R&D Tax Credits vs. Government Contracts: What Works For Your Client?
Picture this: Company X is a new startup biotechnology company seeking to develop technologies and products that can improve crop quality and yield. The company is in its third year of operation, and although it hasn’t yet generated any revenue, it has invested heavily in developing biotech crops that will require lower amounts of pesticides while producing higher output with enhanced nutrition profiles.
Company X believes it is on the verge of developing a breakthrough crop that could change the industry and is considering its options to fund its continued research and development (R&D) activities. Specifically, the management team is evaluating whether R&D tax credits or a government contract will be most beneficial to its efforts.
Company X – or if you have a client in a similar situation – should ask itself the following six key questions to better understand the pros and cons of each of these options:
1. What are the benefits and uses of R&D tax credits and government contracts? Enacted in December 2015, the Protecting Americans from Tax Hikes (PATH) Act permanently extended the federal R&D tax credit, better enabling companies to include R&D tax credits in their long-term tax planning. R&D tax credits can result in cash savings of up to 20 percent of qualified spending – potentially more, if the qualified activity occurs in certain states.
These credits can be used to offset regular income tax liability and, for some smaller businesses and startups, alternative minimum tax and a portion of their payroll taxes. If a company isn’t paying taxes, the credits can be carried back one year and forward for 20 years. These credits can reduce a company’s effective tax rate, increase its cash flow, improve its earnings per share, and provide additional funds for investment in new business opportunities or additional employees.
Cost-reimbursable contracts with the government can minimize financial risk, providing reimbursement for actual costs incurred plus a profit or fee on top of costs. In addition, the government will pay for a proportionate share of indirect costs, including overhead, general, and administrative costs. Because they are largely sunk costs, having the government pay for indirect costs can be beneficial for companies.
There are also tangential advantages to government contracts, including developing customer relationships, strengthening a company’s client portfolio, unlocking new business opportunities, and the potential to receive multiyear, high-dollar awards representing solid and predictable cash flow.
2. Are there any added benefits for a company of our size and/or in the starting stages of operations? The PATH Act provides two additional opportunities for select smaller companies for tax years beginning after 2015. In this case, Company X meets the criteria for a qualified small business (QSB), which is defined as a corporation, S corporation, or partnership with less than $5 million in gross receipts in the current year and no gross receipts in any tax year before the five tax years ending with the current year. As a QSB, Company X can elect to use R&D tax credits against its portion of payroll tax. This election is capped at $250,000 annually and can only be made for five years.
Additionally, there are certain government funds set aside for small businesses, which are defined by gross receipts or the number of employees, depending on the contract. Companies performing contracts under NAICS code 541711 (R&D in biotechnology) with less than 1,000 employees are considered a small business. If the company meets these criteria, it could bid for certain contracts set aside specifically for smaller businesses.
3. What makes us, and other companies, eligible for contracts or credits? All companies are eligible to bid on government contracts, unless they have been previously suspended or debarred by the government. As long as a company is attempting to develop or improve the functionality or performance of its products, processes, software, inventions, techniques, or formulae, it’s likely eligible for R&D tax credits, as well.
4. What systems or documentation are required to pursue either opportunity? There is no specific documentation required to claim R&D tax credits. Although tax examiners may sometimes request project accounting records, time-tracking detail, or other types of documentation, a company generally must only be able to prove that expenditures were in fact made and relate to qualified activities. In addition, several court cases have upheld the principle that oral testimony can be relied upon to substantiate a taxpayer’s credit.
There are no systems required prior to winning a government contract. However, prior to submitting the first invoice, companies must implement a cost accounting system that can track costs by contract, as well as a procurement system documenting the justification of source selections and monitoring subcontracts. Certain requirements may also be unique to each contract, and companies should fully understand what these are prior to submitting invoices to the government.
5. What happens if our company is approved for credits or wins a contract? If Company X wins a government contract, it will need to deliver the statement of work in a timely fashion. In addition, because this would be its first contract, it will need to implement internal controls around the systems described above and any others defined in the contract. The best-case scenario in winning a government contract would be to have all costs recovered, including the costs of implementing a compliance framework, with the company gaining valuable experience and increasing its profile in the industry.
The primary benefit to claiming R&D tax credits is that they offset tax liability. Once the company claims R&D tax credits, it has set the foundation for claiming future credits because its qualified expenditures and activities have already been identified, and the processes for claiming them can be further leveraged.
6. Is it possible for a company to use both a government contract and R&D tax credits? There are scenarios where a company can both win a government contract and claim R&D tax credits. If the contract with the government provides that the company is both at economic risk for its R&D activities and is allowed to use the results of the research or retain substantial rights to the results, then the company is still entitled to a credit.
On the other hand, if the agreement states that the government will pay the company whether or not the research succeeds, or if it provides the government exclusive rights to use the results of the research, then the research is considered “funded” and does not qualify for the credit.
Having answered the questions above, Company X should now be well-positioned to identify a path forward. And though Company X exists only in the hypothetical sense, any of your business clients that attempt to develop or improve their products, processes, or software should determine whether the cost-offsetting tools outlined above can help improve the return on their investment.
Chai Hoang is a manager in the R&D Tax Services Practice, Andrew Stiles is a senior manager in Government Contracting Advisory Services, and Chris Bard is national leader of R&D Tax Credit Services at BDO USA LLP.