Life sciences start-up companies face many tax-related issues. The list below is not all-inclusive, and not all companies will encounter these issues or opportunities. However, even in years when companies incur no tax liability because of operating losses, proper planning is important to maximize the future benefits of current investments.
While these issues are not unique to life sciences start-up companies, in combination, they are not as common in other industries. Ignoring the potential benefit of these opportunities may have a significant impact on cash flow at a time when it could be utilized to expand and grow the company.
Research and development (R&D) credit
Innovation is an important aspect of business growth for both start-ups and early development companies. Taxpayers can help alleviate the costs of innovation by taking advantage of the R&D credit. Up to 20 percent of qualified research expenditures as well as a dollar-for-dollar reduction of a company’s tax liability can be carried forward for 20 years to offset future tax liabilities. Although nearly all start-up companies and manufacturers incur some type of R&D costs, many do not fully realize the tax advantages of these expenditures. Proper review and documentation is necessary to meet the burden of proof required to claim these tax benefits, but the effort can well be worth the cost.
Start-up tax losses
Start-up companies often generate net operating losses (NOLs) during the early stages that can be used to offset future taxable income. Additionally, many of these same companies undergo a number of equity rounds to finance continued operations. Section 382 of the Internal Revenue Code mandates limitations on the ability to utilize NOLs carried forward when certain ownership changes take place. The IRS published final regulations in October 2013 which were taxpayer friendly as they relate to “small shareholders;” however, the rules to determine if a section 382 event occurred are still some of the most complex in the tax code. Good tax planning will help minimize these limitations. Alternately, not considering NOL limitations imposed by section 382 can create undesirable tax complications down the road.
Many early-stage companies must offer noncash compensation in various forms to attract the talent necessary to execute their operational plans. Equity-based compensation is popular for start-ups that want to provide their employees future benefits based on the company’s success. Examples of deferred compensation plans include stock options, phantom stock plans, and stock appreciation plans. The nature of each plan affords a company great flexibility in determining the type of benefit they want to confer to employees. Some plans grant ownership, while others are driven by formulas that are tied to company performance. With this flexibility, a company has to be aware of the tax treatment that governs each plan and how it can impact tax liability.
Many start-up companies use convertible debt as a bridge financing option. It provides risk protection, while still allowing future participation in the company if value increases for investors and a low-cost alternative to equity rounds for investees. Many tax issues may be present in debt conversions; therefore, proper preplanning can help companies avoid a myriad of complications that occur when debt is converted to equity at a later date.
Medical device tax
In December 2015, Congress passed the Protecting Americans from Tax Hikes (PATH) Act of 2015, which includes a two-year moratorium on the medical device excise tax, effective Jan. 1, 2016, through Dec. 31, 2017. Beginning in 2013, manufacturers and importers of certain medical devices were subject to the 2.3 percent medical device excise tax. The tax was based on the sales price of the device by the manufacturer or importer, with quarterly reporting required to report and pay the tax. For purposes of the tax, a medical device is defined as any product that is used in the diagnosis of disease or intended to affect the structure or function of the human body.
Recently, a number of medical device companies started selling new products in Europe before the United States due to the longer timeline for receiving FDA approval versus CE mark in Europe. Before entering into business in Europe or other jurisdictions overseas, consider such issues as:
- Whether the company will have employees or independent contractors
- Whether the activities will give rise to a permanent establishment
- Whether a legal entity should be established
- Implications around non-income tax considerations, such as VAT taxes
- What transfer pricing policies should be established
- Overall entity structuring and whether a holding company or intellectual property (IP) company should be established offshore
Alternatives should be explored in order to find the most beneficial tax structure for a particular company.
Recently, many medical device companies have been successful in obtaining investments from foreign parties. There can be tax implications and structuring considerations that should be addressed if an international investment is obtained.
IP migration is another area of interest for medical device companies. Significant benefits can be derived from the migration of IP to a foreign entity. Successful IP migration takes careful tax planning and should be considered as part of the overall structuring and global tax policy for an entity.
For more information on this topic, or to learn how Baker Tilly life sciences specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.