Following the issuance on Sept. 10, 2020 of the IRS Large Business and International Division revised directive “Guidance for Allowance of the Credit for Increasing Research Activities Under I. R. C. Section 41 for Taxpayers That Expense Research and Development Costs on Their Financial Statements Pursuant to ASC 730,” there was a lot of commentary. I would first add that it should receive an award for the longest title, but I digress. Much of the commentary, including mine, merely explained the changes; however, some seemed to imply the Directive has little benefit left. I disagree.
The benefits have not changed from the original Directive:
- Leverage the work already done to report the ASC 730 amount on U. S. GAAP Financials.
- Claim 95% of wages for qualified individual contributors.
- Claim 95% of wages for 1st level supervisor managers
- Claim the lesser of 10% of wages claimed for individuals and 1st level supervisors or W-2 wages paid to upper-level managers.
- Eliminate expensive studies year after year.
- Once methodology is established, eliminate contentious examinations year after year (some states follow the Federal Directive).
- Have certainty on research credit tax position.
I would say that from the IRS’ standpoint, if they no longer wanted to offer the Directive as a way of simplifying the way taxpayers claim the research credit and reduce resources for both parties, then they would have simply rescinded the Directive. Think of it as a pre-approved IRS methodology. If audited, once the initial review is conducted by the Service, you should be good to go for years to come, provided you do not deviate from what you are doing.
Then, you may ask, why did the IRS feel compelled to make changes? As I stated in my article “5 Things Taxpayers Should Know about 2020 R&D Tax Credit Directive,” I believe they recognized some holes in the original Directive. The whole premise was based on a belief that external auditors had certified the disclosed ASC 730 amount as being a reliable number on the financial statements. Since section 41 and ASC 730 have enough similarities, with some adjustments, a taxpayer can use the ASC 730 amount to claim a credit under section 41. This made it a reasonable alternative to the traditional time-consuming way of claiming the research credit.
However, after some experience with the Directive, the IRS discovered the following:
- In reality, the financials are certified in their totality, not a line-by-line certification.
- The ASC 730 amount is not always a material amount, and in some instances, very little attention is given by the auditors.
- Costs can be expensed whether in ASC 730 or elsewhere in the financials (i. e. does not overstate earnings).
- In some instances, there may be non-ASC 730 amounts included in the ASC 730 total.
- Some examiners were doing an inadequate job of substantiating the accuracy of taxpayers computing the final section 41 amount.
The revised Directive requires examiners to take more thorough steps to substantiate how taxpayers are applying the Directive and primarily focuses on two additional items – (k) and (l) under documentation.
Item k requires a taxpayer to demonstrate, in writing, the methodology and calculations for determining the amount listed in Appendix C, Lines 3a and 3b, see below. If no amounts are listed, then the taxpayer must show how they determined none were included in the U. S. Financial Statement R&D amount. Line 3a is referring to software development costs other than software for sale, lease or otherwise marketed. Line 3b refers to the expenses identified under ASC 730-10-55-2 (similar to 41(d)(4)) or any other non-ASC 730 expenditures.
A written methodology can be developed to explain how expenses not qualifying as ASC 730 costs are carved out and if none exist, how that determination was made. This means some analysis not necessarily conducted for financial purposes must be performed. The documented methodology will need to be established showing how costs are captured and classified. To meet both requirements in item k, the starting point would be to analyze the cost centers and G/L accounts that make up the Financial Statement R&D amount. This should establish the criteria for ensuring costs for software development not qualifying under ASC 730 and amounts excluded under ASC 730-10-55-2 or other non-ASC 730 amounts have been properly captured and quantified. The requirement goes on to say if there is no amount for these items, then a taxpayer must show how they established none were included in the ASC 730 amount. A methodology that analyzes all cost centers and G/L accounts included in the book R&D amount should satisfy this requirement and can be presented.
Keep in mind that this is in lieu of the normal research credit substantiation, including disagreements over business component, uncertainty and process of experimentation. Also, establishing a process to substantiate your compliance with the Directive will likely only have to be done once. This initial setup is an investment in claiming what can be millions of dollars in tax benefits over the years.
Item l requires substantiation of Internal Control Over Financial Reporting (ICFR) designed to mitigate material misstatement of the expenses reported per financial statements. For public companies, the external auditors will have used some version of a checklist to meet the requirements of ICFR. The checklist is designed to evaluate internal controls and may not specifically address R&D expenses as required by FAQ – Substantiation Q5.
This presents a challenge; the Directive applies to public companies as well as private companies as long as they have certified financials under U. S. GAAP. Since ICFR is only a requirement for public companies, auditors may need to implement a specific checklist for the taxpayer’s R&D expenses. Even if the company is public, the checklist is not specifically geared towards R&D expenses. In order to take advantage of the Directive, a taxpayer will need to ensure the external auditors have substantiated ICFR, designed to mitigate material misstatement of the taxpayer’s expenses reported per their financial statements, (e. g. , a checklist covering internal controls, including a general discussion relating to R&D expenses whether public or private).
In summary, the Directive’s benefits have not changed. There are a few additional hoops to jump through, but these should be a one-time set-up and walkthrough. Remember, the IRS does not want to examine a research credit issue any more than a taxpayer wants to go through the issue in Exam. I believe the IRS is motivated to make the Directive work and take the research credit issue off the table.