Tax Implications of the “Innovation Tax” Section 174 for SBIR/STTR

What is Section 174?

The Internal Revenue Code, Section 174, was established in 1954 to clarify the taxation of research and experimentation expenditures, or what we generally refer to as R&D (research and development). In the past, this code allowed businesses to fully deduct R&D expenses in the year they were incurred. Essentially, this meant that SBIR- and STTR-funded companies did not have a significant tax liability on their grant/contract income because their expenses for R&D activities were tax deductible in the same fiscal year. This was advantageous for startup companies’ cash flow and greatly reduced their taxable income. 

However, the 2017 Tax Cuts and Jobs Act included a provision requiring that R&D costs must now be capitalized and amortized over at least five years (60 months). In 2022, amortization of R&D expenses became mandatory – in other words, the deduction of R&D expenses must now be spread over a five-year period, meaning there is a tax bill associated with SBIR/STTR funding that, practically speaking, did not exist before. 

What does it mean for SBIR/STTR recipients? 

The major implication is that companies must be sustainable outside of the Phase I funding and must employ long-term financial and tax strategies. For example, if a company receives $100,000 in SBIR funds for R&D in 2024, instead of deducting the entire amount in 2024, they will have to deduct $20,000 per year for five years. If the company’s operations rely entirely on a Phase I grant, they will likely encounter cash flow issues while trying to pay their tax liabilities. 

The funding agencies are looking harder at applicant companies’ overall cash flow and ability to pay taxes, so showing a robust funding roadmap and workable financial situation is crucial. Financial planning and tracking must therefore be better than ever. Keeping detailed records and tracking everything in an accounting software platform will be extremely important in order to be able to justify the amortization of expenses over the five-year period. Additionally, discussing your situation with a tax planning CPA is certainly advisable to optimize your tax strategy and ensure compliance. 

A larger award in Phase II only amplifies the impact. Expect significant tax implications stemming from receipt of a Phase II, and be prepared to put forth extensive effort in maintaining compliance.

What should you do about it? 

At least in Phase I, it may still be possible to almost entirely deduct your R&D expenses by employing creative strategies. One such strategy involves recording R&D expenses under Section 162, which covers “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business,” meaning R&D-related business expenses can be included. 

To qualify for deductions under Section 162, a business must receive funding whether the project succeeds or not – most SBIR/STTR awards fit this requirement. Additionally, the business’s ownership of the technology influences whether it qualifies for deductions under Section 162. You must “maintain an excluded product right,” which could be the case if the research or use of the innovation are reliant on a deal or relationship with its original contractor. These stipulations are one area where a tax professional can provide additional insight.

Overall, a few key steps no matter what tax strategy one chooses to employ include the following:

1. Keep detailed records: invoices and receipts for R&D activities, payroll for R&D staff, documentation of R&D timelines and progress.
2. Be prepared: perform regular updates and reviews of R&D expense records, and leverage accounting software for most accurate tracking. 
3. Have a professional assist: consult with tax professionals to ensure compliance. SBTDC can make referrals to experienced SBIR/STTR accounting groups on request. 

Is there a fix on the horizon? 

No changes are expected to this tax code in the immediate future, and the recent election may impact the amount of time before any changes occur to the taxation of SBIR/STTR grants. The Tax Relief for American Families Act, passed by the House of Representatives in 2024, would have included changes reinstating immediate deduction of R&D expenses. However, it was held up in the Senate for a long time and ultimately did not pass, receiving only 48 of the required 60 votes. Especially with an election having just occurred, it may be late 2025 or 2026 before Congress passes relevant tax legislation. 

SBIR/STTR-funded small businesses will be wise to prepare to continue navigating tax responsibilities related to Section 174 for the foreseeable future.