Life sciences companies face many industry-specific tax challenges when preparing for an IPO, including regulations relating to Financial Accounting Standards Board (FASB) Accounting Standard Codification® (ASC) 740, US federal and state income tax, and sales and use tax.
Below, we’ve compiled the top six tax considerations your life sciences company can benefit from addressing before going public.
Accounting for Income Taxes Under ASC 740
US generally accepted accounting principles (GAAP), specifically ASC 740, requires corporate entities to account for income taxes on financial statements using the tax asset and liability method. Such methodology requires corporations to record deferred tax assets and liabilities associated with timing differences between the recognition of income and expense for GAAP and tax reporting purposes. Further, ASC 740 provides guidance on recording and reporting income tax expense and income tax payables and receivables for financial statement purposes.
Before an IPO, it’s important to make sure your company’s inventory of deferred tax assets and liabilities meets the standard imposed by ASC 740-10. This guidance specifies a tax position won’t be recognized in a company’s financial statements unless it’s likely the position will be sustained upon examination.
Life sciences corporations commonly maintain deferred tax-attribute carry-forward assets pertaining to:
- Federal and state net operating losses
- R&D tax credits
Before an IPO, it’s important to verify the completeness and accuracy of these attributes. Companies should also determine if a valuation allowance is required with respect to all or some portion of their deferred tax assets—especially if the assets are expected to expire before being used.
Once publicly traded, corporations are subject to heightened scrutiny and stricter deadlines, including:
- Increased audit requirements
- Additional scrutiny of ASC 740-related items
- More stringent SEC reporting deadlines
- Required quarterly income tax provision reporting
- Increased tax footnote disclosure requirements
Adopting these changes can be complex, so it’s important that your team of external and internal tax specialists can quickly and effectively manage the ASC 740 reporting process while adhering to complicated guidance and income tax-based internal control requirements. These processes should be established well in advance of an IPO.
Internal Revenue Code (IRC) Section 382 specifies a corporation experiencing a 50% or more ownership change over a three-year testing period has limited future use of tax attribute carry-forwards.
Often, life sciences companies maintain significant unused net operating loss and R&D credit carry-forwards because they operate at a taxable loss prior to obtaining government approval for product offerings.
To fully benefit from carry-forward opportunities, before selling shares, corporations should analyze whether an ownership change event—within the meaning of IRC Section 382—is triggered. They should also analyze the impact of the event on their ability to use tax attributes in the future, for both tax compliance and ASC 740 reporting purposes.
R&D Tax Credits
Life sciences companies are often eligible for R&D tax credits and often maintain a large unused credit carryover balance in the earlier stages of their life cycle.
IRC Section 41 allows companies to claim a federal tax credit related to wages, supplies, and contract research if the company has R&D activities in the United States. These credits can be carried forward for 20 years and used once a corporate entity becomes taxable—after applying other specified tax-attribute carry-forwards.
R&D tax credits are subject to significant IRS scrutiny. Prior to applying these credits, companies can benefit from receiving a formal study from a certified professional to confirm credits carried forward are based on eligible expenses and documented appropriately. This can help confirm credits are available for future use and help the corporation maintain proper ASC 740 reporting.
To determine your eligibility and receive an estimate, fill out our R&D Estimate Request Form.
Stock Issuance Costs & IRC Section 1032
Per IRC Section 162, stock issuance costs associated with an IPO aren’t considered deductible, ordinary, and necessary business expenses. Also, IRC Section 1032 states that a corporation can’t recognize gain and loss upon receiving money or other property in exchange for its own stock. That means stock issued via IPO is generally a nontaxable event to the corporate issuer.
IRC Section 162(m)
Public corporations are limited in the deductibility of executive compensation exceeding $1 million if it pertains to certain covered employees, such as CFOs and other highly paid officers.
IRC Section 162(m) provides definitions of what constitutes executive compensation and provides grandfathering rules for certain historical employment agreements. Prior to an IPO, a company should determine the impacts of IRC Section 162(m) on its executive compensation deductions.
State and Local Tax Considerations
While most companies act diligently to make sure federal income tax obligations are met as part of their regular course of business, state tax obligations can often be overlooked.
Nexus, Wayfair, and Shifting Direct-Tax Systems
States are only allowed to impose taxes on companies that have a sufficient connection with the state, referred to as nexus. This requires companies to remain vigilant about if they have these connections.
State and local taxes can generally be broken into two spheres: direct taxes in the form of income or franchise taxes, and indirect taxes such as sales and use taxes. Companies looking to go public should understand nexus as it applies to both types of taxes.
For indirect tax purposes, a company historically had nexus within a state if it had a physical presence there—typically an office location or employee travel. However, this standard was upended in June 2018 by the Supreme Court’s decision in South Dakota v. Wayfair, Inc. (Wayfair).
Wayfair broadens the traditional concept of nexus to include sales activity in a state if the activity exceeds an established gross receipts threshold or number of sales. As a result, additional states adopted similar laws requiring indirect tax filings if a company has sufficient sales to customers within the state.
Given the increased indirect tax exposure companies may face following Wayfair, they can benefit from practicing greater scrutiny when reviewing their filing obligations.
There’s been a clear shift in direct taxation wherein states are adopting gross receipts-based taxes. These taxes are determined by a business’s gross receipts attributable to the state rather than its income.
While companies in federal loss positions may have minimal state obligations, that may not translate in states that have adopted a gross-receipts-based system. Additionally, even though Wayfair relates to sales tax, states have increasingly adopted factor-based nexus provisions that require businesses with sufficient property, payroll, or sales into a state in a given year to pay direct tax.
A nexus study is one of the most common ways to determine a company’s potential direct- and indirect-tax filing obligations based on its activity in various states in a given year. Activities nexus studies evaluate include:
- Employee travel
- Office locations
- Property owned
- Third-party affiliations
- Sales into each state
A single nexus study can reveal a business’s potential exposure in each state, which is an important consideration for companies facing a pre-IPO valuation. It can also capture a business’s total potential tax exposure while helping the financial team keep up with complex regulation changes as they occur—especially if it files returns at both state and local levels.
Voluntary Disclosure Agreements
A company can pursue a voluntary disclosure agreement (VDA) if a nexus study reveals it has an unfulfilled state obligation. A VDA is an agreement wherein a business voluntarily discloses its identity and tax obligation to the state and begins filing in accordance with its identified obligations.
Companies looking to go public are encouraged to consider VDA programs for all applicable taxes, whether direct or indirect, since companies with unfulfilled state obligations aren’t eligible for programs and are subject to all associated penalties for failing to file. In some states, late or failure-to-file penalties can be as high as 38% of the tax due.
The benefits of VDA programs vary by state, but most states offer:
- A waiver of certain penalties
- A limited lookback period
Prior to an IPO, a nexus study that flows into VDAs in all states where obligations are identified is a comprehensive way to address state and local tax obligations that may otherwise be unaccounted for.
Life sciences companies can receive significant benefits from maintaining their losses at the state level. Companies with activity in multiple states are generally subject to income or franchise taxes, as measured by property, payroll, and sales—or apportionment—in a given state. While most companies consider apportionment when in a taxable position, apportionment can also impact losses a company can claim for a particular state.
To capture relevant losses, a company should review its reported apportionment on its state returns to determine if it’s receiving the correct amount of claimed losses for carryforward purposes. Filing state income-tax returns without considering losses can lead to missed opportunities to plan and prepare for taxable years in a state, which can ultimately impact a business’s overall tax exposure.
R&D Tax Credits
Companies that receive federal R&D credits could also benefit from utilizing them at the state level. Most states allow credits for R&D activities, and credits are typically generated based on where the activities occur.
For example, a company with activity in a state that allows R&D credits, such as California, as well as a state that doesn’t allow R&D credits, such as Tennessee, should know that the breakdown of overall R&D activity between the two states will impact the amount of credit available from the permitting state.
While there are other credits to consider, R&D credits are especially relevant to life sciences companies. Companies that consider their direct state-tax liabilities will likely benefit from factoring in R&D credits when determining their overall tax exposure.
We’re Here to Help
While going public is a significant undertaking, understanding tax considerations impacting the industry can help position your company for success. To learn more about tax structuring strategies and best practices, contact your Moss Adams professional.