How the TCJA is Reshaping Tax Strategies for Venture Backed Companies

The Tax Cuts and Jobs Act (TCJA) introduced significant changes to corporate tax rules that continue to ripple through businesses and fundamentally alter tax planning strategies.

A specific combination of modifications and regulations has created a perfect storm for organizations attempting to manage tax liabilities in a post-TCJA environment.

Net operating loss limitations under TCJA

Before the TCJA, organizations could fully offset taxable income with historical net operating loss carryovers (NOLs), reducing tax liabilities to zero in profitable years. However, under the TCJA, losses incurred in 2018 and beyond can now offset only 80% of taxable income in a given year. This limitation forces corporations to pay taxes on 20% of their profits, even when substantial NOLs remain available.

For instance, a company with $100 million in NOLs and $1 million in profits would still have to pay taxes on $200,000, resulting in a federal tax bill of $42,000 at the 21% corporate tax rate. In this new landscape, corporations begin paying taxes at an effective rate of 4.2% on their first dollar of taxable income despite having massive accumulated losses.

Consider developing a strategic plan with a tax advisor to help balance this limitation. This might involve the timing of income and deductions to enhance tax outcomes and leveraging state-specific regulations.

Capitalizing R&D costs under Section 174

The TCJA also introduced sweeping changes to the treatment of research and development (R&D) expenses. Historically, organizations could immediately deduct R&D costs, reducing taxable income in the year incurred. Under the TCJA, however, Section 174 of the Internal Revenue Code (IRC) requires these expenses to be capitalized and amortized over five years for domestic R&D (15 years for foreign R&D) beginning in 2022.

This shift artificially inflates taxable income by spreading deductions over multiple years rather than allowing an immediate deduction. Companies that historically operated at a loss may now find themselves in a profit position solely due to these changes, triggering tax liabilities earlier than anticipated.

The combined impact: A double blow

When the Section 174 rules interact with the 80% NOL limitation under Section 172, the result is a compounded tax burden. Companies previously in loss positions are now being pushed into profitability on paper, with NOLs unable to fully offset taxable income.

The combined impact of these changes created an intricate and often burdensome tax environment for corporations. The rules can force companies to pay taxes even if they’re not historically profitable or cash-flow positive.

For example, consider a company with:

• $50 million NOL (post-2018)
• $4 million book loss
• $5 million taxable income after capitalizing R&D expenses

Under Section 172, only 80% of the $5 million taxable income can be offset by NOLs, leaving $1 million subject to taxation. At the 21% corporate tax rate, the company owes $210,000 in taxes, despite having never been cash-flow positive and showing a significant book loss.

R&D tax credits and the “25/25 limitation”

Adding another layer of complexity, companies may have R&D tax credits to offset liabilities. However, IRC Section 38 imposes the 25/25 limitation, restricting companies with tax liabilities over $25,000 to using R&D credits to offset only 75% of their total tax liability.

In the prior example, the remaining liability of $210,000 would result in roughly $50,000 in cash taxes due, even after applying R&D credits. This can create a frustrating scenario for organizations with substantial historical losses, sizeable NOLs, and significant R&D investments.

Additional hurdles: IRC Section 382 ownership changes

Organizations must also contend with potential limitations under Section 382. This provision restricts the use of NOLs following significant changes in ownership, such as through funding rounds or mergers. Generally, if a company experiences a cumulative ownership change (involving 5-percent shareholders) exceeding 50% over a three-year period, its ability to use existing NOLs may be severely limited.

How CLA can help with business tax planning

Lawmakers continue to introduce potential tax reforms that could impact your organization’s tax planning and financial strategies. If you’re struggling to manage the complexities of corporate tax under the TCJA, CLA’s qualified tax professionals can help you mitigate the effects of these limitations.

We can also help you calculate the Section 382 limitation and determine your correct research costs, potentially reducing the amount of costs required to be capitalized and increasing the amount of net operating losses you can use.

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