The research and development (R&D) tax credit is one of the most widely applicable tax credits available to businesses. It provides an incentive for most companies to bring new or improved products to the marketplace or to improve production processes. R&D tax credits may also be applied retroactively, which could result in cash refunds from previously filed tax returns. Smaller businesses benefit as well. Companies with gross receipts that are less than $50 million can use the credit to offset alternative minimum tax (AMT) liability, and qualifying start-up companies can use the credit to offset payroll tax.
R&D tax credits can be significant, and taxing authorities want to ensure that they are being used for their intended purpose. As a result, R&D activities come with a high level of scrutiny.
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 is often disallowance of the amount claimed, which can often be applied to other periods.
The IRS recently released guidance that may relieve some of the R&D compliance burdens for large companies. 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. Large companies should pay particular attention to the directive and consider implementing its recommendations.
What Are the Main R&D Compliance Issues?
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 four main criteria in order to be eligible:
- Relate to a new or improved business component’s function, reliability, performance or quality
- Technological in nature, relying on principles of physical, biological or computer science or engineering
- Eliminate uncertainty in capability, method or design
- Involve the process of experimentation and the evaluation of alternatives through trial and error, testing, or modeling
Parameters for qualifying R&D activities can be broad, and 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. Reviews can be very time-consuming and costly for the taxpayer.
How Does the IRS Directive Help with R&D Compliance?
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 (LB&I) division to accept the qualified research expenses of taxpayers who 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. The directive has the potential to dramatically reduce the compliance process should a large company’s R&D expenditures be the subject of an audit. For more information on how the changes to R&D expenses compliance actions could affect your business, please contact us.
Copyright © 2017, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).