Credits for research and development are among the most significant tax-reduction opportunities available to businesses. As a result, taxing authorities give R&D activities a high level of scrutiny. Based on a recently released directive by the IRS, taxpayers may find this burden relaxed if they comply with the guidance.
In addition to the potential for significant savings on future taxes using the guidance, taxpayers may also consider a retroactive look at their historic filing positions to determine if they could avail themselves of refunds on previously filed tax returns.
Taxing authorities examining a company’s R&D tax credit will independently determine whether costs included are qualified research expenses. This determination has been a major point of contention between taxpayers and the IRS. If companies cannot substantiate their claim, the result can be disallowance of all or some of the amount claimed.
The IRS recently released guidance that may provide some protection for companies claiming the R&D credit. A directive issued in September 2017 provides taxpayers with an approach that could make a review of an R&D claim easier for both the company and the taxing authorities.
The main issue taxing authorities often target is whether a company’s activities and related expenses qualify as R&D activities. R&D expenses must meet the following preliminary criteria to be eligible:
• Permitted purpose: The activity must eliminate uncertainty related to a new or improved business component’s function, reliability, performance or quality.
• Technological in nature: The discovery process must rely on the principles of hard sciences (such as physical, biological, or computer science or engineering).
• Process of experimentation: The evaluation of alternatives through trial and error, testing or modeling.
Parameters for qualifying R&D activities can be broad, but there are also a number of exceptions and exclusions to the criteria above. Tax courts have held various interpretations over which activities and costs qualify for the credit. If your company’s claim is audited, regulators will want to review a variety of documentation, including requests for research expenses for past and current projects, documented interview records on the claim qualification and quantification efforts, explanations of how the business components were being developed and detailed calculations on how the consistency requirement under the statute was met.
The IRS directive simplifies the R&D review process for both regulators and large companies. It applies to companies that have more than $10 million in assets and directs examiners in the IRS Large Business & International division to accept the qualified research expenses of taxpayers that complete certain certification requirements.
Companies that complete and attach the Certification Statement Claiming Adjusted ASC Topic 730 Financial Statement R&D as Qualified Research Expenses and its appendices to their federal income tax return will not have their certified qualifying research expenses questioned by the IRS. Under the guidance, taxpayers are permitted to add additional expenses but anything not subject to the ASC 730 audit will not be protected under review by a taxing authority. Taxpayers must still be able to produce documents to support the computation of the credit, including the taxpayer’s chart of accounts, the list of cost centers that contributed to the R&D expenses and many other items.
LB&I taxpayers that choose to use the directive may implement it for income tax returns filed after Sept. 11, 2017.
Carl J. Giardino is a managing director in the Tax Group at CBIZ & MHM New England, with offices in Providence, Boston and nationwide.