Gimme Shelter. Generally speaking, a taxpayer is allowed to deduct ordinary and necessary expenditures in carrying on a trade or business, but pre-opening expenditures must be capitalized — thus placing a person establishing a business in a similar tax position to a person buying a business.

To encourage taxpayers to enter into R&D ventures, the Internal Revenue Code provides that R&D expenditures are deductible even before the taxpayer begins actively selling goods or services.  Fully accomplishing such a goal, however, can get a bit tricky if the person putting up the money owns less than all of the equity in the company.

Consider the following rather common fact pattern. A genius and an investor form an S corporation, each owning 50%. The genius contributes his idea and the investor contributes cash. The corporation spends all of the investor’s contribution in an effort to develop the idea into a commercial reality. Since the investor owns 50% of the stock, he can only deduct 50% of the losses. The genius, on the other hand, cannot deduct any of his share of the losses because he had no cost basis in his idea. His 50% of the corporation’s losses are suspended until he makes an investment in the corporation or the corporation makes a profit.

If the venture were taxed as a partnership, however, the partnership agreement could specially allocate the R&D deductions to the investor. If the partnership agreement provided that capital accounts determine what a partner gets on dissolution of the partnership - the usual case - then a special allocation of the R&D deductions to the investor would have a substantial economic effect and thus be permissible.

Note that the special allocation would not necessarily affect the investor’s share of the profits since the partnership agreement could provide that profits are to be shared via a different formula.   Note also that the R&D credit (discussed below) can also be specially allocated to the investor.

Suppose the genius already contributed his idea to a corporation.  Can the investor deduct the R&D expenses after he makes his investment? Yes. The solution is for the corporation and the investor to form a partnership with the corporation contributing the idea, the investor contributing cash and the partnership agreement providing a special allocation of losses to the investor.   But see below…

And capital gains.  Royalties are generally taxed as ordinary income, but royalties from certain technology licenses are taxed as long-term capital gain. To achieve this wonderful result the license must consist of all of the rights to the technology (i.e., to make, use and sell), for a geographic region (i.e., at least a country) and the license must be issued to an unrelated party (discussed below) before the technology is "reduced to practice" (i.e., before all the significant technological risks are resolved.)

For reasons that escape me, this tax break is only available to individuals. For such purpose individuals who are partners can qualify, but not individuals who are S corporation stockholders.  Accordingly, the R&D company must be taxed as a sole proprietorship or partnership in order to qualify its royalty stream for capital gain treatment.

As mentioned above, the licensee cannot be a "related party." The definition of related party is technical.  It is possible to form a licensee which is controlled by the owners of the R&D company, so long as less than 25% of the licensee is owned by the owners of the R& D company (or persons related to them). 

The license can call for royalties based on profits, instead of sales. 

The R&D Credit.  The R&D expenditure can also qualify for an income tax credit of up to 10% of the expenditure.   The credit, however, reduces the R&D deduction.     

The rules regarding the credit can be absurdly complex for a company with an active business.  It’s kind of silly, but the R&D credit provisions periodically expire, only to be extended again by Congress.

Conclusion.  Anyone who is engaging in R&D activities should consider doing some planning to achieve the extraordinary tax benefits available for such activities — but the planning is most valuable if done before the technology is "reduced to practice". 

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(c)2008 Steven M. Chamberlain.  All rights reserved.  Republication with attribution is permitted.