What Is the Orphan Drug Tax Credit and How Does It Work?

Developing treatments for rare diseases is costly and financially risky, often discouraging pharmaceutical companies from investing. To address this, the U.S. government offers financial incentives, including the Orphan Drug Tax Credit (ODTC), to encourage drugmakers to develop treatments for conditions affecting a small number of patients.

This tax credit helps offset research and development costs, making it more viable for companies to bring these treatments to market. Understanding how the ODTC works, what expenses qualify, and how to claim it can help businesses maximize benefits while complying with tax regulations.

Requirements for Orphan Drug Status

For a drug to qualify for the Orphan Drug Tax Credit, it must first receive orphan designation from the U.S. Food and Drug Administration (FDA). This designation is granted under the Orphan Drug Act when a drug is intended to treat a disease affecting fewer than 200,000 people in the United States. The FDA may also grant orphan status if development and marketing costs would not be recovered through sales, even if the patient population exceeds this threshold.

To obtain designation, a drug manufacturer must submit a formal request to the FDA’s Office of Orphan Products Development (OOPD), including scientific evidence demonstrating the rarity of the disease and data supporting the drug’s potential effectiveness. The FDA evaluates submissions based on prevalence estimates, clinical data, and the availability of alternative treatments. If approved, the drug gains access to incentives, including seven years of market exclusivity and exemptions from certain regulatory fees.

Qualified Expenses for the Credit

The ODTC applies to qualified clinical testing expenses incurred after the FDA grants orphan designation. Preclinical research, such as laboratory studies and animal testing, does not qualify.

Eligible expenses include payments for clinical trial participants, costs of administering tests, and expenses related to monitoring patient outcomes. Compensation for investigators, research coordinators, and other personnel involved in the trials also qualifies. Expenses for acquiring and maintaining clinical testing facilities may be included if they are not reimbursed by other sources such as government grants.

Only expenses incurred in the United States or its territories qualify. Clinical testing conducted abroad, even if contributing to the drug’s approval, does not count toward the credit. Additionally, expenses deducted elsewhere on a company’s tax return cannot be double-counted for the ODTC.

Calculating the Credit

The ODTC allows companies to claim 25% of qualified clinical testing expenses. For example, if a company spends $10 million on eligible trials, it can claim a $2.5 million tax credit, directly reducing its tax bill.

Unlike a deduction, which lowers taxable income, this credit provides a dollar-for-dollar reduction in taxes owed. If the credit exceeds the company’s total tax liability for the year, it cannot be refunded but can be carried forward for up to 20 years or carried back one year to offset past liabilities. This flexibility benefits smaller biotech firms that may not yet be profitable but anticipate future earnings.

Companies must ensure only qualified expenses are included. Costs funded by government grants or other tax-advantaged sources must be excluded to prevent double-dipping. Businesses using the credit must also adjust their research and development expense deductions by the amount of the credit claimed, as required under Internal Revenue Code Section 280C.

Coordination with Other Tax Provisions

Companies claiming the ODTC must account for its interaction with other tax incentives, particularly the Research & Experimentation (R&E) Tax Credit under Internal Revenue Code Section 41. The same expenses cannot be claimed under both credits, so costs must be allocated accordingly to maximize tax benefits while complying with IRS regulations.

Net operating losses (NOLs) are another factor. Many biotech firms operate at a loss during early-stage drug development. Under Internal Revenue Code Section 172, NOLs can be carried forward indefinitely but are limited to offsetting 80% of taxable income in a given year. This limitation affects how businesses apply the ODTC, as they may need to balance its use with future tax planning strategies.

For companies receiving federal grants or other non-taxable funding, the IRS prohibits double-dipping, meaning expenses reimbursed by grants cannot be included when calculating the credit. Firms must maintain detailed records to substantiate expense allocations and ensure compliance with tax laws and financial reporting standards.

Claiming the Credit on Your Return

To claim the ODTC, companies must complete IRS Form 8820, “Orphan Drug Credit,” and attach it to their corporate tax return (Form 1120 for C corporations). The form requires businesses to report total qualified clinical testing expenses and calculate the allowable credit based on the 25% rate. Proper documentation is essential, as the IRS may request supporting records such as invoices, trial agreements, and payroll reports.

Once the credit amount is determined, it is reported on Form 3800, “General Business Credit,” which consolidates various business-related tax credits. If the credit exceeds the company’s tax liability, any unused portion can be carried back one year or forward for up to 20 years. Businesses must also adjust their deductible research expenses by the amount of the credit claimed, as required under Internal Revenue Code Section 280C, to prevent double tax benefits.

Common Misconceptions

A common misconception is that the credit applies to all research and development costs related to orphan drugs. Only clinical testing expenses incurred after FDA orphan designation qualify. Early-stage research, manufacturing costs, and marketing expenses are excluded. Companies that fail to distinguish between these categories may overstate their credit and face IRS scrutiny.

Another misunderstanding is that only large pharmaceutical companies benefit. Smaller biotech firms and startups can also claim it, even if they are not yet profitable. The ability to carry forward unused credits for up to 20 years allows emerging companies to accumulate tax benefits that can offset future earnings.

Some businesses mistakenly believe receiving government grants disqualifies them entirely. While expenses reimbursed by grants cannot be included, other eligible costs may still be claimed if properly documented and allocated.