Consider Section 174 When Selling a Life Science Business

Since 1954, Internal Revenue Code Section 174 has allowed Life Science companies engaged in research and development to deduct those costs for tax purposes as incurred. When the Tax Cuts & Jobs Act (TCJA) was signed into law in late 2017, Section 174 was scheduled to sunset on January 1, 2022. Since then, the ability to deduct these costs has drastically altered for Life Science companies.  

Impacts pre and post TCJA:

 The revised Section 174 provision means that in the year an R&D expense is incurred, only 10% of domestic expenses would be deductible for tax purposes. In comparison, only 3.33% of foreign expenses would be deductible. For Life Science companies primarily engaged in R&D, the impacts on taxable income and cash flow are significant.  

As Life Science companies continue to navigate these changes, nearly three years later, an often-overlooked issue is taking center stage during M&A transactions: Section 174(d). Section 174(d) states: “…no deduction shall be allowed concerning such expenditures on account of such disposition, retirement, or abandonment and such amortization deduction shall continue with respect to such expenditures.” Said another way, any R&D costs that have been previously capitalized under the newly revised Section 174 rules cannot be disposed of as part of a sale, for example, as follows:  

Facts:  

• Company A incurs $100,000 in R&D expenses in 2023 
• All other assets capitalized and depreciated for tax purposes have a remaining basis of zero 
• January 1, 2026, Company A sells its corporate assets to Company B for $1,000,000, recognizing a gain under Section 1001 

Analysis: 

• 2023, Company A amortizes $10,000 (10% × $100,000) 
• 2024, Company A amortizes $20,000 (20% × $100,000)  
• 2025, Company A amortizes $20,000 (20% × $100,000)  
• Remaining tax basis in the capitalized Section 174 asset: $50,000 ($100,000 – 10,000 – 20,000 – 20,000) 

Conclusion: 

• During 2026, Company A recognizes a gain on sale of $1,000,000 
• Although there is a remaining tax basis of $50,000 in the capitalized Section 174 asset, Section 174(d) prohibits the consideration of the remaining tax basis in the computation of gain or loss 
• During 2026 – 2028, Company A continues to amortize the remaining $50,000 in tax basis  
• Company B does not amortize any portion of the Section 174 assets paid initially or incurred by Company A 

The exception to the above occurs when the corporation ceases to exist under certain types of transactions. Under these types of transactions, a liquidation or reorganization will result in the following:  

• The acquiring corporation will continue amortization on the unamortized Section 174 asset over the remainder of the applicable amortization period beginning with the month of transfer. 
• The selling corporation is entitled to a deduction equal to the unamortized Section 174 asset in its final taxable year. 

The unique rules of Section 174 during a transaction necessitate close collaboration with a tax advisor to proactively implement available opportunities to keep both the sell and buy sides happy. To ensure you’re making informed decisions and maximizing available opportunities, contact your WG advisor today. We’re here to help you navigate these complex rules and develop a strategy that aligns with your business goals.