R&D tax credit: Significant reporting changes proposed by the IRS
Recently proposed reporting changes currently being contemplated by the IRS and Congress could impact taxpayers claiming the R&D tax credit as soon as the 2024 tax year. In light of these potential changes and recent court cases, taxpayers should review their substantiation strategy and prepare to provide additional information should that be required to claim the credit going forward.
On September 15, 2023, the IRS released a preview of proposed changes to Form 6765, Credit for Increasing Research Activities (which is also commonly known as the federal research credit or R&D tax credit). Form 6765 is the main form used by taxpayers to claim the credit.
According to IRS release IR-2023-173, the proposed changes would make tax reporting more consistent and would improve the information received for tax administration.
Taxpayers should note that while Congress is currently contemplating rule changes regarding the capitalization of Section 174 costs, notwithstanding those changes, the changes to Form 6765 could potentially be implemented by the IRS beginning with tax year 2024.
Whereas the current Form 6765 focuses almost exclusively on the quantitative aspects of the research credit calculation (i.e., the amount of qualified research expenditures [QREs]), the new form previewed by the IRS includes qualitative information related to the research projects and products of the taxpayers.
New sections proposed on Form 6765 for R&D tax credit claims
Among the most significant of the proposed changes to Form 6765 is the addition of a new Section E composed of five questions seeking additional information, including:
- The number of business components included in the credit calculation,
- The amount of officer’s wages included in the credit calculation as wages for qualified services,
- Whether any major portion of a trade or business was acquired or disposed of in the tax year,
- Whether any new categories of expenditures were included in the current year qualified research expenditures (QREs),
- Whether any QREs were determined following the ASC 730 Directive.
The fourth question of this new section E raises questions among R&D tax practitioners. The IRS did not provide an explanation nor definition for the term “new categories of expenditures.” While this question appears to relate to the statutory and regulatory consistency requirement between the credit year and the base years, it is not clear what constitutes a new category of expenditures.
The second significant addition to the proposed Form 6765 is the new Section F. Section F would require taxpayers to provide additional details for each of the business components included in the credit calculation. The proposed questions ask for the following information:
- The descriptive name of each business component,
- A description of the information sought to be discovered and the identification of the one or more alternatives evaluated in the process of experimentation for each business component,
- Whether the business component is new or improved,
- The business component type (product, process, computer software, technique, invention, or formula),
- The business component use (whether it is to be sold, leased, licensed, or used by the taxpayer in a trade or business),
- If applicable, classification of the computer software (only applies if that is the type of business component).
- The breakdown, for each business component, of direct research wages, direct supervision wages, direct support wages, cost of supplies, rental or lease cost of computers and appliable amount of contract research expenses.
For most taxpayers, each research project identified in a credit claim involves a specific business component, meaning that taxpayers will now have to report, on Form 6765, details and breakdowns of activities and expenses for every research project.
Lastly, the proposed Form 6765 would also require the taxpayer to make the election for a reduced credit at the top of the form, and to indicate if it is a member of a controlled group or business under common control.
Based on the explanations provided by the IRS, it appears that the Service could be considering making the new Section F optional for certain taxpayers including those:
- With qualified research expenditures less than a certain dollar amount at a controlled group level,
- With a Research Credit less than a certain dollar amount at a controlled group level,
- That are a Qualified Small Business for the Payroll Tax Credit.
Substantiation is key for claiming research credit
There is no indication yet as to when the IRS will finalize any changes to Form 6765. However, whether or not the IRS moves forward with the proposed Form 6765 (with or without modifications) recent administrative and judicial guidance suggest a renewed emphasis on the substantiation of R&D tax credit claims.
Taxpayers were denied the research credit in several recent U.S. Tax Court cases due to the taxpayer’s lack of documentary substantiation. Such cases include Moore v. Commissioner, T.C. Memo. 2023-20 and Betz v. Commissioner, T.C. Memo. 2023-84. In Betz for instance, the Court stated that “merely identifying a project difficulty and the eventual design solution, without bridging the gap with evidence as to what investigative activities were performed, does not satisfy petitioner’s burden.”
In light of the proposed changes to Form 6765 and the signals sent by the courts, taxpayers claiming the R&D tax credit should plan ahead and review their substantiation strategy. Additional information will likely be needed to claim the credit starting in 2024. Waiting until the end of 2024 to consider changes in documentation methodology could prove costly and inefficient. Taxpayers should consult with their R&D tax credit advisors as early as possible to design a plan that proactively aligns with the IRS’s proposed reporting requirements and the Court’s renewed focus on documentation.