NAVIGATING CHANGES IN 2022 BUSINESS TAX CREDIT RULES

How R&D Can Cost or Save Your Fintech Startup in the Ever-Changing Tax Landscape (or Minefield)

Lisa Johnson, Tax Director

Research and Development is a cornerstone of many startup businesses. For over 70 years, businesses have also been allowed to treat their efforts in research and experimentation like any other current trade or business expense for tax purposes. But as of 2022, that changed, bringing with it some good news and some bad.

If you’re a business owner, especially a startup or an aspiring unicorn, this applies to you. As we catch our breath from the end of another tax season, it’s important to highlight recent tax code changes in Research and Development (R&D) and Research or Experimental (R&E) expenses that will likely affect your bottom line.

RESEARCH AND DEVELOPMENT EXPENSES (THE BAD NEWS FIRST)

The Tax Cuts and Jobs Act (“TCJA”) enacted in 2017 introduced significant changes to the Internal Revenue Code regarding R&D expenses for tax years starting after December 31, 2021. These changes require businesses to capitalize and amortize certain R&E expenses over a period of years rather than deducting them in the year incurred, resulting in reduced deductions and thus increased taxable income. Critics contend that these requirements hinder innovation and growth in the United States.

Senate Bill 866, the American Innovation and Jobs Act, was introduced in March 2023 to counteract those effects. It’s designed to promote innovation and job growth in the United States by repealing the TCJA changes in the treatment of R&E expenses.

BUSINESS R&E EXPENDITURES INCLUDE:

• Creating new or innovative products
  
• Improving or redesigning existing products
  
• Developing processes, patents, formulas, techniques, prototypes, or intellectual property including software
  
• Contracting with scientists, designers, or engineers who engage in qualified activities

NOW WHAT? As of June 2023, this Senate bill is still pending. Generally Accepted Accounting Principles (GAAP) remain the same, requiring the cost to be expensed in the year it is incurred. Tax professionals have hoped for more expedient relief from these requirements, and many requested tax filing extensions in anticipation of changes before the final deadline. That hope is dwindling, and it is mandatory for all businesses to comply with the daunting task of identifying direct and indirect expenses related to R&D solely for tax purposes.

RESEARCH AND DEVELOPMENT TAX CREDITS (THE GOOD NEWS)

R&D Credit expenditures are described in a different tax code section. Classified as Qualified Research Expenditures (QREs), these direct costs are more easily identified than the R&E expenses mentioned earlier.

QREs MAY INCLUDE:

• Wages paid to employees engaged in, supporting, or supervising qualified research
  
• Up to 65% of amounts incurred by non-employees for qualified research
  
• Supplies directly used to conduct qualified research
  
• As R&D tax credits, they are independent of the changes to R&E deductible expenses and remain a valuable tax strategy, even for companies with limited income tax exposure.

HOW SO? Businesses may elect to use this income tax credit against payroll tax. This is a great opportunity for cash-strapped startup businesses. Eligible organizations who have less than 5 years of generating gross receipts and less than $5 million in gross receipts in the current year could offset up to $1.25 million in payroll taxes.

The documentation and processes for tracking QREs as well as the compliance with the new R&E expense requirements can be overwhelming. IRS guidance continues to evolve on this topic. As with any new tax regulations, it is important to proactively discuss the impact of these changes with your experienced tax advisor.

STARTUP FUNDRAISING AND PAIN POINTS

Based on FintechMeetup Las Vegas Panel: How to Raise Capital in a Challenging Environment

Dan Rogers, CEO

I had the honor of moderating a panel in Las Vegas last week on this topic with world-class investors.  It was great to spend time with the pros who shared many of the insights that I’ve incorporated into this post.

Fundraising is hard in normal times.  Founders need exceptional plans, teams, and progress at every stage to compete with thousands of companies.  In today’s challenging environment, it’s even harder.  Valuations are down, investors are protecting their existing assets, and the exuberance of 2021 and 2022 has subsided.  Founders need to be deliberate in their preparations – because exceptional fundraising execution is just as important as your idea, your brilliant code, and your capable finance team.  Here’s the secret sauce.

LEVERAGE YOUR EXISTING BOARD AND NETWORK.  I can’t say this enough.  It’s their job and role to make connections and help you fundraise.  It’s good for them to protect their investment in your business, and also show their colleagues how smart they were to invest in your business last year.  Your Board will send you to like-minded investors, so you’re saving time on diligence.  Introductions from investors derisk you and your company in the eyes of the receiving investor and give you instant credibility above the crowd.  If you’re a seed-stage company and have no Board, use your network and financial advisors: they can achieve the same effect.  Relying on your Board and network will accelerate the process, save you time, and have compounding benefits.  

REFRESH YOUR DATA ROOM CONSTANTLY.  Every week you should be refreshing your Docsend account with slides, a model, incorporation documents, a cap table, pipeline reports, and sales materials.  The average VC looks at 2,000 deals a year.  They have no time to wait for founders to update materials in the data room.  Companies need to share their best selves in real time. When you leave the Zoom meeting, send the link to your data room so they can look at the materials that night.  Keep the momentum.  If it takes you two weeks to update your model and cap table, you’re not going to get another meeting.  Be ready to move as fast as your investors.

POSITION YOUR BUSINESS TO SUCCEED IN THIS EXERCISE.  If you have no momentum, a skinny pipeline, and two months of runway, investors will conclude that you don’t know how to run your own business.  From your own perspective, you bring no leverage to the term sheet conversation.   It’s a losing proposition.  Make sure you have at least 6 months of runway and can stretch to 9 months if needed.  Build a pipeline of clients: a lot of SMBs or some well recognized whales in your target vertical.  Unless you’ve done this five times and have the magic touch, you should run a smart, sound business based on the fundamentals.  90% of start-ups fail because they run out of money, and this simple idea will help you outlast the competition and be confident in the asset you’re selling to investors.

In the current environment, you need extra time, extra friends, and extra luck.  You can manage this challenging space if you follow the steps above.  Beneath each of these steps is a project plan of To Dos, so they should all be taken seriously.  If executed effectively, you will fundraise faster than your peers, build on your existing relationships, and get back to the business of building faster.