As more and more pharmaceutical companies invest in new and improved drug development activities, certain drug indications dictate whether or not the medicine will be viable for a small or large segment of the population. To encourage pharmaceutical companies to invest in drug discovery and development that will only be useful for a small population of patients, the U.S. government enacted the Orphan Drug Act to help companies combat unique medical conditions. Since most pharmaceutical companies attempt to develop larger and more widely available drugs, this tax credit incentivizes the investigation of drugs with fewer commercial applications. The Orphan Drug Credit under IRC § 45C(a) provides taxpayers a tax credit against income taxes equal to 50% of the “qualified clinical testing expenses” paid or incurred during the taxable year.
Several key conditions must be satisfied to claim the Orphan Drug Credit. The tax credit references some of the same rules and requirements as the federal R&D tax credit under IRC § 41, except that you must receive an Orphan Drug designation.
For activities to qualify for the Orphan Drug Credit, companies must first receive Orphan Drug designation for treating rare diseases or conditions that inflict 200,000 people or less in the U.S. The qualifying expenses are only for human clinical trials existing before the date the drug is approved for commercialization.
Employee Wages Based On Qualifying Activities
1. Employee wages from qualified activities represent one of the most common types of qualified pharmaceutical R&D expenses. The Orphan Drug Credit is an activity-based tax credit that allows companies to claim R&D expenses for anyone who is performing “direct research,” “direct supervision” or “direct support” activities.
2. Secondly, an often-overlooked activity is that of the supervisors who have direct responsibilities over employees conducting direct research activities. Since the company’s supervisors and managers typically have higher wages and bonuses than the first-line engineers, failing to include direct supervision wages can cost your company tens of thousands of dollars in R&D tax credits.
3. Thirdly, it can be difficult to calculate how much of an employee’s time is devoted to R&D services and non-R&D services throughout the year. IRC § 3401(a) defines “wages” as subject to federal income tax withholding. For example, if half of the employee’s time is for R&D eligible activities, you would multiply their annual wages by 50% to arrive at the employee’s qualified wages. An important rule sometimes overlooked is that if 80% or more of any employee’s time is devoted to qualified R&D services that year, you can include 100% of their annual wages as qualified for the credit under Regs. § 1.41-2(d)(2).
Employees’ wages can make up a substantial portion of the R&D expenses for the Orphan Drug Credit, so companies should be familiar with all of the rules and regulations available to them to maximize the benefit.
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