Deductions can lighten life sciences startup costs


During the past 60 years, the life sciences industry has seen spectacular developments in commercial drugs and medical devices — think insulin, HIV inhibitors, pain management, psychiatric medications — that improve and save lives worldwide.

But the advances come with a price, literally. The cost to get a new drug approved by the Food and Drug Administration (FDA) has increased dramatically in recent years. And it’s not only costly; it’s time-consuming. The time to get a product from the preclinical stage to the point where it is approved can take 12 to 15 years and costs an average of $300 million to $600 million. Clinical trials and regulatory approval account for as much as 75% of a life sciences company’s startup costs.

With high costs and little revenue, it makes sense for companies to look for as many tax advantages as possible. And to stay out of trouble, companies must read the laws and regulations carefully and understand how the IRS defines certain concepts.

Deductions for active businesses

In general, under Section 162 of the Internal Revenue Code, a taxpayer can deduct business expenses that are incurred in carrying on any trade or business. This deduction is for businesses that already have an ongoing trade or business.

Startup expense deductions

By contrast, Section 195, which allows a taxpayer to take a deduction for a startup cost, only allows that deduction when the taxpayer is deemed to have an active trade or business. Once a taxpayer is deemed to have an active trade or business, they can deduct normal operating expenses as ordinary and necessary under Section 162.

It’s fairly common for early-stage life sciences companies to treat a majority of their costs as deferred startup expenses under Section 195; however, companies must keep in mind that, to the IRS, a life sciences company does not have an active trade or business until it has an approved therapeutic product

  Costs that are part of research and experimentation are deductible under Section 174 and are specifically excluded from the definition of "startup costs" under Section 195(c). Interest and state taxes are excluded from the definition of "startup expenses" under Section 195 as well.  

When is a company considered active?


The point when a company starts an active trade or business for the purposes of Section 195 can be one of contention between the IRS and the taxpayer. The text of Section 195 and its accompanying regulations do not offer many specifics, so looking to the relevant case law is critical to determine whether a company has actually begun an active trade or business. 

The case of Richmond Television Corp. v. US

In 1963, Richmond Television Corporation brought suit in U.S. District Court seeking a refund of more than $21 million in income taxes that it paid after the IRS disallowed $35,129 of the deductions claimed on tax returns for 1956 and 1957. The deductions were born from employee training expenses that the company had incurred while waiting for its broadcasting license. Richmond Television held that the deductions were ordinary and necessary expenses related to its business and contended  that, if not deductible, the expenses were at least subject to amortization.

The Fourth Circuit Court of Appeals determined that the expenses were not deductible because, prior to actually receiving the license, “there was no certainty that [the taxpayer] would obtain a license, or that it would ever go on the air.”

Other relevant tax law

The case law in this area holds that a trade or business begins when the essential operating assets are acquired and those assets are put to use.

Dean v. Commissioner, 56 T.C. 895 (1971)

Tax court held that “carrying on a trade or business” requires showing more than initial research into, or an investigation of, business potential.

McKelvey v. Commissioner, T.C. Memo 2002-63, aff’d 76 Fed. Appx. 806 (9th Cir. 2003) 

The court said business operations must have actually begun for an expense to be deductible under Section 162.

PLR 9047032

The IRS stated a manufacturer’s trade or business began under Section 195 when substantially all of the parts used in the taxpayer’s manufacturing process met the corporation’s quality standards, thereby permitting production of saleable goods to begin. The fact that sales to the public had not begun did not preclude the taxpayer from having begun its active trade or business.

Rev. Rul. 81-150 


A limited partnership was organized to build an offshore drilling rig and engage in contract with major oil companies. The IRS said the trade or business began when the rig was completed and drilling began. A management fee paid to a managing partner to oversee construction was considered a Section 195 expenditure.  

One can compare this case with the ruling in Madison Gas & Electric Co. v. Commissioner, 633 F.2d 512 (7th Cir. 1980), which stated that expenses could not be deducted until a power plant was completed and ready to produce energy.

How these cases relate to life sciences companies

Though these cases cover television stations, manufacturing and oil rigs, they are relevant to life sciences companies for a similar reason — the court closely analyzes when a business is actually viable. For life sciences companies, this most likely means that they'll need FDA approval to sell and market their therapeutic medication before they can generate revenue and therefore take deductions. 

Under the holding of Richmond Television, a pre-revenue life sciences company can be considered a startup for many years under Section 195 because obtaining FDA approval (akin to a Federal Communications Commission license) can take several years.

Other considerations

  • GAAP classifications
    Keep in mind that how you classify your company for financial reporting purposes is relevant to the tax analysis. For example, if a prerevenue company is classified for financial reporting purposes under GAAP as a development stage company because its only activity is R&D, that classification is relevant.
  • Amortizing costs
    Costs that are required to be capitalized under Section 195 are amortized over 15 years once the company is deemed to have an active trade or business. Typically, a taxpayer would look for a specific identifiable event that defines when the company is deemed to have an active trade or business. In the case of an emerging life sciences company, the identifiable event may be when they have a therapeutic that has received Phase III approval.
  • Capitalizing costs under Section 195 versus a deduction under Section 162
    In some cases, capitalizing costs under Section 195 may be preferred to a current deduction under Section 162. For example, a C corporation that undergoes an ownership change after the company has a marketable therapeutic would have a net operating loss (NOL) carryforward at the time Phase III approval is received, assuming the company was not required to capitalize costs and claimed a current deduction during its early stages. In this instance, the C corporation could have limitations placed on its NOL carryforwards because of a Section 382 limitation, which would not be the case if costs were capitalized under Section 195.

While circumstances may differ, it can be difficult for life sciences companies undertaking extensive R&D to create and market a therapeutic drug to decide when a trade or business has started. Richmond Television v. U.S. suggests that a company needs to have an identifiable event that results in a trade or business. Even then, each situation is different.

For many biopharmaceutical companies, the startup period will be long, and the ability to begin deducting expenses will be labored until the point when production of a marketable drug can legally begin.

Lifecycle of a new drug 

Need help?
Alan Osmolowski is a Tax partner in Grant Thornton's Technology Industry Practice, in the New England office cluster.