Increased documentation and substantiation requirements for claims could significantly burden small companies.
By Andre Shevchuck, Partner, Tax
The Internal Revenue Service is making significant changes to the popular Credit for Increasing Research Activities, more commonly known as the R&D Tax Credit. Starting on Jan. 10, 2022, the IRS is requiring that specific documentation accompany a taxpayer’s amended tax return when seeking a refund claim using the R&D credit. The changes are outlined in a memorandum from the IRS Office of the General Counsel. These new requirements impose a significant burden on taxpayers seeking to successfully claim refunds using the R&D credit on amended returns. In fact, the burden might be so onerous that many smaller companies may shy away from utilizing the credit on an amended return which is counter to legislative intent. Specifically, these new requirements outline five essential pieces of information that are required to make a refund claim:
- All the business components that form the factual basis of the Internal Revenue Code Sec. 41 research credit claim for the claim year
- All research activities performed, broken down by business component
- All individuals who performed each research activity, by business component
- All the information each individual sought to discover, by business component
- The total qualified employee wage expenses, supply expenses and contract research expenses
To discover how the new requirements might impact your business, read on for our summary of the changes as well as some tips to help your business be prepared, whether your company is planning to make a refund claim or claim the R&D credit on a timely filed return.
What is required to make a claim
The R&D tax credit is a government-backed incentive intended to increase R&D spending in the United States. It was introduced as a temporary economic stimulus in 1981 to support the slumping economy and reverse a decline in research spending by American firms. The goal of the incentive was to bolster business investment in basic and applied research by reducing the after-tax costs of conducting qualified research. At the time, American companies were facing increased competition from European and Japanese markets, especially in the automotive and electronics sectors.
The current criteria to be eligible to claim the R&D tax credit is broad. A company needs to evaluate that their research activities meet a four-part test in order for certain costs to be considered qualified to compute the credit:
- The Technological in Nature Test. Essentially, this means the research activities must rely on hard sciences, like engineering, biology, chemistry, computer science or physics.
- The New or Improved Business Component Test. The research activities must be conducted in an attempt to develop or improve a new or existing business component in terms of functionality, performance, reliability or quality. A business component can be a product, process, technique, formula, software or invention.
- The Technical Uncertainty Test. The activities meant to develop or improve a business component need to demonstrate an attempt to overcome or eliminate a technical uncertainty or obstacle. There are three types of uncertainty: capability (being able to accomplish the objective), methodology (how to get from concept to finished product or design), and design (how the end product will look and work).
- The Process of Experimentation Test. While working to overcome technical uncertainties, there must be evidence of experimentation to evaluate alternative solutions. This can be accomplished through prototyping, iterating and testing, among other methods. Having successful experiments is not a requirement for the credit. The IRS states that failures still qualify for the credit (and in fact offer a good case for proving uncertainty).
What cannot be claimed
How to interpret the four-part test, along with the thousands of pages of additional IRS guidance around the credit, and put it into practice is where your specialized tax services team comes in. For instance, the IRS has a substantial list of items that are explicitly excluded from eligibility for the tax credit:
- Research after commercial production. Once the business component is developed to the point where it is ready for use, companies cannot claim any further research tax credit.
- Adaptation. A business cannot claim the tax credit by merely tailoring the activities to customers’ requirements.
- Duplication. Companies cannot reproduce (either in whole or in part) an existing business component previously developed.
- Surveys, studies, research relating to management functions. Activities such as market research, employee training, customer satisfaction surveys and the like do not qualify for the tax credit.
- Internal use software. Software for internal use has a higher threshold to prove innovation, including the criterion that a similar product cannot be commercially available.
- Foreign research. The research must be done in the United States or any of its territories (including Puerto Rico and the U.S. Virgin Islands).
- Social science research. As mentioned above, research must be in the hard sciences, not in softer science domains like economics, business management or behavioral science.
- Funded research. Research funded by contract, grants, or a person or government entity does not qualify.
3 Tips for Dealing with the Guidance
The IRS has increased the level of documentation required to prove a company’s activities qualify for the R&D tax credit on an amended return, likely in an attempt to deter fringe or borderline interpretations of the tax code. What’s plain is the IRS’s intent with the recent guidance to have taxpayers provide more support for their R&D credit claims by citing exactly what they’re expecting to receive. Below are three tips for any business looking to make an R&D tax credit claim, whether the business is seeking a refund claim or not.
- Identify the Nexus Between the Project and Expenses.
The IRS now requires a detailed breakdown of the Qualified Research Expenses (QREs) related to the Qualified Research Activity (QRA), also known as the “nexus.” Previously, this level of detail was typically requested only when a company was being examined by the IRS. To make a refund claim using the credit, companies must identify all research activities performed during the year, which staff members worked on the projects, their tasks, and what they were attempting to discover through the research. Understanding where the nexus is will also help make Tip No. 2 significantly easier.
- Document All Activities.
Knowing the nexus and tracking the expenses are two different things, but both are equally important. A company needs to show how researchers, supervisors, and support staff worked on the QRA, including time during the calendar year worked on the QRA, the types of tasks performed, and the various materials and other expenses incurred on the project. It is easier to have a contemporaneous account of these activities, so companies and their accounting teams should (if they haven’t already) create systems and processes that can handle this influx of information.
- Have a Sophisticated Service Provider to Help Navigate This New Landscape
The IRS revealed their changes to the R&D tax credit on Oct. 15, 2021, surprising many taxpayers and accounting professionals alike. It has already required many service providers to complete the herculean task of collecting and submitting the information by the end of the grace period on Jan. 9, 2022. However, not all companies are aware of these dramatic changes or are equipped to handle this new complexity. That’s why companies must partner with a service provider that understands what these new rules require and have the expertise to make informative decisions.
To Stay on Top of the IRS’s Latest and Any Future Changes, Choose BPM.
The R&D tax credit is a very popular incentive for many companies. It has helped reduce the cost of innovation across virtually every industry. In 2018, more than 26,000 companies received over $22 billion in credits from the IRS. The changes to the program will likely reduce these figures significantly in the future.
That said, the U.S. tax code is fluid, and change can happen with little notice. That’s why the professionals at BPM are ready to help companies, big and small, with all their R&D-related tax matters. Our professionals are recognized authorities on corporate and specialized tax matters. To learn more about how we can help, please contact Andre Shevchuck, Tax Partner and Head of BPM’s R&D Tax Credit Consulting practice, today.