In recent years the IRS has become increasingly aggressive in challenging research and development (R&D) credit claims, particularly refund claims. After introducing a compliance campaign targeted specifically at research credit claims, on October 15, 2021, the IRS announced it is requiring additional R&D credit documentation to be submitted by taxpayers seeking refunds attributable to the R&D tax credit under Internal Revenue Code §41.
The Chief Counsel memo issued by the IRS lists the new requirements, which generally involve the taxpayer’s underlying research activities and projects. Although routinely requested during IRS audits, these items have not previously been required when submitting a valid R&D credit claim for a refund. Therefore, the Memorandum takes the IRS’s enforcement efforts concerning research credit claims to a new level, by placing significant new R&D credit documentation requirements on what constitutes a valid refund claim.
Recently, the IRS has issued additional information about its new standards for documentation of refund claims. The January 2022 releases include some FAQs and interim guidance for agents, as well as a modification to the perfection period set forth in the initial guidance.
Items Necessary to Document a Refund Claim Based on the R&D Tax Credit
In the context of the R&D tax credit, a refund claim was generally considered valid by submitting a complete and correct Form 6765, outlining how the taxpayer computed its R&D credit along with the various inputs used in that computation. The R&D Credit Memo significantly increased the amount of R&D credit documentation that a taxpayer must provide with an amended return for it to become a valid refund claim. As a result, a taxpayer must provide the following information along with its amended return:
- 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.
The IRS issued a press release along with the R&D Credit Memo that set January 10, 2022, as the effective date for the new policy, and announced a transition rule. It also announced a one-year transition period during which the IRS will give taxpayers that submit deficient refund claims 30 days to perfect their claims before they are rejected.
January R&D Credit Documentation Requirements
The FAQs issued in January aim to answer some of the questions related to the R&D Credit Memo. When it comes to the effective date and the transition period, the FAQs state that the R&D Credit Memo will only apply to amended returns that are postmarked on or after January 10, 2022. The FAQs also extend the time that a taxpayer must perfect a deficient refund claim during a one-year transition period from 30 to 45 days. During the transition period, taxpayers will be notified when the IRS determines that their refund claims are deficient and will be informed about the date by which they have to correct their claims. At the same time, the FAQs fail to provide guidance on the process of informing taxpayers of deficient refund claims after the transition period.
The FAQs also address concerns about the additional administrative burden the R&D Credit Memo will impose on taxpayers:
- Taxpayers can identify individuals performing research activities by title or position rather than first and last names;
- Taxpayers may group individuals that performed research activities in pursuit of the same information for one business component;
- Taxpayers that use a statistical sample to determine their R&D credit pursuant to Rev. Proc. 2011-42 must comply with the R&D Credit Memo but only provide information about business components, employees, and the information sought with respect to the sampled units;
- Taxpayers that use statistical sampling must still provide their total qualified expenses on Forms 6765.
Lastly, the FAQs explain that an amended return on which a taxpayer claims additional R&D credit and other items will be considered deficient in its entirety if the information provided with respect to the R&D credit is not considered sufficient under the R&D Credit Memo.
Even though FAQs provide additional information and explanations regarding the R&D Credit Memo, they fail to address some issues. Rather, the FAQs provide details on transition rules as well as clarifications aimed at easing taxpayer compliance.
Proper Handling of New R&D Credit Documentation Requirements
Taxpayers who are planning to file an amended tax return claiming a refund based on the R&D tax credit should be aware that they may be subject to significantly higher R&D credit documentation requirements after Jan. 10, 2022. To remain compliant, it is critical that they monitor developments on this issue and establish how the R&D Credit Memo might affect their claim for an R&D tax credit.
To ensure proper handling of new R&D credit documentation requirements, businesses can outsource R&D credit management and rely on experts in this area who take time to fully understand their research activities so they can identify how these recent developments may impact their organization.