Notice: This article is prepared for informational purposes only. You should consult a tax and legal advisor for your tax return filing. Join our waitlist for more details. This is published in partnership with our SBIR accountant Trinity.

Congratulations on winning an SBIR award! For many founders, it marks an important milestone as their business starts generating revenue for the first time. 

However, this also means you will file a significant business tax return for the first time. 

A new tax law, the Tax Cuts and Jobs Act (TCJA), enacted in 2022, has added to the problem. Its provision about R&D expenses has caused a tax bill storm for startups and is especially problematic for SBIR awardees. 

The good news is you aren’t destined to pay a large tax bill that could bankrupt your startup. In this article, we will dive into ways to minimize your tax liability.

Income Tax, Payroll Tax, and R&D Tax Credits

If you are new to business taxes, here is a brief overview: 

Income Tax. You must pay federal and state income taxes yearly by April 15 or extend it by Oct 15 [1]. Your Taxable Income = Revenue - Deductible Expense. 

And yes, your SBIR grant counts as revenue in the IRS' eyes. Most business expenses are deductible. A common exception is capital expenses, like buying large equipment that should be amortized [2]. 

Say you bought equipment worth $500k with a useful life of 5 years. You would file an expense claim stating that this cost you $100k every year for five years. The idea is because the equipment is used to create revenue over the years, the expenses should be as well. 

Payroll Tax. Once you start paying your or your employee's salaries, you pay payroll taxes via your payroll provider, like Gusto or ADP. 

R&D Tax Credit. Congress put in R&D tax credits to encourage R&D in the U.S. Since startups spend most on R&D, you can claim R&D tax credits on up to 20% of qualifying R&D expenses. 

Before 2022

Because most startups wouldn't have generated income for years [3], you didn’t have to pay any income taxes and only payroll taxes. Startups can use their R&D tax credits towards payroll tax and get a nice cash refund. 

After 2022

To balance out the corporate tax break introduced in TCJA, it introduced a provision that added hefty tax bills to startups [3]. It requires businesses to amortize R&D expenses over 5 years, like how you’d treat capital expenditure of buying equipment. 

Say you won $1 million in SBIR Phase II and spent all $990k on R&D in 2022 [4]. Your new amortized 2022 expense is only $200k, and you have to pay $168k taxes on $800k in income 

This effect is bad for many startups - see Axios, and CNBC. But it is awful for SBIR awardees because you can’t expense federal income taxes towards SBIR, and most don’t have VC funding to offset it. 

SBIR budgets allow a 7% “fee,” or in reality “profit,” that you can spend on anything, including taxes. But it is not enough to cover the 21% federal income tax. 

Silver Lining

This is a classic example of federal agencies’ right hand hitting the left hand. Fortunately, the same lack of coordination also means that the SBIR programs and the IRS have different definitions of R&D [5], which can help you and your tax preparers reduce tax liabilities. 

Claim your expense not R&D expense but general business expense

If you received a reimbursement-based grant from NIH, DOE, DOT, ED etc., the tax accountants can claim your expenses not as R&D expenses but as business expenses [5] to fulfill a contract. 

NSF grants are special because they are dispensed like a fixed-price contract but require detailed cost bookkeeping with corresponding terms in the contract. The contract terms do allow the tax accountants to argue the contract is effectively reimbursement but just being paid on a fixed schedule.  

The IRS guidance says that for an expense to count as R&D, the business must not bear financial risks and must not have rights to the research's outcome without explicit approval [8]. Because your grant will reimburse you regardless of the research outcome, they can likely claim it like a business contract. 

Classify your expense as business expense as much as possible and claim the rest with R&D tax credits

If you receive a fixed-price grant contract from DoD, NASA, or the Navy, the tax accountants can try to minimize your tax liability. For example, they can claim travel expenses to a military base as business expenses instead of R&D expenses. We can claim R&D tax credits for the remaining to minimize taxes.

Claim additional social benefits tax credits

Most SBIR awardees’ work has societal benefits. You may qualify for one of the business credits like the Orphan Drug Credit, or the Renewable Electricity Production Credit. 

The Congress has been trying to pass a new tax law to ratify the situation. Though it has stalled this year due to the election, both parties have committed to tax cuts for small businesses. We are optimistic that it will pass in the near future. 

Lastly, if your business does last five years, you will end up with lower business income taxes down the line. 

What can you do? 

As the awardee yourself, there are also a few things you can do: 

Save your 7% fee as much as possible

Even without the tax liability, it is still a good idea to save the fee for a rainy-day fund

Extend your 2025 tax filing to Oct 2025

Normally we wouldn’t advise anyone to delay their tax filing. But if you are filing your 2025 tax (not 2024!), extending to Oct may mean Congress will pass the new tax law in time. 

Join the Forge mailing list or set up a consultation 

We are in the early stage of setting up a partnership with a tax accounting group with expertise in SBIR recipients to help support our customers. Stay tuned!

[1] Larger businesses file an estimated income tax return every quarter to avoid an April surprise.

[2] There are other non-deductible business expenses. For example, you can only reimburse 50% of business meals. But by large, the largest non-deductible business expenses for startups are capital expenditures. 

[3] In tax terms, Net Profit Loss (NOL) 

[4] In tax terms, Internal Revenue Code (I.R.C) Section 174 - R&D Amortization

[5] In tax terms, Internal Revenue Code (I.R.C) Section 164 - Computation of Taxable Income

[6] Let’s say it is all domestic R&D for the sake of explanation. 

[7] In fact, the IRS tax code has different definitions of R&D in different sections of the code. 

[8] For the tax nerds, the IRS audit techniques § 41 and final guidance on this issue requires the IRS auditor to treat a contract’s research as “funded” if the answer is no to either question below: 

• Is payment for the contractor’s research activities “contingent upon the success of the research” under Treasury Regulation section 1.41-4A(d)(1)?

• The research provider bears financial risk (i.e., risk that the research provider may suffer financial loss related to the failure of the research), or The research provider has a right to use any resulting SRE product in its trade or business or otherwise exploit any resulting SRE product through sale, lease, or license. 

• A research provider is not treated as having a right to use the SRE product in its trade or business if such right is available only upon obtaining approval from another party that is not related (within the meaning of Section 267 or Section 707).

For cost-reimbursement grants, the contractor, aka in the startup, gets paid regardless of the success of the research. Startups do sometimes use them in the trade but do get final approval at the end of the program. 

The IRS guidance is admittedly murky because it is very new—it was issued in December 2023—whereas most guidance has been practiced for years. It is also possible the IRS is loose on this guidance because they understand it is a mistake and believe will be ratified soon.