From 2016 to 2021, the biotechnology industry increased its R&D spending by 94% to a total of $88.6 billion. To incentivize even more research and innovation, the US government allows biotech and life sciences companies to apply for an R&D tax credit, as well as other tax incentives, to help them lower costs.
Before applying, however, biotech companies need to be aware of IRS regulations that define qualified research activities. Additionally, companies should evaluate whether they will prepare for the tax claims process in-house or simplify the process by implementing an automated tax claims tool.
Qualified R&D Activities for Biotech and Life Sciences Companies
All R&D activities, regardless of industry, must pass the IRS four-part test to be eligible for tax credits. It includes:
- The Section 174 Test: All expenditures must be related to the business and constitute an R&D cost “in the experimental or laboratory sense.” For expenditures to meet this stipulation, they must be related to activities that aim to eliminate uncertainty regarding product development or improvement.
- The Discovering Technological Information Test: Qualified research must be technological in nature, relying on the “principles of the physical or biological sciences, engineering, or computer science.”
- The Business Component Test: A business must use any newly discovered information to improve or develop a new business component. Inventions, formulas, products, and software all constitute business components.
- The Process of Experimentation Test: During a process of experimentation, a business must identify the uncertainty that is the target of the research, identify alternatives to remove the uncertainty, and identify and carry out a process of evaluating different alternatives.
It’s up to each individual company to look into its R&D activities and see whether it is eligible for tax credits. Examples of activities in the biotech and life sciences industry that may qualify include:
- Working on new drugs, medical devices, and methods of drug delivery.
- Researching new or improving existing gene therapy treatments.
- Performing research to identify interactions between different drugs.
- Performing clinical trials and comparing the efficacy of various drugs.
- Identifying new drug indications.
The following activities do not qualify for the R&D tax credit:
- Research that starts after the beginning of commercial production.
- Activities that aim to adapt a business component to the needs of an individual customer.
- Duplicating existing business components.
- Studies, efficiency surveys, and research related to “management functions,” such as prepping financial data, preparing employee trainings, etc.
- Internal-use software that did not pass the high-threshold-of-innovation test.
- Research performed outside the US or any possession of the US or Puerto Rico.
- Social sciences research.
- Research funded by grants, contracts, or a third-party or government body.
Payroll Tax Credit for Biotech Startups
Prior to 2015, small businesses and startups that weren’t yet profitable were unable to benefit from their R&D tax credit until they started paying federal income taxes. The Protecting Americans from Tax Hikes (PATH) Act of 2015 introduced changes that allowed startups and small businesses to leverage the R&D tax credit to offset their payroll taxes.
The payroll tax offset was limited to $250,000; however, the new Inflation Reduction Act has increased it to $500,000. From January 2023, businesses can apply $250,000 against their Social Security payroll tax liability and another $250,000 against the Medicare portion.
Startups can use this benefit for a maximum of five years.
The Orphan Drug Tax Credit
In addition to R&D tax credits, biotech companies that are developing drugs for the treatment of rare diseases (also known as orphan drugs) are also eligible for the orphan drug tax credit.
A disease is considered rare when it affects no more than 200,000 people in the US or where there is no possibility of profitable treatment development. The credit, which amounts to a maximum of 25% of the amount spent on qualified clinical trials, incentivizes biotechs to develop treatments that help a small segment of the population.
State R&D Tax Credits for Biotech and Life Sciences Companies
In addition to the federal R&D tax credit, biotech and life sciences companies may be eligible for additional tax credits on a state level. Not all states offer this type of tax credit, so it’s up to the companies to research the eligibility requirements in their state.
In New York, for example, life sciences companies can get a tax credit of:
- 15% on qualified R&D expenses in New York State if the company has at least 10 employees.
- 20% on qualified R&D expenses in New York State if the company has fewer than 10 employees.
Companies can claim the credit for up to three years in a row, with a limit of $500,000 annually.
Other states where biotech companies might be eligible for R&D tax credits include:
- Arizona: The tax credit amounts to 24% of the first $2.5 million in qualifying expenditures. For expenditures exceeding $2.5 million, there is a 15% credit.
- California: Non-refundable tax credit of 15%.
- Texas: Tax credits in Texas vary depending on the type of research the business conducts and whether it is done in partnership with higher education institutions.
Simplify R&D Tax Credits for Biotech Companies With Boast
Although biotech companies are the perfect candidates for the R&D tax credit, the claims process can be complex and time consuming, considering all the required documentation. And despite investing considerable time and resources to maximize their tax claims, many companies unknowingly leave money on the table by not submitting all of their qualified expenses.
Boast’s AI platform expedites this process by integrating directly with payroll, financial, and project management platforms and automatically categorizing eligible R&D activities. With Boast, companies like Smirta were able to save 80 hours on the tax claim process and receive a 30% larger claim. In case of an audit, you can rely on AuditShield to produce audit-ready documents, lowering preparation time by 90%.
Download our complete guide to R&D tax credits to learn more about how to calculate your potential return, get more examples of qualifying activities, and access valuable documentation tips. If you’re in Canada, download our guide to SR&ED tax credits.