Protecting Qualified Small Business Eligibility While Navigating Section 174

Section 174 rules requiring businesses to capitalize their R&D expenditures instead of immediately deducting them as expenses increases the company’s gross assets, which can jeopardize the eligibility of a qualified small business (QBS) for attractive tax benefits and capital gains exclusions.

The capitalization requirement under the Tax Cuts and Jobs Act (TCJA) Section 174, which took effect in 2022, can create unpleasant surprises for business owners and investors by increasing their adjusted tax basis.

A Qualified Small Business (QSB) is defined as:

There are a number of other requirements as well, including industry-specific eligibility.

Qualified Small Business Stock (QSBS) are shares in a QSB that need to meet certain criteria. Section 1202 is the Internal Revenue Code Section that lays out the rules related to QSB and QSBS requirements. 

Section 1202 is designed to encourage long-term investment in small businesses by giving QSB owners generous tax benefits and allowing the exclusion of up to 100% of the capital gains on sale or exchange, depending on when the stock was acquired. Investors must hold the QSBS for at least five years to be eligible for the favorable tax treatment.

A company can lose its valuable QSB status for several reasons. The one we will focus on here is the $50 million gross asset threshold. Prior to the 2022 change, companies often lost their QSB status after several rounds of funding as increasingly large cash infusions pushed the company past this threshold. Now, however, the added burden of a large tax basis being created by R&D capitalization is spoiling QSB status earlier in startup lifecycles.

Section 174 has been a part of the tax code since the 1950s. Previously, companies had the option of EITHER currently deducting OR capitalizing and amortizing R&D expenses over a period of years (five years for domestic expenses, 15 for foreign, and using the mid-year convention). Most companies elected to deduct expenditures in the year incurred. The Tax Cuts and Jobs Act (TCJA) of 2017 changed the tax code to require MANDATORY capitalization for tax years beginning after 2022.

Under current rules, if a company spends $1 million on domestic R&D, it is only able to amortize $100,000 of expenses the first year (note: only 10% can be deducted in the year incurred, while 20% will be deducted the next four years with the final 10% in year).

Because the first year of amortization under Section 174 only allows 10% of the amount as a current expense, the remaining 90% becomes part of the adjusted tax basis. This potentially counts toward the hard limit of $50 million under Section 1202 required to maintain QSB status.

In year 2, while an additional 20% of year 1 expense can be amortized, 90% of the year 2 amount becomes a tax asset. During 2024 (typically year 3), 50% of year 1 remains, 70% of year 2, and 90% of year 3. If the company is investing consistently in R&D, this substantial increase in tax basis can count toward the $50 million gross asset limit.

For entities with Controlled Foreign Corporations (CFCs) or other foreign R&D, the outlook is even more dramatic given the 15-year amortization, rather than five-year amortization for domestic expenses.

The QSB status and associated QSBS tax exclusion are lost the day the company reaches the threshold, impacting future stock issuances. Shareholders who invest after the loss of QSB status are not able to take advantage of the capital gains exclusion. Investments made prior to the QSB status change are not impacted, assuming the other QSBS requirements are met.

A simple example is shown below for a start-up company that received a round of funding and has a major investment in R&D. Other property includes capitalized and not yet amortized start-up costs and equipment depreciation, prior year Section 174 unamortized capitalization, fixed assets, and others.

While it looks like the company is well below the $50 million QSB threshold, it is normal for high-tech startups to invest heavily in R&D.

Companies that use a basic General Ledger approach to determine R&D expenses under Section 174 often over-include amounts for personnel and the associated expenses incidental to R&D. A detailed review that investigates spending at the individual expense level can substantially reduce the capitalization amounts.

Individual expense analysis for Section 174 can identify exactly when the company reaches a specified deferred tax asset amount. This can help determine the date QSBS status was lost, potentially protecting investors before the cap is breached. Continuing the example from above, here is the Section 174 impact of a basic vs. detailed approach:

If the company is close to the QSB threshold, evaluating the amounts included under Section 174 to make sure over capitalization has not occurred can potentially defer the company reaching the threshold by a critical period of time.

If you are concerned your company might be over-capitalizing under Section 174 or are close to the $50 million cap and may lose your QSBS status, please reach out to our team. We can work with you to see if a detailed Section 174 analysis can help!