R&D Tax Benefits
The Internal Revenue Code (IRC) provides three extraordinary benefits relating to research and development (R&D): the R&D deduction, capital gain royalties, and an R&D credit.
Gimme Shelter: The R&D Deduction
Generally, a taxpayer may deduct ordinary and necessary expenditures in carrying on a trade or business, but pre-opening expenditures must be capitalized — placing a person establishing a business in a similar tax position to someone buying a business.
To encourage taxpayers to enter into R&D ventures, the IRC provides that R&D expenditures are deductible even before the taxpayer begins actively selling goods or services. Fully accomplishing this goal can be tricky if the person putting up the money owns less than all of the equity in the company.
Example: Genius and Investor
A genius and an investor form an S corporation, each owning 50%. The genius contributes his idea; the investor contributes cash. The corporation spends all of the investor’s contribution to develop the idea.
- The investor can deduct 50% of the losses (matching his ownership).
- The genius cannot deduct his 50% share of the losses because he has no cost basis in his idea.
- The genius's losses are suspended until he makes an investment or the corporation earns a profit.
If the venture were taxed as a partnership, however, the agreement could specially allocate the R&D deductions to the investor. Since capital accounts typically determine dissolution rights, such an allocation would have substantial economic effect and thus be permissible.
Importantly, the special allocation need not affect the investor’s share of profits, which can be shared under a different formula. The R&D credit (discussed below) can also be specially allocated to the investor.
Restructuring a Corporation
Suppose the genius already contributed his idea to a corporation. Can the investor deduct R&D expenses after investing? Yes. The corporation and investor can form a partnership:
- The corporation contributes the idea.
- The investor contributes cash.
- The partnership agreement provides a special allocation of losses to the investor.
Capital Gain Royalties
Normally, royalties are taxed as ordinary income. However, royalties from certain technology licenses qualify for long-term capital gain if:
- The license grants all rights to the technology (make, use, sell).
- The license covers at least a country (geographic scope).
- The license is issued to an unrelated party before the technology is “reduced to practice” (before significant technological risks are resolved).
For reasons unclear, this tax break is available only to Individuals. Individuals who are partners can qualify, but S corporation stockholders cannot. Thus, the R&D entity should be taxed as a sole proprietorship or partnership to qualify.
The licensee cannot be a related party. However, it is possible to form a licensee controlled by the R&D owners if less than 25% is owned by them (or their related parties). Royalties can even be based on profits instead of sales.
The R&D Credit
R&D expenditures may also qualify for a tax credit. However, the credit reduces the R&D deduction.
The rules are complex for companies with active businesses. The R&D credit provisions periodically expire, only to be extended again by Congress.
Conclusion
Anyone engaging in R&D should consider planning to take advantage of these extraordinary benefits. The planning is most valuable if done before the technology is reduced to practice.
