The Internal Revenue Service (IRS) has attempted to review and audit R&D credit claims through various techniques and strategies over the years. In addition to a compliance campaign targeted specifically at research credit claims, the IRS introduced R&D credit documentation requirements for taxpayers seeking refunds attributable to the R&D tax credit under Internal Revenue Code §41. New requirements include changes in the IRS’s approach both to research credit refund claims and to research credits more broadly.
In January 2022, the IRS updated its October 2021 memorandum and released additional information about its new standards for R&D credit documentation requirements. These updates include some FAQs and interim guidance for agents, as well as a modification to the perfection period outlined in the initial guidance.
Finally, in September 2022, the IRS extended the transition period during which taxpayers are given 45 days to perfect a research credit claim for a refund before the IRS makes a final determination on the validity of the claim. The transition period was extended for one more year, through January 10, 2024.
Items Necessary to Document a Refund Claim Based on the R&D Tax Credit
The Research and Development (R&D) tax credit is designed to incentivize innovation and has been used since 1981 by companies. However, the tax credit has also been exploited by taxpayers who have claimed it for doing little in the way of innovation, and it often appears on the IRS’s annual list of the Dirty Dozen tax scams.
The January 2022 Chief Counsel memorandum came in response to questions from IRS officials about what information taxpayers should provide with their claims for refunds or tax credits, what format they should use, and how the statute of limitations applies. As a result, the amount of R&D credit documentation requirements for an amended return to become a valid refund claim was significantly increased.
Taxpayers must provide the following information along with their amended returns:
- Identify all the business components to which the research credit claim relates for that year.
- For each business component:
- Identify all research activities performed;
- All individuals who performed each research activity; and
- All the information each individual sought to discover.
- Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year.
This can be done using Form 6765, Credit for Increasing Research Activities.
The format in which the IRS published this memorandum has resulted in different ambiguities about what happens next. This type of modification to the process for claiming a refund based on credit is usually released in a proposed form with a specific period for comments from affected taxpayers.
However, in this case, an internal memorandum was released to the public accompanied by an information release saying that the service will not require the disclosures described for several months and that comments can be emailed to a specific address. No specific comment period was listed and while the release indicated that further details will be forthcoming, there is no information about what form those details will take.
Taking this into consideration, the latest R&D tax credit documentation requirements provoked different reactions from tax professionals and clients, along with requests for more clarification. The IRS extended the deadline for perfecting the refund claims, expanding the transition period from 30 to 45 days to provide more evidence to back up tax refund claims involving the research credit. However, for claims that include a research credit claim filed during the transition period from January 10, 2022, through January 9, 2023, taxpayers were given 45 days to perfect the claim that is filed on a timely basis but does not provide the five essential pieces of information.
Ensuring Compliance with R&D Tax Credit Documentation Requirements
New R&D tax credit documentation requirements are part of the IRS’s ongoing efforts to manage issues with the tax credit and IRS resources in the most efficient manner. The IRS receives thousands of R&E claims for credits from corporations, businesses, and individual taxpayers. Claims for the research credit under Section 41 of the Tax Code are examined in a substantial number of cases and take up significant time and resources for both the IRS and taxpayers. By requiring taxpayers to comply with new R&D credit documentation requirements, the IRS can simplify the process of determining upfront if an R&E credit claim for refund should be paid immediately or whether further review is needed.
Even though this creates additional obligations for them, taxpayers must consider R&D credit documentation requirements when pursuing R&D refund claims. The new IRS updates may potentially discourage some companies from claiming R&D credit refunds that they are entitled to, but a carefully designed R&D credit study can provide answers to most of the questions required by the memorandum. To do so, an R&D credit study should demonstrate the business component test, how uncertainties were eliminated, the research activities performed, the personnel performing those activities, and the total wage expenses.
In addition to this, to ensure proper handling of new R&D tax credit documentation requirements, businesses can outsource R&D credit management. By relying on exceptional experience, technology and resources, taxpayers can remove the burden of R&D tax credit documentation and calculations and the necessity of monitoring for changes in regulations that could affect tax credits. Instead, they can gain a deeper view of incentive opportunities for which they may be eligible, and focus more on potential cost offsets and less on compliance activities.