Accounting for R&D Tax Credits and Grants for Biotech and Deeptech Startups Practical Guide

R&D Tax Credits vs. Grants: Navigating the Accounting Interactions in the USA

Securing non-dilutive funding through a government grant is a major milestone for any R&D-intensive startup. It extends your runway and validates your technology without giving up equity. However, that influx of cash brings immediate questions about financial compliance, particularly how to account for R&D tax credits and grants together. For US-based biotech and deeptech companies, understanding the interaction between these two powerful funding sources is not just good practice, it is a requirement.

The central issue is preventing the "double-dipping" of government benefits. Successfully navigating this requires a clear accounting strategy from day one. This guide provides a practical framework for early-stage founders to manage this complexity, ensuring you maximize your startup tax incentives in the USA without creating future compliance risks.

The Fundamental Rule: No Double-Dipping on Funded Research

The principle governing the interaction between grants and R&D tax credits is simple: you cannot claim a tax credit for research expenses that were paid for by someone else, including a governmental entity. This concept is formally known as the funded research exclusion, and it is the foundation of government grant accounting rules in this context.

The IRS lays this out clearly. "Internal Revenue Code (IRC § 41) governs the R&D tax credit and states that research 'funded by any grant, contract, or otherwise by another person (or any governmental entity)' is excluded from the calculation."

But what does "funded" actually mean? The tax code provides specific criteria in the Treasury regulations. An expense is considered funded if two conditions are met: the payment for the research is not contingent on its success, and the company does not retain substantial rights to the research results. Most government grants easily meet this test.

A clear example involves two of the most common funding sources for tech startups. "Expenses funded by federal grants like the Small Business Innovation Research (SBIR) or Small Business Technology Transfer (STTR) programs are considered fully funded and must be excluded from the R&D tax credit calculation." This means every dollar of an SBIR or STTR grant you spend on research must be carved out of your R&D tax credit claim. The government will not allow you to use the same expense to both justify grant funding and generate a tax credit.

The Practical Challenge: Proving Which Expenses Are Eligible

While the IRS rule is straightforward, the practical implementation is where startups often struggle. The burden of proof is on the company to demonstrate which expenses were covered by grant funds and which were paid for with its own at-risk capital. A rough estimate at the end of the year is not a defensible position during an audit.

This is where contemporaneous record-keeping becomes essential. You must have a system to track and allocate costs as they are incurred, not months later. This applies to all potential research expenses, which generally fall into two categories:

• Direct Costs: These are expenses easily tied to a specific project, such as specialized lab supplies for a grant-funded experiment or a software license used exclusively for an internal R&D project.
• Shared Costs: These are more complex to allocate. They include the salaries of engineers working on both grant-funded and internally-funded projects, as well as overhead like rent and utilities for your lab space.

The reality for most Pre-Seed to Series B startups is that you do not need an expensive, enterprise-level system. A well-configured QuickBooks account combined with disciplined spreadsheet management is often sufficient to create a clear, auditable trail. The key is to establish a reasonable and consistent methodology for cost segregation and to document it. An unsupported estimate holds little weight, but a simple, documented process followed consistently is a powerful defense.

How to Account for R&D Tax Credits and Grants Together: Three Tracking Methods

To satisfy IRS requirements when coordinating tax credits and grants, you need a reliable method for separating funded from unfunded expenses. Here are three common approaches, ranging from best practice to least advisable, for managing your deeptech research funding compliance.

1. Segregated Project Accounting (The Gold Standard)

This is the cleanest and most defensible method, particularly for direct costs. It involves using features within your accounting software to tag transactions to specific projects, creating distinct buckets for grant-funded and internally-funded work.

Consider a biotech startup with a Phase I SBIR grant. Here is how they could set this up in QuickBooks:

1. Enable Project Tracking: In QuickBooks Online, turn on the "Projects" feature. For each major initiative, create a new project. You would create one named "SBIR Phase I - Assay Dev" and another named "Internal - Platform Tech."
2. Tag Every Relevant Transaction: When the lab manager orders a reagent used only for the SBIR project, the bill is entered into QuickBooks and tagged to the "SBIR Phase I - Assay Dev" project. When the company pays for a cloud computing service for its internal platform, that expense is tagged to "Internal - Platform Tech."
3. Run Project-Based Reports: At year-end, you can run a "Profit & Loss by Project" report. The total expenses listed under the "SBIR Phase I - Assay Dev" project are the exact costs that must be excluded from your R&D tax credit calculation. The expenses under "Internal - Platform Tech" are potentially eligible for inclusion. This creates an unambiguous, contemporaneous audit trail.

2. Pro-Rata Allocation (For Shared Costs)

For shared costs like salaries and rent, project accounting alone may not be enough. You need a logical and consistent way to allocate them. The most accepted method is a pro-rata allocation based on a reasonable metric. When it comes to salaries, time tracking is the gold standard for salaries.

Let’s illustrate with an engineer whose salary is a shared cost:

• Scenario: A deeptech engineer, David, earns a $150,000 annual salary ($37,500 per quarter).
• Documentation: David maintains a simple weekly timesheet, noting hours spent on the company's STTR grant project versus its core, internally-funded product development.
• Calculation: In Q2, David worked a total of 480 hours. His timesheet shows 160 hours were dedicated to the STTR project, and 320 hours were on the internal project.
• Allocation: The portion of his time spent on the grant is 160 divided by 480, or 33.3%.
• Exclusion: Therefore, 33.3% of his Q2 salary, or $12,500 ($37,500 * 0.333), must be excluded from the R&D tax credit calculation. The remaining $25,000 is a qualified research expense (QRE).

3. The "Gross-Up and Exclude" Method (Less Advised)

This method involves calculating your total QREs for the year and then simply subtracting the total amount of grant funds spent. While simple, it's a risky approach because it assumes every grant dollar was spent on an otherwise qualified expense and fails to establish a direct link between the funding and the expenditure. The IRS treatment of grants favors a more direct nexus. This method should only be considered a last resort if no contemporaneous tracking was performed.

A Critical Detail on Timing: Syncing Grant Income and R&D Expenses

One of the most common points of confusion for founders is the timing of grant funds. A critical distinction in government grant accounting rules is the difference between when you receive cash and when you incur the related expenses.

The IRS is clear on this point. As a required fact, "The exclusion of expenses from the R&D credit calculation is tied to the tax year in which the research expenses are incurred, not the year the grant cash is received." This means the impact on your R&D tax credit eligibility is determined by your spending timeline, not your banking timeline. For tax credit purposes, always focus on the expense date.

For example, imagine your company is awarded a $300,000 grant and receives the full cash payment in December 2024. However, the actual research and spending will occur throughout 2025. For your 2024 R&D tax credit calculation, there is no exclusion related to this grant because no expenses have been incurred yet. The $300,000 exclusion will apply to the research expenses you incur in the 2025 tax year.

This is fundamentally different from how you might recognize revenue for financial reporting. "Grant income recognition for financial statement purposes is typically guided by US GAAP standards such as ASC 606 or ASU 2018-08, which is a separate consideration from the R&D tax credit calculation." FASB has also proposed specific guidance on accounting for government grants. You can read the proposal summary to understand these separate financial reporting requirements.

Stage-Specific Guidance for Biotech and Deeptech Startups

How you implement a system for tracking R&D tax credit eligibility depends on your company's stage. The key is to build a foundation that can scale as your funding and operational complexity grow.

Pre-Seed / Just Won First Grant

Your immediate priority is to start tracking now, not at year-end. In your QuickBooks account, activate the "Projects" or "Classes" feature and create separate trackers for your grant and internal R&D. For your technical team, implement a simple, mandatory time tracking process. A shared spreadsheet is a perfectly acceptable starting point. The goal is to create a contemporaneous record, however simple.

Seed / Series A (Multiple Grants or Projects)

At this stage, your spreadsheet-based systems may start to break down. It is time to formalize your process. Review your Chart of Accounts to ensure it can support more granular tracking. Most importantly, create a short internal memo that documents your allocation methodology. Document a policy that explains why you use timesheets for salaries and how you allocate shared costs like rent. Documentation is your audit defense file if the IRS ever asks questions.

Series B (Nearing a Dedicated Finance Hire)

A scenario we repeatedly see is startups at this stage facing a significant cleanup of past records. The R&D credit is larger, the financial complexity is greater, and the audit risk is higher. It is time to professionalize your systems. Consider time-tracking software that integrates with your payroll and accounting systems. Conduct a thorough review of your prior years' credit calculations to ensure consistency and identify potential weaknesses. Proactively addressing these issues is far less painful than dealing with them under the pressure of an IRS inquiry. See our Government Grants & Contract Accounting hub for more implementation details.

Frequently Asked Questions

Q: What happens if I mistakenly claim an R&D tax credit on a grant-funded expense?
A: If the IRS disallows the claim during an audit, you would owe the amount of the improperly claimed credit plus interest and potentially substantial penalties. Correcting this proactively by amending your tax return is always the better course of action, as it can mitigate penalties.

Q: How do state R&D tax credits interact with federal grants?
A: It depends on the state. Most states conform to the federal "funded research exclusion," meaning you must also exclude federally funded expenses from your state R&D credit calculation. However, some states have different rules, so it is essential to check your specific state's tax code.

Q: How long should I keep records for my R&D tax credit and grant accounting?
A: The IRS can typically audit tax returns for three years from the date they were filed. However, for R&D credits, which can involve multi-year calculations, it is best practice to retain all supporting documentation, such as project records, timesheets, and allocation methodologies, for at least six to seven years.

Q: Can I use grant funds to pay for the R&D tax credit study itself?
A: Generally, no. Most federal grants have rules about allowable costs, and professional fees for tax preparation or credit studies are typically not considered direct project costs. You should review your specific grant agreement, but assume these administrative fees must be paid from company funds.