The IRS’s New R&D Documentation Demands
It’s no secret that the IRS is tightening its tax-compliance belt, promising an increase in the number of corporate tax audits, more transfer pricing scrutiny—and now according to the IRS’s Chief Counsel Memo released on October 15—new guidance regarding R&D tax credit refund claims. Why? The IRS wants to make screening refund claims for validity easier for the agency to handle, and a new level of documentation is a good place to start. The new guidance requires granular details surrounding R&D activities, as opposed to allowing taxpayers to report on a big-picture scale. And apparently, there’s no time like the present: The new requirements go into effect on January 10, 2022, though there will be a year-long transition period where taxpayers will be provided an opportunity to revise amended claims if they initially fail to meet the new demands.
What does the new guidance mean for taxpayers? You’ll be saddled with additional documentation burdens. The IRS is going to the trouble of spelling out exactly what they want to know from taxpayers, and it has an unforgiving attitude toward those who fail to deliver. If a claim is rejected because it’s substandard (i.e., you didn’t follow the new guidance), the taxpayer may not be able to amend it. And since courts won’t review claims that fail to meet the minimum standards, you won’t have legal recourse either.
What are the Agency’s new demands? We’re providing a rundown of the new guidance—along with what it could mean for taxpayers. The worst-case scenario, of course, isn’t the extra work, it’s that taxpayers may think it’s not worth applying for the refund credit altogether. Wrong. The R&D tax credit—a dollar-for-dollar credit—continues to be the most generous tax credit available to corporations in the U.S. So, as always, follow regulations and produce robust, accurate documentation that won’t leave the IRS guessing and you’ll see one aspect of the refund credit—and the regular credit—that hasn’t changed: Applying is still a no-brainer.
Forget the big picture. There’s nothing wrong with an overview of an R&D activity, but on an R&D tax credit refund claim, the IRS wants to see activities on a micro-level. In fact, the new guidance is requiring that “claims for refund,” (i.e., when you amend a return to include the credit and request a refund of tax you already paid for that tax year,) include specific information about each business component—essentially any product, process, computer software, technique, formula, or invention—that comprises R&D activity. For some taxpayers, the number of business components—and therefore, paperwork—could really add up. For each business component, the taxpayer should include three things: 1.) all the research activities performed 2.) all the individuals who performed each research activity and 3.) all the information each individual sought to discover. Unfortunately, if a taxpayer has a long list of components, or a large number of involved employees, the documentation could be hundreds of pages.
Break down expenses. Along with examining the contribution to R&D activities on a business-component level, the IRS wants to see the expenses associated with each component, on a unit-by-unit level, too. In the past, taxpayers have had to list the total wages, supply expenses, rental or lease costs of computers, and contract research expenses, so this should be one of the easier demands given they have the information and just have to list it component-by-component. Total expenses for a particular software equals X. A new packaging process project’s expenses equal Y. And so on.
Do some handholding. Think a mere stack of documents will satisfy the IRS? Think again. The IRS doesn’t have the time to sift through pages and pages to support the facts and circumstances in a refund claim, it’s the taxpayer’s job to spell things out—now literally, in a “written statement,” not a “production of documents.” No doubt one of the more profound burdens of the new guidance, the IRS wants to see a narrative around R&D activities and is essentially asking taxpayers to write a persuasive case for the refund. However, the Agency will permit if a taxpayer presents documents that include a credit study and specifies the precise page that supports a corresponding fact.
Sign off. How sure are you about the facts listed in your claim? The IRS says you had better be absolutely sure. The Agency is requiring that the taxpayer declare under penalty of perjury that all of the facts in a claim are correct—for most taxpayers, signing forms 1040X or 1120X should do it. While not a new requirement for amended returns, the additional information required to be submitted increases the burden correspondingly.
Claim on time. To be considered for the R&D tax credit, you must file a claim within the statute of limitations, typically within three years of the date the original return was filed or two years from the time the tax was paid, whichever happens last.
Stay tuned. The new guidance still leaves some questions unanswered: Will these requirements become standard for original returns claiming R&D? Will the IRS expect an increased level of detail on amended returns that came in before January 10, but haven’t yet been processed? For now, it’s too early to tell so watch for updates.