Tax Implications of Government Grant Funding
Many startup technology companies receive government grants to help fund their research activities. From a GAAP perspective, assuming the money is collected up front, grant funding is generally treated as a deferred revenue liability until the obligation of the agreement has been met (when or as the funds are expended on qualified activities).
From a tax perspective, grant funding is considered taxable income. The timing of when that income must be recognized is different for accrual method and cash method taxpayers. For cash method taxpayers, revenue must be recognized in the year the cash is received. For accrual method taxpayers, the IRS only allows revenue to be deferred for one year, meaning that grant revenue must be recognized either when funds are expended or in the year after the cash is received, whichever is earlier. It is therefore possible in either case that a company may ultimately find itself in a taxable position depending on the timing of when grant funds are received and expended, even if it has no other revenues. The easiest way to avoid this situation is to ensure that all grant funds are expended on deductible costs by the time the revenue will have to be recognized.
However, when planning for the tax effect of grant revenue, companies must also consider the possibility of Section 174 capitalization requirements reducing deductible expenses. The good news is that research & development expenses covered under Federal grants are generally deductible for tax purposes as ordinary business expenses. However, any additional R&D expenses funded by loans, equity, or other revenues (including state or private grants) may need to be capitalized under Section 174 and amortized over 5-15 years. (Click here for additional information regarding Section 174 expenses.) Additionally, if a company has large amounts of fixed asset purchases (such as machinery & equipment or building/leasehold improvements), it must also consider the effects of certain provisions under the current tax law that limit allowable depreciation deductions in the year of acquisition, including limits to bonus depreciation and Section 179 deductions. Such expenditures are capitalized for tax purposes, meaning that the benefits of the deductions are spread out over a number of years even though the cash was fully paid in the year of acquisition.
These issues can result in businesses incurring tax liabilities despite not yet earning true operating profits. It is important to consider these effects and plan appropriately to minimize tax consequences. If you have any questions, please do not hesitate to contact us.
