it was only being used by profitable companies. (A majority was claimed by Fortune 500 corporations.) But that meant that the most innovative companies in the country—tech startups—weren’t able to file for the credit. That changed with the passage of the Protecting Americans from Tax Hikes Act (PATH Act) in 2015: now, pre-revenue startups can claim the R&D credit against payroll taxes for up to 5 years.
In 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), which did not affect IRC §41. It did, however, amend IRC §174, which more broadly covers all R&D expenses (both those that pass the 4-part test and those that do not). Because of that amendment, it has now become extremely important to maximize qualified R&D expenditures while minimizing those that don’t pass the Four-Part Test. The ones that don’t will have to be deducted over 5 or 15 years and won’t be eligible for a tax credit—which we now understand means a massive accounting headache and an extremely painful tax bill.
The graph is essential to memorize in this new R&D tax reality. Now, say it with us: “IRC §41 expenses good; IRC §174 bad.”
So, now you know what amortization means, the new implications when it comes to NOLs, and the difference between IRC §41 and IRC §174. I hope you’ve enjoyed R&D Tax Capitalization 101. The biggest takeaway is that this change hurts startups, but savvy founders can still make the R&D Tax Credit work for them—so long as they’re mindful of how their R&D spend fits into a holistic tax strategy. That strategy has to take into account several factors: NOLs, qualified vs. non-qualified R&D expenses, and your business’s future plans for revenue and profitability.
So, be mindful of where your R&D spending is happening. And, hey, if you’re looking to get the most money back and spend the least time doing it, we might just know of an automated R&D tax service that’s right for you! 😉