I consider Qualified Small Business Stock (QSBS) to be an example of the government utilizing tax policy wisely – to help spur economic growth and drive innovation. It therefore came as a shock when in late 2021 the Build Back Better Act proposed a curtailment to QSBS. While it was a relief that the change to QSBS didn’t make it into the final law, another legislative action or inaction regarding the treatment of R&D expenditures may soon cause fewer shares to qualify as QSBS.
Capitalization of R&D
For the first time in the past 70 years – unless this is delayed or modified, during 2022 corporations need to start to capitalize Research & Development (R&D) costs. This change came about as part of the 2017 Tax Cuts and Jobs Act. The headline of the act was the reduction of the corporate tax rate to 21%, however some of the finer print included a change in the treatment of R&D costs in an effort to make up for some of the lost tax revenue. Basically, since a company will no longer be able to expense all of their R&D costs, they are more likely to generate taxable income.
This “one size fits all” approach to R&D can make an early-stage company pay taxes much earlier than they would have previously, and therefore have less to allocate to developing technologies and growing their business.
The past February, Congressman John Larson (D – CT), called for an immediate reversal of this change in treatment for R&D, noting that it will make America less competitive. He compared treatment of R&D in the US to China, noting how the Chinese have “enacted a super deduction for R&D expenses” whereby Chinese companies can deduct up to twice the amount spent on R&D. Larson’s early warnings have gone unaddressed, and now in Q4 2022 the capitalization of R&D is looking more and more likely to take effect.
How Capitalizing R&D Impacts QSBS
Driving innovation in America is generally not a partisan issue, so the negative impacts of capitalizing R&D on innovation may have been an oversight. A likely additional unforeseen impact is in how the capitalization of R&D will impact QSBS.
To be QSBS, stock needs to be issued before the company reaches the $50M gross asset threshold (IRC Section 1202(d)(1)).
Aggregate Gross Assets is based on the tax basis of assets and generally includes cash, equipment net of depreciation, receivables and other balance sheet assets. The capitalization of R&D is likely to cause companies to reach the $50M threshold earlier than they otherwise would have.
EY Partner, Tony Nitti, detailed the potential impacts to QSBS exclusions in an article published in TaxNotes in early October 2022. Nitti points out how a tech company that has raised more than $50M over its history may now achieve a tax basis of assets in excess of $50M much earlier than it otherwise would have due to the capitalization of R&D. Any shareholder that obtains their stock after this point or option holders who don’t exercise their options prior to this point will not be able to benefit from the QSBS exclusion.
Much of lobbying is simply to inform legislators of how certain legislation can impact their constituents. When the QSBS amendment was proposed in the Build Back Better Act, we were glad to join forces with the NVCA, Carta, the Angel Capital Association, the Center for American Entrepreneurship and others to help legislators see the impact such a change would have on innovation in the US. Legislation negatively impacting innovation and QSBS are emerging a bit too frequently these days, but we continue to monitor developments and work with the coalition to ensure the voice of the early stage ecosystem is heard. We encourage companies and their shareholders to start to evaluate the impact of capitalizing R&D, both on their business and the potential to impact the securities that can qualify as QSBS and are here to assist should you need help.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.