Taxes

The Research and Experimentation Tax Credit – commonly known as the research and development (R&D) tax credit – was created as part of the Economic Recovery and Tax Act of 1981 to incentivize technological progress and innovation by allowing businesses to deduct a portion of the cost of research and product development from their taxable earnings.  The United States was one of the first countries to incentivize R&D by way of the tax code and claimed the world’s most generous tax treatment of R&D into the early 1990s.

Since its introduction, the R&D tax credit has been shown to be a powerful driver of innovation and economic growth.  A large and growing body of research indicates that R&D investment is associated with future gains in profitability and market value at the firm level, and with increased productivity at the firm, industry, and broader economy levels.  R&D also has significant “spill-over” benefits, as research conducted by one firm can lead to progress that increases the productivity, profitability, and market value of other firms in related fields.  A 2015 analysis of the R&D expenditures of 15 OECD countries over the period 1990 to 2013 concluded that a 1 percent increase in R&D spending accelerates economic growth by 0.61 percent.

Research also shows that R&D investment has become increasingly mobile, with businesses and corporations locating more of their investment outside their home countries.  Investment location decisions are determined by many factors, including the growth of foreign markets, production costs, talent and skills availability – and tax and other incentives offered by governments.

The United States no longer claims the most favorable tax treatment of corporate R&D.

A recent analysis by the Information Technology and Innovation Foundation has shown that the United States now ranks 24^th out  of 34 nations studied in terms of R&D tax treatment.  More favorable tax treatment of R&D means that foreign companies are able to invest more heavily in relative terms, with potentially profound implications for innovative advantage over the longer term.  Moreover, as global companies – including American companies – look for places to invest in R&D, many other countries are now substantially more attractive than the United States.

Restoring America’s preeminence in incentivizing R&D will not be cheap.  But losing the innovation advantage our nation has enjoyed for 80 years would be much more costly.  Moreover, academic research regarding the stimulative effect of R&D investment on the rate of economic growth and job creation, as well as the significant “spillover” impact of such investment, strongly suggests that any short-term loss in tax revenue will be substantially or even entirely recovered through faster economic growth and job creation over the longer run.

For nearly 70 years prior to 2022, Section 174 of the Internal Revenue Code permitted the first-year expensing from taxable income of research and development (R&D) investment by American businesses, including startups.  This favorable tax treatment promoted innovation by powerfully incentivizing critical investments in research and technological advancement.  Those investments led to countless scientific breakthroughs, powered economic growth, and produced many significant commercial and military advantages for the United States.

But when Congress passed the Tax Cuts and Jobs Act (TCJA) in 2017, it changed the tax treatment of R&D in order to off-set the revenue impact of the tax cuts.  Beginning in tax year 2022, businesses are now required to amortize R&D investments over five to fifteen years, depending on where the R&D was conducted, dramatically increasing their annual tax liability and disincentivizing innovation generating investments.

The nation’s startups are hit disproportionately by the change, as they tend to invest heavily in developing, testing, and improving their new product or service.  A tax liability that is substantial and unexpected can be devastating for innovative but fragile new companies earning little income in the crucial early years.  Indeed, for many startups across the country, the required amortization of R&D investments can be fatal.  This reality is of enormous economic consequence as research has repeatedly demonstrated that startups are disproportionately responsible for the innovations that drive productivity growth and economic growth, and account for virtually all net new job creation.

Restoring first-year expensing of R&D investments is about more than tax rates and federal tax receipts – it is central to our nation’s long-term economic competitiveness and ability to win the economic future in a world in which power is defined in terms of technology and innovation.  With this reality in mind, CAE strongly supports enactment of the Tax Relief for American Families and Workers Act, which passed the House 357 to 70 on January 31, 2024, but was held up in the Senate.

Launching a new business requires investment – investment to research and develop a new technology or innovation, to prototype and perfect a new product or service, to fund the salaries for critical initial employees, and to pay other essential early expenses.  Because such costs are incurred long before the first dollar of revenue, most new businesses lose money in their initial years.  Such losses are referred to as net operating losses, or NOLs.  Tax law permits all businesses to deduct NOLs from taxable income.  But because most startups have little or no income in their early years against which to apply losses, NOLs are carried forward to apply to income the startup, if it survives, will hopefully earn in the future.

But two aspects of the current tax code – Sections 382 and 383 – complicate the tax treatment of NOLs and other tax credits for startups.  Section 382 pertains to net operating losses and Section 383 pertains to other tax credits.  Sections 382 and 383 were written in the mid-1980s to prevent a practice known as “loss trafficking” – companies acquiring failing young firms with large losses solely to use the acquired company’s tax losses to offset other unrelated income.  As currently written, the sections restrict startups from carrying forward NOLs and other tax credits, and can have the effect of virtually eliminating any value associated with carry-forwards for startups, especially following transactions perceived to be a change in ownership.  And perceived changes in ownership can include investments from venture capital firms or other sources – investments that startups often depend on for many years.

Losses in the value of NOLs and other tax credits artificially and unfairly reduces the value of startups over the longer term.  This lost value, in turn, undermines innovation in several important ways.  First, it reduces the incentive for new companies to invest in their new product or service, new technologies and innovations, and critical employees – investments upon which new companies’ survival and growth depend.  Second, restricted carry-forwards undermines the ability of entrepreneurs and their investors to realize the full value of what they have created – either by going public or through acquisition – following years of sacrifice and hard work.  Indeed, companies that acquire startups commonly justify a lower price for an acquiree because of uncertainty regarding the legal status of tax assets like NOLs.  And because the proceeds of IPOs and acquisitions are frequently invested in new startups, restricted carry-forwards short-circuit the flywheel dynamic whereby the monetized value of the current generation of startups helps finance the next generation of startups and the innovation, economic growth, and job creation they will contribute.

In short, the carry-forward restrictions of Sections 382 and 383 as currently written actually punish startups for incurring the same kinds of investments that federal tax policy explicitly and correctly encourages for older established firms – with the effect of undermining American innovation.

With these realities in mind, CAE urges Congress to modernize Sections 382 and 383 to reflect the unique nature and importance of startups.  Specifically, we urge Congress to establish a safe harbor for startups that will enable new businesses to maintain the value of NOLs and other tax credits as they continue to need and accept outside investment.

The Research and Development tax credit is particularly relevant for startups, which often incur substantial losses in their early years due to research and development of new products and services, methodologies, and techniques – and for whom preservation of cash flow and operating capital is crucial to survival.  And yet, until recently, startups were largely shut out of any benefit associated with the credit because startups often have no taxable earnings (for years) against which to apply the credit.

The Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made a number of improvements to the application of the R&D tax credit, perhaps most notably finally making the credit permanent after numerous extensions and expirations since its creation in 1981.  Now certain of the credit’s availability, businesses can make investment decisions more effectively and efficiently.

The PATH Act also addressed the disconnect between the policy intention of the R&D credit and startups by allowing new businesses to apply the credit against payroll taxes, rather than income taxes, up to $250,000 annually.  To qualify, companies must have had gross receipts for five years or less and gross receipts of less than $5 million for the tax year the credit is applied.

CAE recommends enhancing the PATH Act’s tax provisions for startups by: 1) aligning the criterion for eligibility with that of Section 1202 of the tax code; 2) raising the eligibility threshold; and, 3) increasing the deduction limit.

First, CAE recommends that the eligibility criterion be changed from gross receipts to gross assets.  This change would make the PATH Act provisions consistent with the tax code’s definition of “Qualified Small Business,” (QSBs) which are currently defined as businesses with “less than $50 million in gross assets.”  This consistency would simplify and harmonize related provisions of the tax code, facilitating compliance and reporting by investors and, thereby, promoting capital formation.

Second, CAE recommends that the eligibility threshold for the PATH Act’s payroll tax provisions be raised from the current definition of QSBs of “less than $50 million in gross assets” to “less than $100 million in gross assets.”  The current gross asset limit is too restrictive, as the high costs of innovative research, coupled with valuable intellectual property and successive rounds of financing, often push new innovative companies over the $50 million limit (see recommendation regarding Section 1202 below).

Finally, CAE recommends that the payroll tax credit deduction limit be raised from the current $250,000 to $1 million.  Doing so would align U.S. policy with similar policy in Canada, a major innovation competitor to the United States.

Section 1202 of the tax code was enacted in 1993 to incentivize investment in “qualified small businesses” (QSBs) by excluding 50 percent of capital gains on investments held for at least five years from federal income tax.  The PATH Act of 2015 made permanent a 100 percent exclusion from capital gains tax for any gains on long-term investments in qualified small businesses, up to $10 million or ten times the original investment, whichever is greater.  Previously, the American Recovery and Reinvestment or “Stimulus” Act of 2009 raised the excluded portion from 50 percent to 75 percent, and exempted any gains from the Alternative Minimum Tax (AMT).  Subsequent legislation raised the exclusion to 100 percent and extended the AMT exclusion temporarily.  CAE recommends that this full exclusion from federal income tax of any gains on angel investments in startups held for at least five years be retained in order to maximize the pay-off on any successful investments.

CAE also recommends that the Section 1202 gross asset definition for QSBs be raised from the current “less than $50 million in gross assets” to “less than $100 million in gross assets.”  The current gross asset limit is too restrictive, as the high costs of innovative research, coupled with valuable intellectual property and successive rounds of financing, often push growing new companies over the $50 million limit and, therefore, out of Section 1202’s favorable treatment of capital gains.

Finally, at present the Section 1202 exclusion only applies to investments in companies organized as C corporations.  Because most new businesses are launched as S corporations, partnerships, or limited liability companies (LLCs) – “pass-throughs” – CAE also recommends that the 1202 exclusion be applied to any startup that converts to a C corporation within five years, and that the period of time spent as a pass-through count toward the five-year holding period required by Section 1202.  In other words, angel investors would not have to hold the investment for five years beyond conversion to a C corporation, but only five years beyond the original investment in the company.

As a counterpart to the Section 1202 tax treatment of angel investment gains, Section 1244 of the tax code allows investors in qualified small businesses to deduct losses on such investments as an ordinary loss (deducted from ordinary income) rather than as a capital loss.  Normally, the tax code treats equity investments as capital assets and, therefore, losses are deducted as capital losses to offset capital gains.  If capital losses exceed gains in a particular year, remaining losses are deductible up to a limit of $3,000 annually, with any additional remaining losses carried forward to subsequent years.  By contrast, a loss on a Section 1244 investment is deductible from ordinary income up to $50,000 for individuals and $100,000 for couples filing jointly.

To qualify for Section 1244 treatment, the issuing company’s aggregate equity capital must not exceed $1 million at the time of issuance, the company must have derived more than 50 percent of its income from business operations rather than passive investments for the previous five years, and the shareholder must have purchased the stock directly from the company and not received it as compensation.  Startups generally don’t issue stock for years after launch, if ever – nor have they been in existence for five years – and, therefore, currently don’t meet the requirements of qualifying small businesses.

To further incentivize seed-stage investments in start-ups, CAE recommends expanding Section 1244 to permit losses sustained by angel investors on investments in new companies held for at least 5 years to be deductible from ordinary income up to $250,000 annually.