What is the Orphan Drug Credit and Why Does it Exist?
Imagine there’s a medical condition that affects very few people. Because it’s not widespread, companies might not find it profitable to develop treatments. That’s where the Orphan Drug Credit comes in. It’s a tax break designed to encourage companies to invest in finding cures and treatments for these rare, or “orphan”, diseases. The Orphan Drug Credit, claimed using IRS Form 8820, is a financial incentive to get the ball rolling for drug development in areas where profits may be lower.
Understanding Form 8820: The Key to Claiming the Credit
Form 8820 is the specific IRS form that you (or your business) must fill out to claim the orphan drug credit. It’s not as intimidating as it might sound. Essentially, it’s your way of telling the IRS, “Hey, we invested in developing a drug for a rare disease, and we’re claiming the credit!” The form will ask for details about the qualifying clinical testing expenses incurred, the orphan drug designation, and will help you calculate the tax credit you’re eligible for.
The History of the Orphan Drug Act: Paving the Way for the Credit
The Orphan Drug Credit isn’t just a random incentive; it’s a part of a broader initiative. It started with the Orphan Drug Act of 1983. Before this act, many rare diseases were left without treatments because the market for them was too small for companies to justify the huge research expenses. The act aimed to change this. By introducing various incentives, including the tax credit, the US government encouraged pharmaceutical companies to put in the resources needed to develop these life-saving medications.
How Does the Orphan Drug Credit Work?
Here’s how it breaks down:
- Qualifying Drug: First, the drug must be designated as an “orphan drug” by the Food and Drug Administration (FDA). This designation is usually granted for diseases that affect fewer than 200,000 people in the US, or for diseases where the market isn’t large enough to justify development.
- Qualified Clinical Testing Expenses: The credit applies to specific research expenses related to clinical testing for the orphan drug. This can include costs for staff, equipment, and research facilities. These expenses must be for testing done in the U.S., and they have to be eligible for an R&D tax credit.
- Calculating the Credit: The credit is a percentage of the qualified clinical testing expenses. The percentage has varied across years, but it is typically a significant amount.
- Claiming the Credit: Once calculated, this credit is claimed by completing and filing Form 8820. This credit directly reduces the business’s tax liability.
- Carryback and Carryforward: If the tax credit is more than the tax the business owes, unused credit can often be carried back to prior tax years or carried forward to future tax years.
Examples of the Orphan Drug Credit in Action
Let’s imagine a company, “Rare Cure Inc.”, that’s working on a treatment for a genetic disorder that affects only 5,000 people in the US. They get FDA approval for “orphan” status. Rare Cure Inc. spends $2 million on clinical trials. Because of the Orphan Drug Credit, Rare Cure Inc. can claim a tax credit, let’s say for this example it equals 25% of their eligible expenses, which would be $500,000, thereby reducing their tax liability. This makes the process of developing the drug more viable for them.
Who Can Claim the Orphan Drug Credit?
Typically, it’s pharmaceutical and biotechnology companies that can claim the credit. These are the entities that are most often involved in the research, development, and clinical testing of new drugs. To be eligible for the credit, the company must:
- Have incurred qualified clinical testing expenses.
- Be developing a drug that’s been designated as an orphan drug by the FDA.
- Be claiming qualified research expenses on form 6765.
Related Tax Concepts: R&D Tax Credit and Tax Credits vs. Tax Deductions
The Orphan Drug Credit is closely related to the Research and Development (R&D) Tax Credit. In fact, Form 8820 itself takes information directly from form 6765, which is the R&D Tax Credit form. The expenses that qualify for the orphan drug credit usually also qualify for the R&D credit.
It’s important to understand the difference between a tax credit and a tax deduction. A tax credit, like the orphan drug credit, reduces your tax liability directly. If your credit is $10,000, then your taxes are reduced by that full amount. A tax deduction, on the other hand, reduces the amount of income that is subject to tax. This means a $10,000 deduction would save you less than a $10,000 credit, since the amount you save depends on your tax bracket.
Key Steps to Claiming the Orphan Drug Credit on Form 8820
- FDA Orphan Drug Designation: Ensure your drug has received the necessary “orphan drug” designation from the FDA.
- Track Qualified Expenses: Keep detailed records of all clinical testing expenses that might qualify for the credit. This includes laboratory costs, staff expenses, and equipment costs.
- Complete Form 6765: Form 6765, “Credit for Increasing Research Activities” must be completed to determine what qualifies as research expenses to be inputted onto form 8820.
- Complete Form 8820: Accurately fill out Form 8820, providing information about your qualified expenses and the orphan drug designation. Ensure all calculations are correct.
- File With Your Tax Return: File Form 8820 along with your business tax return. If you have unused credits, understand your options for carryback or carryforward.
- Professional Tax Advice: It is usually a good idea to have a professional tax advisor review all calculations and confirm accuracy before filing.
Common Mistakes and Misconceptions
- Assuming all R&D expenses are eligible: Not all research expenses will qualify for the orphan drug credit. The expense must be directly tied to the clinical trials of the orphan-designated drug.
- Incorrectly calculating the credit: The formula for calculating the credit can be complex, so ensure that you or your tax professional accurately calculate it.
- Not keeping thorough records: Detailed expense records are critical. Without them, you might not be able to justify your claim to the IRS.
- Misunderstanding “orphan” designation: Not all rare diseases automatically qualify; the drug must receive the official designation from the FDA.
- Confusing with R&D Credit: Although often claimed together, and on the same form, the Orphan Drug Credit is distinct from the general R&D Credit. The eligibility requirements and expense considerations are similar but they are not the same.
- Missing the Deadline: Like all tax-related forms, Form 8820 has a deadline for filing. Make sure you file it on time, as you may not be able to claim it otherwise.
- Forgetting the Carryforward/Carryback: If your credit is more than the tax liability you owe, you may be able to carry the unused credit backward or forward to other tax years. Failing to do so may result in missing out on what you’re owed.
The Impact of the Orphan Drug Credit
The Orphan Drug Credit isn’t just about companies; it’s about people who suffer from rare diseases. The credit helps make it more feasible for companies to invest in the development of life-saving medications, which otherwise might never reach the market. It helps foster innovation in an often-overlooked area of medical research. The financial incentive helps alleviate human suffering and improve quality of life.