12 Ways the New Tax Law May Impact Technology and Life Science Companies

By Alexandra Colman and Michael Hadjiloucas

The recently enacted Tax Cuts and Jobs Act (“H.R. 1”) provides both challenges and opportunities for the technology and life science sectors.

For instance, because H.R. 1 Tax Act was signed before the end of the year, all 2017 financial statements will need to reflect the new tax rate and all other effects of the new tax rules.

This simply means every company’s deferred tax assets (liabilities), tax provisions, effective tax rate and overall tax footnotes will be affected significantly.  For more information, visit https://www.sec.gov/interps/account/staff-accounting-bulletin-118.htm

A number of new provisions may apply to technology and life science companies.  Among these are:

  1. Corporate Tax Rate – Reduced from 35% to 21% effective January 1, 2018. Therefore, fiscal-year filers will have a prorated tax rate for the period that spans over 2017-2018. The impact of the change in rate on existing deferred tax assets and liabilities will be recognized as a discrete item in the period in which tax legislation is enacted.
  2. Corporate Alternative Minimum Tax – Repealed effective for tax years beginning after December 31, 2017. Taxpayers that have AMT credit carryforwards will be able to use them against their regular tax liability and will also be able to claim a refundable credit equal to 50% of the remaining AMT credit carryforward in years beginning in 2018 through 2020 and 100% for years beginning in 2021.
  3. R&D Credit – Maintained.  With the elimination of AMT, it should be an advantage for life science companies.
  4. Orphan Drug Credit – The Orphan Drug Credit will now be limited to 25% of qualified clinical testing expenses for the tax year. H.R. 1 imposes additional reporting requirements. In addition, you are now able to take a lower credit instead of adding back the entire tax credit. This provision is effective for amounts paid or incurred in taxable years beginning after December 31, 2017.
  5. Limitation on Business Interest Expense Deduction – The deduction for net interest expenses incurred by a business will be limited to the sum of 30% of the business’ EBITDA. For tax years beginning after December 31, 2021, the net interest expenses incurred will be limited to 30% of EBIT. This applies to company’s whose average annual gross receipts are more than $25m.
  6. Net Operating Loss – Net operating loss deductions are limited to 80% of taxable income effective for losses arising in taxable years beginning after December 31, 2017 and have an indefinite carryforward period. There will no longer be a NOL carryback provision. Prior NOLs continue to use the prior carryforward and usage rules.
  7. Amortization of Research and Experimental Costs – For years beginning after December 31, 2021, specified research or experimental expenditures, including software development, incurred in the U.S. would have to be capitalized and amortized over a five-year period. Upon retirement, abandonment or disposition of property, any remaining basis would continue to be amortized over the remaining amortization period. For costs incurred outside of the U.S., the amortization period is 15 years.
  8. Self-Created Intangibles –. The gain or loss from the disposition of a self-created patent, invention, model or design (whether or not patented), or secret formula or process is ordinary in character, effective for dispositions of property after 2017.  This is consistent with the treatment of copyrights under current law. The election to treat musical compositions and copyrights in musical works as a capital asset is repealed.
  9. Medical Device Excise Tax – Although H.R. 1 was silent on this tax, it is set to be reinstated on January 1, 2018.
  10. Other Accounting Methods – Revenue cannot be recognized for tax purposes in a period later than revenue is reported in the applicable financial statements. An exemption applies for any item of income for which a special accounting method is used. In the case of income from a debt instrument having (original issue discount?)OID, these rules would apply to tax years beginning after December 31, 2018, and any I.R.C. Section 481 adjustment made due to a change in method of accounting would be taken into account over six years.
  11. Cost Recovery:
    • Bonus – Qualified property placed in service after September 27, 2017 and before January 1, 2023 can be immediately expensed using 100% bonus depreciation. There is no longer a requirement that the original use of the qualified property commence with the taxpayer. The bonus depreciation percentage will decrease by twenty points every year for tax periods between January 1, 2023 and January 1, 2027.
    • Section 179 – The immediate expense limitation under I.R.C. Section 179 would be increased to $1,000,000 if less than $2,500,000 of eligible property was placed in service during the tax year. The $1,000,000 expense is decreased dollar for dollar for all asset additions in excess of $2,500,000. For tax years beginning after 2018, the limitations will be indexed for inflation.
    • Observations – Immediate 100% expensing is now available under bonus depreciation (I.R.C. Section 168(k)) and I.R.C. Section 179. It is important to consider the state filing requirements of your business before deciding which section to choose. Each state has different depreciation modifications and these should be considered prior to filing.
  12. Domestic Production Activities Deduction – Repealed for tax years beginning after December 31, 2017.

 

Has the New Tax Law Created an “Open Season” for Exercising Incentive Stock Options?

By Gregory Pospichel, EisnerAmper

Stock option compensation is a popular perk of working for a startup company. Most early-stage companies set aside a tranche of corporate shares to offer to employees in the form of stock options — usually incentive stock options (ISOs). An employee is granted the option to purchase shares of the company stock at a price equal to the fair market value of the shares on the date of grant. These grants are typically subject to a four-year vesting schedule starting after year one, and monthly vesting thereafter. When the employee actually exercises the ISO, the difference between the current fair market value of the shares and the exercise price that the employee pays is referred to as the “spread.” No income is recognized for regular tax purposes on the spread, but the spread is includible in taxable income for alternative minimum tax (AMT) purposes. Thus, a taxpayer who is not subject to AMT in a given year would theoretically be able to exercise ISOs tax-free, while a taxpayer who is subject to AMT would incur a tax bill upon purchasing the shares.

Prior to the Tax Cuts and Jobs Act (TCJA), being subject to AMT was a common occurrence for startup employees in popular tech locales such as California, New York, and New Jersey due to those jurisdictions having high state income taxes and expensive real estate, and therefore high real estate taxes (state income taxes and home real estate taxes are a deduction for regular tax purposes, but are disallowed for AMT). Oftentimes, even if a taxpayer in one of these areas was not subject to AMT, they were “on the verge” of AMT, meaning that even a modest spread on an exercise of ISOs could subject them to the alternative minimum tax. Couple these factors with the trend of highly-valued startup companies delaying initial public offerings, and you end up with large amounts of employees finding themselves in a situation where they cannot realistically exercise. Imagine an employee who has vested stock options in a private company for shares that are worth millions of dollars, but the employee can’t afford to exercise the shares because of the astronomical tax bill that would follow thanks to AMT. The employee is essentially stuck at their employer because if they terminate employment, they typically forfeit the stock options if they don’t exercise them within 30 days.

While complete repeal of the alternative minimum tax was discussed, the final version of the Tax Cuts and Jobs Act retained the AMT for individuals. However, AMT is projected to not ensnare as many taxpayers as before due to a few key changes. First, the personal exemptions that taxpayers claimed for themselves and their dependents have been eliminated. The personal exemption was allowed against regular tax only, not against AMT. Second, the itemized deduction for taxes (state income taxes and real estate taxes combined) has been limited to $10,000. Recall that these taxes were also not allowed as a deduction for AMT. This means that for residents in the high state tax states, their AMT taxable income will generally only start off $10,000 higher than their regular taxable income, as opposed to tens or hundreds of thousands of dollars higher when there was no limit on itemized deductions for taxes. Third, the AMT exemption amounts were increased (the AMT exemption is an extra reduction of AMT income taxpayers receive, subject to phase-outs). Lastly, the phase-out levels for the AMT exemptions were also increased. The AMT exemption doesn’t begin to phase out until tentative alternative minimum taxable income is $500,000 for an individual, or $1 million for a married couple. These changes should mean that a lot fewer taxpayers are subject to AMT, and those taxpayers may find that they have more room available to exercise ISOs tax-free.

If a taxpayer still finds that they are subject to AMT even with these changes, there are still strategies to employ including straddling two tax years for exercises, bunching certain deductions or ordinary income, delaying or accelerating capital gains, and disqualifying dispositions.

9 Questions When Dividing Founder Equity

By Charles Weinstein, EisnerAmper LLP

A trio of 20-somethings has a great new product idea tied to the gig economy. Each brings something unique to the table, and all are committed to getting this disruptive innovation to market. While they have to address a myriad of issues, one issue they overlook at their peril is dividing ownership in this embryonic company. Splitting start-up equity among founders can be an emotionally charged experience. However, there are some tips for refining the process:

  1. Are All Founders Created Equal? Topping the to-do list is deciding if the founders will split equity evenly or unevenly. While expedient, this approach may not reflect the relative contributions of the founders. Will an equal ownership split impede future decision-making because founders have the same voting rights? There’s no one-size-fits-all answer. Take the time to fully examine the many facets of equity.
  2. What factors would favor an uneven split? This is the age-old question of ideation versus execution. Are you betting on the jockey or the horse? The answer is really both. Look holistically at who is investing capital, bringing in key contacts, providing elbow grease and leveraging experience. Decide if more risk and sweat deserve extra equity.
  3. When do we tackle this issue? There’s no exact time; it can take years for an idea to turn into a business. However, the equity distribution decision should be made early in the process, prior to external capital investment. As you reconcile this, take some time to get a lay of the land now and what it may be in several years. Have a discussion that is open, thorough and practical.
  4. How can we determine the best unequal split? There are some guidelines you can use. It can be milestones based on owners’ expected roles and performance, or you can assign a weighted average to some of the aforementioned parameters to arrive at an “equity score.” There are several online equity calculators you may want to try.
  5. How about a vesting schedule? To really gauge the founders’ commitment, equity might vest over several years. VCs generally like to see a one-year cliff; if an owner leaves within a year of formation he/she walks away from all or most of his/her equity.
  6. Are there equity levels? First, determine and allocate shares for founders and then establish an option pool for key current and future employees. Explore phantom stock as an alternative incentive.
  7. Are there tax implications? Shares are often used to lure staff and talent. According to Internal Revenue Code Section 83B, company founders can elect to pay tax on unvested restricted shares when they are issued, at a presumably lower value than paying tax on them when they vest. The caveat is they may not have cash for the tax liability. Conversely, they can pay taxes on income as shares vest, which could be at a higher value. It can make a significant financial difference for owners, and they have a short window in which to make the 83B election.
  8. What about company valuation? VCs and founders often have a different opinion on valuation. At the company’s inception, founders need to look at valuation and equity, from a number of perspectives, both now and into the future, perhaps, five years out. Shareholder agreements should include guidance in the event of an exit. Will there be a put option or call option for founders who leave? Remember, buybacks can be expensive.
  9. Are there other VC considerations with respect to owner equity? Because shares will get diluted when angels and VCs enter the picture, it again necessitates that owners look at both the journey and the destination. Investors want a return commensurate with their risk level. Thus, founders need to have a vision and a long-term commercial strategy. VCs may recognize company limitations (technology, sales, and marketing) unseen by owners. In this case, founders need to be knowledgeable about the business’ prospective cash needs and the impact future dilution may have on ownership amounts.

The conversation regrading founder’s equity is often overlooked or deferred while the focus is on making dozens of other, sometimes more exciting, start-up decisions. Dividing founder’s equity sets an important tone. Talk it through. Make every effort to avoid the “let’s just shake on a number and move on” approach. In addition to the economic ramifications, don’t discount the emotional ones, particularly if the new company involves friends or family members.

Charles Weinstein is the CEO of EisnerAmper LLP.  With more than 35 years of public accounting experience, Charly is an author and frequent speaker on the topics of governance, mergers and acquisitions, and public and private financing. Contact him at [email protected].

This article originally appeared in VC-List.com.

Start-Ups and Small Businesses Shouldn’t Overlook These R&D Tax Credits

 Written By Emmalee MacDonald, EisnerAmper

The 2015 Protecting Americans from Tax Hikes (“PATH”) Act included various changes to the Research and Development credit (“R&D credit”) that are mostly beneficial for start-ups and small businesses.

Payroll

PATH enables a qualified small business to elect to claim a certain amount of its R&D credit as a payroll tax credit against its employer portion of FICA liability, rather than against its income tax liability.

A qualified small business for this purpose is defined as a corporation, partnership, LLC or individual that, with respect to any taxable year:

  • Has gross receipts of less than $5M.
  • Did not have gross receipts for any taxable year preceding the 5-tax-year period ending with the tax year.

In other words, in order for a company to qualify to utilize the payroll tax offset in 2017, the company must not have more than $5M of gross receipts in 2016.  It must also not have had any gross receipts in tax years prior to 2012. The definition of gross receipts is not clearly defined within the section, but many interpretations point to the following guidance: Gross receipts include all sales (net of returns and allowances), service income, interest, dividends, rents and royalties, and any income from incidental or outside sources.

The amount of the credit is limited to the lesser of $250,000 per year or the amount of the R&D credit computed on the taxpayer’s income tax return.  Any credit that exceeds the amount of the taxpayers FICA tax liability in a given quarter may be carried forward to future quarters.

Process for Claiming the Payroll Tax Offset

  • Compute the R&D credit on the 2016 or subsequent income tax return on Form 6765.
  • Complete Form 8974, which is a new form, to report the credits elected to offset FICA tax.
  • File payroll Form 941 with Form 8974 attached for each quarter that there is an offset.

A taxpayer may only claim the election for 5 years for a maximum credit of $1.25 million. Any election to apply the R&D credit to offset payroll tax cannot be revoked without the consent of the IRS.

These changes afford small businesses and start-ups an excellent opportunity to realize the tax benefit of their R&D credits, whereas in the past they may have had to wait years to reach profitability or even been precluded from using their credits due to various limitations.

During the current tax filing season, consideration should be given to the preparation of elections, calculation of the R&D credit and timely filing of the returns in order to enable taxpayers to obtain the largest possible benefit from the new PATH Act rules.

AMT

In the past, the R&D credit could not be used to offset Alternative Minimum Tax (“AMT”), with limited exception. The PATH Act provides the ability for certain taxpayers to utilize the credits to offset both regular or AMT for tax credits generated during tax years beginning on or after January 1, 2016. Credits generated in prior years typically will not be eligible to offset AMT, but can continue to be carried forward to offset future regular tax in accordance with previous tax law.

The AMT offset is available only to eligible small businesses. Eligible small businesses are those that are a:

  • Corporation, the stock of which is not publicly traded
  • Partnership
  • Sole proprietorship

In addition, the average annual gross receipts of such corporation, partnership or sole proprietorship for the 3-taxable-year period preceding the taxable year must not exceed $50 million. For example, if the business wishes to utilize the credit to offset AMT in 2016, its average annual gross receipts for tax years 2013, 2014 and 2015 must not exceed $50 million. Any partner or S corporation shareholder claiming a pass-through credit must also meet the gross receipts test for its pass-through credit to be eligible to offset AMT.

Emmalee MacDonald is a senior tax manager at EisnerAmper. She focuses on the technology and life science sectors. Contact her at 732-243-7466 or [email protected]