As of Jan. 10, taxpayers filing a valid R&D tax credit claim for refund under Section 41 of the Internal Revenue Code must provide, at minimum, five essential pieces of “contemporaneous documentation” including:
- All business components that form the factual basis of the R&D tax credit claim for the claim year;
- All research activities performed by business component (i.e., this must include a description of what the taxpayer did, and how they did it, by business component);
- All individuals who performed each research activity by business component. (i.e., this can be a list, table or narrative but must include the first and last name, and the title/position of the person or persons engaged in the R&D by business component);
- All the information each individual sought to discover by business component. (i.e., this can be a list, table, or narrative providing the information each individual sought to discover); and,
- The total qualified expenses of employee wage expenses, supply expenses, and contract research expenses.
R&D tax credits can be a valuable technique for reducing your clients’ income, but it has been on the IRS Dirty Dozen list for the past decade or so. Trust me, that’s not a list you want to be on. Why is the IRS suddenly clamping down on those claiming the R&D tax credit? Has there been a spike in fraud? While the vast majority of filers are not intentionally trying to commit fraud, so many R&D claims have been filed incorrectly over the years that the IRS is trying to be proactive, albeit with very limited staffing. Think of it as the IRS doing “pre-audits” on R&D tax claims (on amended returns). We typically find issues when somebody is filing a first-time claim on an amended return.
If you’re amending a tax return, the IRS is essentially telling you to provide as much additional information as you reasonably can. They’re going to give themselves six months to evaluate the information you submit. If it looks good, they’ll approve it and you’ll get your refund. If it doesn’t look good, you’ll get a letter informing you that you’re missing certain information. The IRS is trying to avoid additional field audits by doing de facto pre-audits before they approve the R&D tax credit. This new guidance may also put taxpayers in a position in which they seemingly need to provide more information than the courts, statutes and regulations have required in the past. These recent changes by the IRS are untested, however. So, we must wait for additional guidance and perhaps rulings. In the meantime, we continue to adapt our own best practices as needed.If nothing else, these pronouncements may discourage filers from playing “audit” roulette, hoping they can get away with a tax credit claim they know is incorrect.
Filers must now provide five pieces of contemporaneous documentation effective Jan 10, 2022. How is this different from before? Prior to this new guidance, you didn’t need to submit anything other than total salaries and wages, contract research expenses, and total supply costs. It’s a little puzzling since those are just straight line-items from the Form 6765. Now you must include all the other types of documentation (see list above), including business components, employees, research activities they were engaged in, and what they were trying to overcome.
I don’t think it changes the way R&D tax credit studies should be done; it simply changes what you will have to submit. Most likely, it will slow down the process, just because a lot of this documentation may be put together a little later in the entire process. You know it exists and it’s identified. It’s just a matter of putting it in a cohesive package from the outset.
On a scale of one to 10, how much harder will it be for most companies to comply with the new rules? I’d say we’re getting closer to 10. For instance, a CPA firm may very often have a small client with one or two engineers tops. And they base their credit claim on the engineers’ time, which is probably an undervalued credit, but it’s not inaccurate. The numbers can be supported, but they don’t do anything. Let’s say the company is paying $200,000 in wages for the two engineers and they say, “We’ll take a credit based on that salary expense.” But the rules say you can no longer do that, at least on amended returns. You have to start identifying the five essential pieces of contemporaneous documentation listed above. If you’re going to be a do-it-yourselfer here, just know that it’s going to be a lot more time consuming.
Our firm is already providing the additional pieces of documentation for clients, so it won’t be a big adjustment for us. For smaller credit claims, people are just going to start ignoring it on their amended returns. The first year a CPA is working with a client and has identified R&D tax credits, they’re not going to try and capture past years because they’re not going to want to amend under the new rules. They’re only going to take a current-year going-forward approach. Smaller clients are going to be affected more than larger clients. Why? Because they just don’t have the resources needed to do the required documentation or to defend challenges. For larger clients, however, the new rules will require a significant time commitment. If you’re a large manufacturer, you may have 5,000 new products a year. Now you have 5,000 products for which you must identify who on your team was working on each product, what the research activities were for each product, and the challenges they were trying to overcome. Further, you have to do this at the business component level, rather than at the more general level.
If the IRS finds you were intentionally making up an incorrect number, you will probably be hit with a penalty. But the new rules largely eliminate that situation because you will do an amended return when you submit the R&D claim. The IRS will review the claim and determine it doesn’t exist. So, you won’t get to that penalty phase and have to go through an audit. Ironically, it could create a situation in which more people are submitting bad claims because if the IRS mistakenly approves the claim, you shouldn’t have an issue. And if they deny the claim, you won’t get the credit (and refund) under false pretenses, and then have to pay a penalty down the road.
In the past, part of the challenge was creating nexus between the business component and the related expense. The expense is normally the employee. I don’t think many taxpayers have identified the expenses at the component level. More likely, they identify it at the general level. The explanation typically sounds like this: “Hey, this is my engineer and that qualifies. We outsource a prototype and that qualifies. We have some materials that we consumed for this initiative and they qualify.” The biggest challenge for many taxpayers will be breaking things down at the component level rather than at the business level. Even in cases where R&D (and innovation) is obvious, this added level of detailed documentation will convince some companies that it’s just not worth the effort to file a claim. That’s certainly how Congress intended to support business innovation and create good jobs by performing R&D here in the U.S.
Generally, it will be tougher for companies that have more business components. If you’re working on two or three projects a year, it’s going to be relatively easy. However, if you’re working on 200 to 300 projects a year, it becomes a lot more time consuming. If that’s the case, you may want to consider an outside provider to help you.
Let’s talk more about capitalizing R&D expenses. It was part of the Tax Cuts and Jobs Act of 2017, but was deferred until 2022. The Build Back Better (BBB) bill was supposed to kick it down the road even further, until 2026. But, since BBB did not pass, we’re in an R&D tax credit capitalization world. That said, there’s a good chance it could be nullified in a future tax bill. This requirement will have a significant impact on certain industries when it comes to their tax effect. Also, some companies may decide not to take the R&D tax credit, because when you take the credit, you’re identifying that you have R&D expenses which may now have to be capitalized. Hence, you could lose the deduction this year. Now, that thought process is the basis for an incorrect tax return, but many people think that way. Just because you don’t take the credit doesn’t mean you don’t have qualifying Section 174 R&D expenses. Chances are you do. By mislabeling them, you have filed an incorrect tax return. In addition, many businesses perform some type of research and development. Many more filers could be claiming the credit, but they’re not because they simply aren’t aware of their qualifying R&D expenses.
I know many in our profession thought the rules about capitalizing R&D expenses would be deferred again or eliminated well before 2022. But they weren’t, and so here we are playing catch-up again. It’s a big topic of conversation. If you have questions about the R&D tax credit or aren’t sure how to claim it, please don’t hesitate to
