A Publication of Pepper Hamilton LLP
Tax Treatment of Deferred Start-Up Costs for Life Science Companies
Tuesday, June 26, 2012
The pre-commercialization life science company is generally funded with various rounds of financing that are used to research and develop products. During this time frame, life science companies generally do not have a marketable product or any associated revenues. It is common for a life science company to treat a majority of its general and administrative expenses in early years as deferred start-up expenditures, on the assumption that the company is not yet engaged in a business.1 Once a product is approved and the life science company begins recognizing revenue, it typically would begin amortizing the deferred start-up expenses over a 15-year period under a theory that the approval of the product means that the company has a product it can commercialize and thus it is engaged in a business.
This may cause the life science company to have a mismatch in the timing of income and expense recognition, resulting in significant federal income tax. For example, if the company were to enter into a collaboration agreement, the upfront fee could be taxable income in the first two years of receipt, while the expenses would be deductible over 15 years. If the company is able to determine that its trade or business actually began in an earlier year, it may be possible to capture the lost deductions from the earlier year through an accounting method change in which expenses are changed from being treated as deferred start-up expenses to immediately deductible business expenses. Although facts and circumstance are unique with each life sciences company, there may be an argument that the purpose of a life science company is indeed to develop a product candidate and that the development stage is when its trade or business began. Thus, the costs that have been deferred may be more appropriately characterized as ordinary and necessary business expenses.
If the company has erroneously characterized business expenses as start-up expenditures, how can it remedy the situation? One approach is to file an accounting method change with the Internal Revenue Service seeking advance consent to change the life science company’s method of accounting with respect to its trade or business expenses.2 By seeking an accounting method change, a life science company may receive an immediate deduction for the full amount of the deferred deduction in a single year in the year that the accounting method change is made.
Life science companies that have deferred the start-up expenses in an earlier year and could utilize the deductions in a current year should consider filing a method change to recharacterize the position.
1 Generally, Section 195 defers the immediate deduction of start-up expenditures until the taxpayer begins its trade or business. The amortization deduction is calculated by dividing the total amount of costs that have been deferred over the appropriate amortization period, which is a 15-year period for expenses incurred after October 22, 2004. For expenses incurred before October 22, 2004, the amortization period is five years. Deferred start-up expenditures may be claimed on a taxpayer’s return through amortization deductions once the taxpayer has begun business operations. More importantly, once the trade or business has begun, the company may begin deducting operating expenses as immediately deductible.
2 The expenses under the method change are treated as ordinary and necessary under Section 162.
Todd B. Reinstein, Steven J. Abrams and Ellen McElroy
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