As 2020 comes to a close, there are three key areas all technology companies should evaluate for the purposes of smart tax planning. Join Cherry Bekaert’s Eric Pilcher and Sarah McGregor as they discuss opportunities that are particularly important for the tech space. They’ll explore the benefits of both cash and accrual accounting methods, how research & development (R&D) credits can be monetized, and what the Qualified Small Business Stock means for companies seeking funding.
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SARAH MCGREGOR: Hello. I'm Sarah McGregor, and I'm joined by my colleague Eric Pilcher. Eric is a tax partner who concentrates on technology companies and is an important member of our technology industry group.
SARAH MCGREGOR: Eric, let's talk tax planning. It's year-end and tax is on the minds of many clients and tax professionals. There are three areas we want to cover for technology companies: overall accounting method considerations, credits, and special provisions for equity transactions. Let's start with overall accounting methods — cash versus accrual. What does that mean and what is the advantage of each?
ERIC PILCHER: The cash method versus the accrual method differs in timing of income and expense recognition. A few years ago, the IRS changed the rules to allow larger companies to qualify for the cash method — up to $26 million or less in revenue.
ERIC PILCHER: With the accrual method, accounts receivable can keep increasing while accounts payable and accrued expenses also accumulate, so you may recognize revenue before receiving cash. Using the cash method allows you to control timing more, especially at year end. It lets you decide how much accounts receivable to push to collect versus how much accounts payable and accrued expenses to pay out.
ERIC PILCHER: The timing difference between cash collections in January versus December can have a significant impact because you can defer tax for another 12 months rather than recognizing it in the current year. That deferral helps preserve cash flow and shifts tax considerations to a later date.
SARAH MCGREGOR: Why would someone change from the accrual method besides becoming larger and being required to change?
ERIC PILCHER: Many technology companies sign multi‑year contracts. Under the cash method, if you collect payment today, it is income today. Under the accrual method, you can defer that revenue for tax purposes over the contract period, effectively pushing recognition to a later tax year.
ERIC PILCHER: For example, if you collect in December, you can defer recognizing that income until the next year's tax return, which delays the tax payment. That deferral is important for growing technology companies that need cash to fund operations and expansion.
SARAH MCGREGOR: For companies that expect tax rates to rise, converting from cash to accrual could accelerate income into lower tax years. It's a timely planning consideration.
SARAH MCGREGOR: Let's shift to credits. Credits frequently reward expenditures by allowing companies to convert expenses into tax offsets, particularly the R&D tax credit. Why is it important for 2020 to reconsider the R&D credit?
ERIC PILCHER: The R&D tax credit is core to what many technology companies do. Development work, customization for clients, and process improvements can all qualify. Larger, profitable companies can generate credits and offset current federal and state income taxes.
ERIC PILCHER: State credits depend on where the work is performed. For example, if you're doing work in Georgia, you may qualify for a Georgia state credit in addition to the federal credit.
ERIC PILCHER: For 2020, if a company is in a loss position, tax rule changes allow carrying credits back. You can carry them back one year or into 2019 and apply them to earlier years where you paid taxes, potentially generating a refund even if you don't have current tax liability.
SARAH MCGREGOR: Many companies changed products and processes in 2020. Is process change relevant for R&D?
ERIC PILCHER: Yes. Process changes, supply chain disruptions, and new service methods can qualify for R&D. Many companies adjusted how they operate, and those adjustments may meet R&D criteria. Discussing options with your advisor ensures you capture federal and state opportunities and avoid leaving dollars on the table.
SARAH MCGREGOR: Is the R&D credit only for large companies, or can small companies take advantage?
ERIC PILCHER: Smaller companies, including pre‑revenue entities, can benefit. Companies with $5 million or less in revenue can monetize the credit against the Social Security portion of employer payroll taxes. This allows them to use the credit even without current income tax liability.
ERIC PILCHER: The credit carries forward, so you can continue applying it quarter after quarter against payroll until it expires. Many states offer similar provisions for small companies, providing cash savings that startups and growth companies need.
SARAH MCGREGOR: Tech companies in startup and growth phases are always hungry for cash. Let's discuss funding and equity transactions. What is the advantage of a Section 1202 stock gain, and what is it?
ERIC PILCHER: Section 1202 refers to Qualified Small Business Stock. A C corporation with $50 million or less in gross assets can qualify. If the stock qualifies, you may exclude 100 percent of the capital gain on the sale of that stock, up to the greater of $10 million or 10 times the taxpayer's stock basis.
ERIC PILCHER: That exclusion can be a significant benefit for founders, investors, and employees because the appreciation can be essentially tax exempt. Eligible recipients include investors who purchase shares or receive shares as compensation for services, so employees can be rewarded with qualifying stock.
ERIC PILCHER: You must hold the stock for at least five years to obtain the exclusion. The owners of the stock can be individuals, trusts, S corporations, or partnerships — anything other than another C corporation.
ERIC PILCHER: Converting to a C corporation does not necessarily disqualify founders or early investors. We've had a case where an LLC converted and the original founders, through a partnership, qualified as Section 1202 investors in the new C corporation.
SARAH MCGREGOR: Is it only founders who can qualify, or can later investors in subsequent rounds qualify as well?
ERIC PILCHER: Later investors can qualify. Qualification is based on the company having $50 million or less in gross assets at the relevant time. If, for example, the company is at $30 million when a later investor purchases stock, that investor's stock can qualify as Section 1202 stock.
ERIC PILCHER: Multiple investors across rounds can receive the benefit, especially in early rounds and perhaps even a second round, depending on the company's asset level. Many investors prefer a C corporation structure to maximize these benefits.
SARAH MCGREGOR: To summarize the planning points for year end: consider cash versus accrual methods, review available credits, and if a company qualifies or wants to qualify for the Section 1202 exclusion, maintain proper records about the company and its investors.
SARAH MCGREGOR: Thank you, Eric. We look forward to discussing tax and technology again.
