Recent R&D tax credit developments could impact your tax return

The Credit for Increasing Research Activities of Internal Revenue Code (I.R.C) Section 41, commonly known as the R&D tax credit or research credit, is a valuable tax incentive for any business involved in research and experimental development. With the 2021 filing season underway, taxpayers should pay attention to recent administrative, judicial and legislative developments that could impact how they prepare and file their R&D tax credits.

Changes to refund claim requirements

Last fall, the IRS released a memorandum that set forth new documentation requirements, which went into effect January 10, 2022, for taxpayers filing a refund claim based on the R&D tax credit. The IRS later confirmed that these new and more onerous documentation requirements will apply only to claims filed on amended tax returns and will not target R&D credits claimed on original returns.

More specifically, the memo indicates the IRS will require taxpayers to provide additional supporting documentation with refund claims filed on amended tax returns. The documentation must include:

The identification of all business components to which the R&D tax credit refund claim relates;

For each of those business components:

• All research activities performed;
• The individuals who performed each research activity; and
• The information that each individual sought to discover.

The total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (this information can be provided directly on Form 6765, Credit for Increasing Research Activities).

The IRS memo indicates that this information must be provided in a written statement rather than through the production of documents. If a taxpayer submits a credit study, the exact page(s) supporting each fact must be specified.

In a recently released FAQ document, the IRS stated that taxpayers submitting a claim believed to be deficient will be notified and allowed 45 days to correct their filing.

This significant procedural change surprised many R&D tax practitioners. It goes against a recent opinion issued by the United States District Court for the District of Utah (see Premier Tech, Inv. V. United States, No 2:20-CV-890-TS-CMR), an opinion that the IRS is “aware of” and “currently evaluating” according to its own memorandum.

Pending further developments, taxpayers planning on claiming R&D tax credits for prior tax years through amended returns should consult with their tax advisors to determine the best course of action. Taxpayers who intended to claim their 2021 research credit on an amended tax return should revisit their plan to file on an original return.

ERC versus R&D tax credits

There is an interplay between the Employee Retention Credit (ERC) and the R&D Tax Credit. Simply put, taxpayers cannot “double dip” in the ERC and R&D credits.

Pursuant to IRS Notice 2021-23, wages included in the calculation of the 2021 ERC cannot be included as a Qualified Research Expense (QRE) in the calculation of the R&D tax credit. Certain items includable as wages under the ERC, such as pre-tax health plan expenses, are not includable as QREs for the R&D tax credit.

Taxpayers should consult with their tax advisors in order to confirm a proper allocation of wages between the two credits. The number of quarters of eligibility to the ERC and the moment in the year where certain employees performed qualified research services could have an impact on the optimization of both credits.

Recent court Case: Little Sandy Coal

Of all the court cases in 2021, one in particular got the attention of R&D tax specialists.

In Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15 (“Little Sandy”), the court disallowed the taxpayer’s claim for wages paid to workers who built a prototype barge and dry dock. More specifically, the tax court found that the taxpayer failed to meet the “substantially all” requirement of Treasury Regulations Section 1.41-4(a)(6). This rule pertains to the process of experimentation and is satisfied only if 80 percent or more of a taxpayer’s research activities (measured on a cost or other consistently applied reasonable basis) constitute elements of a process of experimentation.

In Little Sandy, the tax court concluded that the services performed by production workers building the prototypes were not elements of a process of experimentation, but rather were services performed in “support” of research. While R&D tax practitioners generally disagree with the conclusion of the court, this case is another reminder of the importance of substantiating the process of experimentation followed in a qualified research project.

Moving forward, taxpayers will want to clearly distinguish and quantify the costs associated with the performance of qualified research services from the costs associated to activities performed in direct support or in direct supervision of research.

Capitalization of research & experimentation (R&E) expenditures

In the absence of a legislative change addressing the unfavorable new treatment of Section 174 Research & Experimentation Expenditure introduced by the Tax Cuts and Job Act of 2017 (TCJA) that took effect on January 1, 2022, taxpayers will need to capitalize current-year R&E expenditures and amortize those over a five-year period. Expenditures for foreign R&E will have to be amortized over a period of 15 years. Any amount incurred in connection with the development of software will be included as R&E and will have to be capitalized and amortized accordingly.

This a major departure from the previous Section 174 rules that allowed taxpayers to immediately deduct R&D expenditures. While a postponement of this new capitalization regime to 2026 has been proposed in Congress, it remains uncertain if Congress will pass any legislation and when such legislation could be enacted.

Taxpayers need to prepare now and consult with their tax advisors about the potential impact on quarterly estimated tax payments.

Looking ahead

With uncertainty about what, if any, tax changes may be on the horizon for 2022, taxpayers should be proactive about speaking with their advisors. The R&D tax credit continues to be a lucrative tax incentive for businesses investing in research and experimental development, which includes many companies in the technology, manufacturing, healthcare and construction industries, among others. Contact me or another member of Kaufman Rossin’s Cost Segregation, Credits & Incentives team to learn more about how your business may be able to benefit.