Tax law Section 174 and its impact on small business R&D

Due to the Tax Cuts and Jobs Act (TCJA, passed in December 2017) that went into effect in 2022, small businesses are now facing the unexpected challenges and overwhelming burden of being taxed on research expenditures associated with a recently included change in Internal Revenue Code (IRC) Section 174. As a consequence, small businesses are now taxed on any research grant they receive, including those from the National Institutes of Health, National Science Foundation, Department of Defense, and other federal funding agencies. Small businesses have depended on these grants to fund their pre-commercialization research and development efforts and to seek investor support to bridge funding gap(s) and bring their products to the market. Nearly all innovation comes out of small businesses, which account for over 60% of all industry. The majority of small businesses are LLC start-ups with less than 10-15 employees spun out of universities that license and support intellectual property developed by faculty and students, and are comprised of women, underrepresented populations, military veterans, and early retirees seeking to develop highly innovative devices and platform technologies at an early development phase (Phase I) through product design freeze (Phase II) and ultimately successful commercialization (Phase IIB). KAS members Gretel Monreal PhD and Steven C. Koenig PhD, faculty at the University of Louisville, know this very well: through their Advanced Heart Failure Research Program, they collaborate with small businesses to write and submit grants to help with the development and testing of mechanical circulatory support (MCS) devices for the treatment of end-stage heart failure (think blood pumps, total artificial hearts, etc), for which they have been awarded 30+ National Institutes of Health (NIH) Small Business Innovation Research (SBIR) grants and helped successfully translate 15 medical devices into clinical practice.

In their MCS field, it’s how nearly all cardiovascular devices start out, be it heart valves, blood pumps, stents, pacemakers – a retired surgeon, engineer, or scientist has a creative idea that they often pursue by working in their garage to build a prototype device and generate some preliminary data to demonstrate proof-of-concept. They seek to collaborate and team up with Drs. Koenig and Monreal to leverage their experience and expertise to apply for a grant (often an NIH SBIR grant) to help fund their initial efforts to demonstrate feasibility and to generate enough data to file for patent(s) and additional SBIR funding to achieve a design freeze. Once this has been achieved, routinely a large, well-recognized company (e.g. Abbott, Johnson & Johnson, Medtronic) acquires the intellectual property (patent portfolio) and/or the start-up company, and then leverages their extensive funds and resources to advance the technology to its eventual commercialization with FDA approval and use in humans.

With this new tax law, small business owners, who are also the inventors, are currently required by law to pay taxes on their grants. As an example of this tax burden and how it impacts the owners, for every $1M in grant money, these taxes are approximately $175,000, and their grant(s) cannot be used to pay the taxes, but rather it’s the small business and/or personnel who are responsible. Most small businesses and individual innovators do not have this money sitting around (or they would not have needed to apply for a grant to begin with). As a result, this situation will either bankrupt the small business and/or individual(s), cause the company to close, and/or result in the company returning the awarded grant. Further, as knowledge of this tax liability spreads, many small businesses will no longer want to assume this liability and risk, which also has the consequence of snuffing out promising ideas and technologies as well as potential life saving devices and therapies.

Congress has acknowledged this issue, but as of September 2023 has failed to codify its intentions.

Links to other references here:

https://www.jamesoncpa.com/learning-center/the-devastating-effect-of-irc-section-174-
on-sbir-funded-companies

https://sbtc.org/sbtc-letter-to-congress-on-sec-174-tax-concerns/


Tax law Section 174 and its impact on small business R&D Due to the Tax Cuts and Jobs Act (TCJA, passed in December 2017) that went into effect in 2022, small businesses are now facing the unexpected challenges and overwhelming burden of being taxed on research expenditures associated with a recently included change in Internal Revenue Code (IRC) Section 174. As a consequence, small businesses are now taxed on any research grant they receive, including those from the National Institutes of Health, National Science Foundation, Department of Defense, and other federal funding agencies. Small businesses have depended on these grants to fund their pre-commercialization research and development efforts and to seek investor support to bridge funding gap(s) and bring their products to the market. Nearly all innovation comes out of small businesses, which account for over 60% of all industry. The majority of small businesses are LLC start-ups with less than 10-15 employees spun out of universities that license and support intellectual property developed by faculty and students, and are comprised of women, underrepresented populations, military veterans, and early retirees seeking to develop highly innovative devices and platform technologies at an early development phase (Phase I) through product design freeze (Phase II) and ultimately successful commercialization (Phase IIB). KAS members Gretel Monreal PhD and Steven C. Koenig PhD, faculty at the University of Louisville, know this very well: through their Advanced Heart Failure Research Program, they collaborate with small businesses to write and submit grants to help with the development and testing of mechanical circulatory support (MCS) devices for the treatment of end-stage heart failure (think blood pumps, total artificial hearts, etc), for which they have been awarded 30+ National Institutes of Health (NIH) Small Business Innovation Research (SBIR) grants and helped successfully translate 15 medical devices into clinical practice. In their MCS field, it’s how nearly all cardiovascular devices start out, be it heart valves, blood pumps, stents, pacemakers – a retired surgeon, engineer, or scientist has a creative idea that they often pursue by working in their garage to build a prototype device and generate some preliminary data to demonstrate proof-of-concept. They seek to collaborate and team up with Drs. Koenig and Monreal to leverage their experience and expertise to apply for a grant (often an NIH SBIR grant) to help fund their initial efforts to demonstrate feasibility and to generate enough data to file for patent(s) and additional SBIR funding to achieve a design freeze. Once this has been achieved, routinely a large, well-recognized company (e.g. Abbott, Johnson & Johnson, Medtronic) acquires the intellectual property (patent portfolio) and/or the start-up company, and then leverages their extensive funds and resources to advance the technology to its eventual commercialization with FDA approval and use in humans. With this new tax law, small business owners, who are also the inventors, are currently required by law to pay taxes on their grants. As an example of this tax burden and how it impacts the owners, for every $1M in grant money, these taxes are approximately $175,000, and their grant(s) cannot be used to pay the taxes, but rather it’s the small business and/or personnel who are responsible. Most small businesses and individual innovators do not have this money sitting around (or they would not have needed to apply for a grant to begin with). As a result, this situation will either bankrupt the small business and/or individual(s), cause the company to close, and/or result in the company returning the awarded grant. Further, as knowledge of this tax liability spreads, many small businesses will no longer want to assume this liability and risk, which also has the consequence of snuffing out promising ideas and technologies as well as potential life saving devices and therapies. Congress has acknowledged this issue, but as of September 2023 has failed to codify its intentions. Links to other references here: https://www.jamesoncpa.com/learning-center/the-devastating-effect-of-irc-section-174- on-sbir-funded-companies https://sbtc.org/sbtc-letter-to-congress-on-sec-174-tax-concerns/
KAS Newsletter - November 2023