Key takeaways
– The orphan drug credit is a federal tax incentive that subsidizes clinical testing costs for drugs and biologics developed to treat rare diseases or conditions (an “orphan” indication).
– As of tax years beginning after 2017 the credit equals 25% of qualified clinical testing expenses (it was 50% prior to 2018).
– To qualify, the drug must be for a disease or condition that affects fewer than 200,000 people in the U.S. (or affects more than 200,000 but there is no reasonable expectation of recovering development costs through U.S. sales).
– The credit applies whether a company performs testing in-house or pays a third party to do it; in most cases the testing must take place in the U.S.
– Companies should obtain FDA orphan designation, capture and document qualified expenses carefully, and claim the credit as part of the general business credit on their federal tax return. Consult tax counsel before filing.
What the orphan drug credit is (plain language)
The orphan drug credit is a tax subsidy intended to reduce the financial barrier to developing treatments for rare diseases. Developing drugs requires expensive clinical trials; for conditions with very small patient populations, usual commercial incentives are weak. The credit reimburses a portion of “qualified clinical testing expenses” (personnel, supplies, contract clinical research organizations, etc.) for drugs intended to treat rare diseases—lowering effective development cost and encouraging investment.
Legal basis and brief history
– The Orphan Drug Act of 1983 recognized the problem of underinvestment in rare-disease therapies and created several incentives (including market exclusivity and grants).
– The tax credit for clinical testing has been part of federal law for decades. Historically it covered 50% of qualified clinical testing expenses; tax reform enacted in late 2017 reduced the credit to 25% for qualified expenses incurred in tax years beginning after 2017. (See 26 U.S.C. §45C for the statutory language.)
Eligibility: when an expense can qualify
– Orphan indication: The drug must be intended to treat a rare disease/condition, defined by statute as affecting fewer than 200,000 people in the U.S., or a condition affecting more than 200,000 but for which there is no reasonable expectation of recovering development costs through U.S. sales. Obtaining FDA orphan designation for the product/indication is a critical practical step.
– Qualified expenses: Generally include clinical testing costs—wages of employees engaged in clinical testing, amounts paid to contract research organizations and clinical trial sites, supplies used in trials, and other expenses directly related to clinical testing. Preclinical or basic research costs generally are not covered.
– Geographic requirement: In most instances the clinical testing must be conducted in the United States to be eligible.
– Timing: The credit applies to qualified clinical testing expenses incurred in the tax year. The reduction to 25% applies to expenses after the statutory change (beginning in 2018).
How the credit works (calculation basics)
– Credit amount = 25% × qualified clinical testing expenses (for qualifying tax years).
– Example: If a company incurs $4,000,000 of qualified clinical testing expenses for an orphan indication in a tax year, the orphan drug credit would be 0.25 × $4,000,000 = $1,000,000.
– The orphan drug credit is part of the “general business credit” family under the Internal Revenue Code; filing and limitation rules for the general business credit apply (companies should confirm current rules and limits with tax counsel).
Practical step-by-step guide for companies
1. Confirm orphan status
– Evaluate whether the target disease meets the “rare disease” statutory definition.
– Apply to the FDA Office of Orphan Products Development (OOPD) for orphan designation early—designation is a key step to access incentives and strengthens the case for credit eligibility.
2. Design trials to maximize qualified costs
– Structure clinical studies and contracting so that trial-related costs will clearly fall within the definition of qualified clinical testing expenses. Ensure trials that support the orphan indication occur in the U.S. where required.
3. Set up accounting and cost capture
– Create project-cost centers for each orphan program. Track wages, contractor payments, investigator fees, supplies, and other trial-specific costs. Use purchase orders, subcontracts and timekeeping systems to tag expenses to the trial.
4. Document thoroughly
– Keep protocols, IRB approvals, invoices, payroll records, contracts with CROs/sites, patient enrollment lists (redacted for privacy as needed), and other documentation that ties specific costs to clinical testing for the orphan indication. Detailed contemporaneous records are essential if the IRS questions the claim.
5. Calculate the credit
– Aggregate all qualified clinical testing expenses for the tax year for that orphan indication and multiply by the applicable credit percentage (currently 25% for post‑2017 expenses).
6. Coordinate with tax professionals
– Work with tax counsel or a specialist in R&D and tax credits to confirm that expenses qualify and to integrate the orphan credit with other credits (e.g., the research & experimentation credit) and with general business credit limitations.
7. Claim the credit on the tax return
– The orphan drug credit is claimed on the company’s federal tax return as part of the general business credit—follow current IRS instructions and attach required schedules and supporting explanations. State tax treatment varies, so check state rules.
8. Maintain records for audits
– Keep all supporting documentation for the applicable statute of limitations (generally several years) and be prepared to explain allocation of mixed-use expenses (e.g., personnel with multiple projects).
Recordkeeping and audit tips
– Separate orphan clinical trial costs from other programs and R&D to avoid confusion.
– Keep contemporaneous timesheets showing employees’ time spent on the orphan clinical trial.
– Maintain clear contracts with CROs and sites that describe the purpose and scope of work tied to the orphan indication.
– Prepare explanatory schedules that reconcile financial records to the claimed qualified expenses before filing—this reduces audit risk.
Limitations, trade-offs, and common issues
– The credit only offsets a portion of clinical testing expenses; it does not eliminate them.
– Policy changes affect the credit rate and rules—companies should monitor tax law changes. The reduction from 50% to 25% (post‑2017) significantly lowered the subsidy amount and has been the subject of debate among patient groups and advocacy organizations.
– Interaction with other tax incentives: Some costs may be eligible for multiple credits (e.g., R&D credit). Careful allocation and professional tax advice are required.
– Domestic testing requirement: Trials conducted outside the United States may not qualify in most cases.
Policy context and debate
– Supporters argue the credit helps patients by making development of drugs for rare diseases feasible and by increasing the number of treatments available.
– Critics note the subsidy can be expensive to taxpayers, that drug pricing and exclusivity can allow sponsors to capture large profits, and that reducing the credit could discourage some investment. Advocacy groups for rare-disease patients (for example, the National Organization for Rare Disorders) have publicly pushed to preserve the credit at higher levels.
Resources and authoritative references
– 26 U.S. Code § 45C — Clinical Testing Expenses for Certain Drugs for Rare Diseases or Conditions (statutory language). (Cornell Legal Information Institute)
– U.S. Food and Drug Administration — Office of Orphan Products Development (information on orphan designation and program structure).
– U.S. Food and Drug Administration — “The Story Behind the Orphan Drug Act.”
– National Organization for Rare Disorders (NORD) — materials on impact of orphan drug incentives and advocacy efforts.
– Congressional materials on tax reform provisions that changed the credit (H.R.1 / Tax legislation enacted in 2017).
Final checklist before claiming the credit
– FDA orphan designation granted (or solid documentation that the drug/indication meets statutory criteria).
– Accurate accounting of all qualified clinical testing costs, with supporting invoices, payroll records, and contracts.
– Clear documentation that trials occurred in the U.S. where required.
– Review by tax counsel of calculation methodology, interactions with other credits, and proper placement on the tax return.
– Secure retention of records for potential IRS review.
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.