Income Taxes

12 Months Ended

Dec. 31, 2021

Income Taxes

Income Taxes

11.  Income Taxes

A reconciliation of taxes utilizing the expected federal tax rate of 21% and the effective tax rate is as follows:

	Years ended December 31,
	2021			2020
Computed “expected” income tax benefit		21.0	%		21.0	%
State income tax benefit, net of federal income tax benefit		6.3	%		6.3	%
Permanent items, primarily change in fair value of warrants and non-deductible share-based compensation		1.0	%		2.6	%
Tax credits		(2.1)	%		(0.7)	%
Stock-option cancellations		(0.2)	%		(8.2)	%
Change in valuation allowance		(26.0)	%		(21.0)	%
Total income taxes		—	%		—	%

The components of the Company’s deferred tax asset are as follows:

	Years ended December 31,
	2021		2020
	(in thousands)
Deferred tax assets:
Operating loss and credit carryforwards	$	16,611	$	15,217
Capitalized research and development		1,470		1,873
Stock-based compensation		1,284		1,078
Accrual for contingency matter		888		—
Lease liabilities		46		50
Excess book over tax depreciation		21		34
Total deferred tax assets		20,320		18,252
Less: valuation allowance		(20,274)		(18,200)
Deferred tax assets		46		52
Deferred tax liability:
Operating lease assets		(46)		(52)
Total deferred tax liability		(46)		(52)
	$	—	$	—

The Company has recorded a valuation allowance against its deferred tax assets for the years ended December 31, 2021 and 2020, because the Company’s management believes that it is more likely than not that these assets will not be realized. The valuation allowance increased by approximately $2.1 million and $1.0 million for the years ended December 31, 2021 and 2020, respectively, primarily as a result of operating losses generated with no corresponding financial statement benefit.

As of December 31, 2021, the Company had federal net operating loss carryforwards, or NOLs, of approximately $52.8 million to offset future federal taxable income and state NOLs of approximately $52.2 million to offset future state taxable income. The federal and state NOLs generated for annual periods prior to January 1, 2018 begin to expire in 2033. The Company’s federal NOL generated for the years ended December 31, 2018 through December 31, 2021, which amount to $26.3 million, can be carried forward indefinitely, however, are limited to be utilized to offset 80% of taxable income in each successive year. As of December 31, 2021, the Company also has federal and state tax research and development credit carryforwards of approximately $1.5 million and $1.0 million, respectively, to offset future income taxes. The federal and state research and development tax credit carryforwards begin to expire in 2033 and 2029, respectively.

Under the provisions of the Internal Revenue Code, the net operating loss and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service and state tax authorities. Net operating loss and tax credit carryforwards may become subject to an annual limitation in the event of certain cumulative changes in the ownership interest of significant shareholders over a three-year period in excess of 50%, as defined under Sections 382 and 383 of the Internal Revenue Code, respectively, as well as similar state provisions. This could limit the amount of tax attributes that can be utilized annually to offset future taxable income or

tax liabilities. The amount of the annual limitation is determined based on the value of the Company immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. The Company has recently completed several equity financings transactions which have either individually or cumulatively resulted in a change in control as defined by Sections 382 and 383 of the Internal Revenue Code or could result in a change in control in the future. The Company does not believe the impact of any limitation on the use of its net operating loss or credit carryforwards will have a material impact on the Company’s consolidated financial statements since the Company has a full valuation allowance against its net deferred tax assets due to the uncertainty regarding future taxable income for the foreseeable future.

For all years through December 31, 2021, the Company generated research credits but has not conducted a study to document the qualified activities. This study may result in an adjustment to the Company's research and development credit carryforwards; however, until a study is completed, and any adjustment is known, no amounts are being presented as an uncertain tax position. A full valuation allowance has been provided against the Company's research and development credits and, if an adjustment is required, this adjustment would be offset by an adjustment to the deferred tax asset established for the research and development credit carryforwards and the valuation allowance.

Harvard Bioscience received a Supplemental Ruling to the Private Letter Ruling dated March 22, 2013 from the IRS to the effect that, among other things, the Separation and Distribution by Harvard Bioscience will qualify as a transaction that is tax-free for U.S. federal income tax purposes under Section 355 and 368(a)(1)(D) of the Internal Revenue Code continuing in effect. The private letter and supplemental rulings and the tax opinion that Harvard Bioscience received from legal counsel to Harvard Bioscience rely on certain representations, assumptions and undertakings, including those relating to the past and future conduct of the Biostage business, and neither the private letter and supplemental rulings nor the opinion would be valid if such representations, assumptions and undertakings were incorrect. Moreover, the private letter and supplemental rulings do not address all the issues that are relevant to determining whether the Distribution will qualify for tax-free treatment. Notwithstanding the private letter and supplemental rulings and opinion, the IRS could determine the Distribution should be treated as a taxable transaction for U.S. federal income tax purposes if, among other reasons, it determines any of the representations, assumptions or undertakings that were included in the request for the private letter and supplemental rulings are false or have been violated or if it disagrees with the conclusions in the opinion that are not covered by the IRS ruling.

To preserve the tax-free treatment to Harvard Bioscience of the Separation and Distribution, for the two-year period following the Distribution, which such period ended November 1, 2015, the Company was limited, except in specified circumstances, from entering into certain transactions pursuant to which all or a portion of the Company’s stock would be acquired, whether by merger or otherwise; issuing equity securities beyond certain thresholds; repurchasing the Company’s common stock; and ceasing to actively conduct the Company’s regenerative medicine business. In addition, at all times, including during and following such two-year period, the Company may not take or fail to take any other action that prevents the Separation and Distribution and related transactions from being tax-free.

If the Distribution fails to qualify for tax-free treatment, in general, Harvard Bioscience would be subject to tax as if it had sold the Company’s common stock in a taxable sale for its fair market value, and Harvard Bioscience stockholders who received shares of Biostage common stock in the Distribution would be subject to tax as if they had received a taxable Distribution equal to the fair market value of such shares.

Under the tax sharing agreement between Harvard Bioscience and the Company, the Company would generally be required to indemnify Harvard Bioscience against any tax resulting from the Distribution to the extent that such tax resulted from (i) an acquisition of all or a portion of the Company's stock or assets, whether by merger or otherwise, (ii) other actions or failures to act by the Company, or (iii) any of the Company's representations or undertakings being incorrect or violated. The Company's indemnification obligations to Harvard Bioscience and its subsidiaries, officers and directors are not limited by any maximum amount. If the Company is required to indemnify Harvard Bioscience or such other persons under the circumstances set forth in the tax sharing agreement, the Company may be subject to substantial liabilities.

All deferred tax assets prior to the Separation remained with Harvard Bioscience.

The Company has determined that any uncertain tax positions would have no material impact on the consolidated financial statements of the Company and there are no unrecognized tax benefits or related interest and penalties accrued for the period for the years ended December 31, 2021 and 2020.

The Company is subject to U.S. federal income tax and Massachusetts state income tax. The statute of limitations for assessment by the IRS and state tax authorities is open for all periods from inception through December 31, 2020; currently, no federal or state income tax returns are under examination by the respective taxing authorities.

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security, or CARES, Act was signed into law making several changes to the Internal Revenue Code. The changes include but are not limited to increasing the limitation on the amount of deductible interest expense, allowing companies to carryback certain net operating losses, and increasing the amount of net operating loss carryforwards that corporations can use to offset taxable income. The tax law changes in the CARES Act did not have a material impact on the Company's income tax provision.