Tax Strategy for Startups: A Guide to R&D Capitalization

  • Accracy
  • 26th Nov, 2023

A version of this article originally appeared at Neo.Tax

Tax Strategy for Startups: A Guide to R&D Capitalization
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There was hope that legislators could overturn this costly tax law before the 2023 tax year (and even pass a law that would undo the effect on the 2022 tax year), but Congress was unable to strike a deal. So, for the foreseeable future, R&D Capitalization is here to stay.

How R&D is taxed has changed and it impacts startups

Capitalizing R&D is the process a business will use to classify a research and development activity as an asset rather than an expense. Capitalized R&D moves the costs of research and development from the top of the balance sheet to the bottom.

The new law changes the way R&D spend can be deducted, which completely changes the calculus for pre-revenue startups. Up until 2023, R&D spend could be deducted all at once, which allowed companies in the red to stack Net Operating Losses (NOLs). Now, R&D spend must be amortized fractionally over the course of 5 or 15 years, depending on whether the expenses are domestic or international. That means, tax bills will rise and NOLs will become harder to compile; it's tough news for innovative companies.

The shift from immediate deduction to ratable amortization under Section 174 for the 2022 tax year will be treated as a change in a method of accounting. This new R&D Capitalization rule means that a 12-month tax strategy has now become essential for founders. Here's what you need to know: Before these changes were written into law by then-President Donald Trump in 2017, 100% of R&D spend could be deducted from your income.

If you brought in $1 million in revenue and spent $2 million on R&D to develop your innovative product, you would end the year with $1 million in (NOLs). Now, you have to spread the R&D deduction over five or 15 years depending on if the spend is made in the United States or abroad—this is called amortization. Worse than that, only six months of the first year of R&D spend can be deducted. So, if the $2 million you spent on R&D is domestic, you'll only have $200K to deduct from your $1 million.

This new reality means that startups that once were pre-profit now look like post-profit companies during tax season—rather than accruing valuable NOLs as they prepare to become cash-flow positive, they're being saddled with an expensive tax bill.

Impact on hiring

Because foreign spend needs to be amortized over 15 years, you'll be feeling the costs every tax season if you hire abroad. By Year 2, a domestic R&D spend of $2 million will bring you $600,000 in deductions. If that spend is foreign? Year 2's deduction will only be $200,000. By Year 3, it'll be $1 million vs. $333,333.33. Year-over-year, as spending grows, that difference hurts more and more every April or October.

Most experts agree that the change to R&D Capitalization was "a cynical gimmick intended to make the bill look cheaper for official budget scorekeeping purposes," as Washington Post columnist Catherine Rampell put it. But taking it at face value, the new law is ostensibly designed to promote hiring and spending within the United States. Until the law is amended, that is the reality for startups when it comes to R&D: unless you can save more than three times your spend, hiring abroad is probably not worth it.

Impact on profitability

The changes to R&D Capitalization markedly affects the amount of NOLs that pre-profit companies will collect each year. Whereas before the change, a company that was $1 million in the red would receive a $1 million NOL going forward, now, due to amortization, that company might appear as though they are $800,000 in the black. That means, rather than $1 million in NOLs, they'll be burdened with a tax bill of $168,000 (21% of $800,000). All of a sudden, being unprofitable is an expensive prospect for startups.

With this new law, NOLs can be used to offset only 80% of taxable income, but those NOLs can be carried forward indefinitely. (Before the change, NOLs could offset 100% of taxable income, but would only carry forward for 20 years.)

Thus, a pre-profit company could spend five years in the red, only to get hammered with a massive tax bill once they do become profitable, because they can no longer be entirely rescued by their NOLs. Historically, these NOLs have functioned as a strategic tool for startups—a skilled founder could plan ahead for that first year of profitability and apply their stockpile of NOLs to vastly decrease their tax burden for that year—and even some of the years that followed. In fact, NOLs have even been considered when valuing startups for acquisition.

These new rules have also diluted a startup's ability to collect NOLs, especially if that startup spends heavily on R&D. Now, it has never been more important to focus on the manner in which you spend on R&D—pay attention to the Four-Part Test and make sure your R&D spending can be claimed as an R&D credit! Because expenses that do not qualify for the R&D credit must be amortized (with only 1/10th being deductible in Year 1), R&D spending that does qualify is more than 10x as valuable to a pre-profit startup.

So, what does that mean for your startup's tax strategy? It means that it'll be much harder to remain unprofitable in the view of the IRS. The upshot is that you may need to accelerate your gameplan: it's exceedingly expensive to be in the red in reality, but in the black when it comes to your taxes. That can lead to a triple whammy, where you burn through your runway, pay an expensive tax bill, and fail to accrue any valuable NOLs.

Mega-corps are planning ahead, you should too

The change to how R&D costs are deducted will vastly change the tax bills of the most innovative companies in America.

Some of the largest corporations are altering their earnings projections and it stands to reason you should do the same. The reality is: tax season has been expanded to a 12-month job. The innovative companies that start tax planning at the time of hiring and R&D spending will be the ones who best weather the storm and address the rising costs of R&D.

Accracy partner Neo.Tax helps startups continue to build innovative technology without being burdened with an untenable tax bill. Neo.Tax exists to give startups peace of mind when it comes to their taxes, and we've done this by maximizing R&D credits for our customers. The change to R&D Capitalization has made that more important than ever.

 
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