By Sanjiv Gaitonde, ADP Senior Director of Tax, R&D Tax Credits and Elizabeth Bowman, ADP Senior Tax Manager, R&D Tax Credits.
Approach R&D tax credits with the confidence needed to maximize your potential opportunities as an employer. This article highlights IRS regulatory guidance updates for credit recovery that can help with understanding compliance expectations.
Research & development (R&D) tax credit opportunities are more vital than ever as companies look to offset rising costs in an era of record inflation. However, 80% of potentially qualifying small-to-midsize businesses don't believe they qualify for federal credits— or have an easy path to get them.
To identify and tap into eligible tax credit opportunities, employers must overcome hesitations surrounding the complexities of compliance requirements. A better understanding of recent IRS guidance will help provide the clarity needed to apply for these rewarding R&D tax credits with confidence.
What is an R&D tax credit and who qualifies?
As defined under Section 41 of the Internal Revenue Code, the R&D tax credit is a dollar-for-dollar reduction of a company's tax bill, based on qualified domestic expenses related to the development or improvement of products, processes, techniques, formulas, inventions or software.
When established in 1981, the R&D tax credit was intended to encourage the performance of U.S.- based technical sciences and to keep those businesses in the U.S. Due to The Protecting Americans from Tax Hikes (PATH) Act of 2015, (effective January 1, 2016) the R&D tax credit was permanently extended and the ability of many businesses, especially small-to-midsize organizations, to monetize it, has broadened significantly.
Once you've identified your business as qualifying for R&D tax credits, you'll want to review new guidance updates and conditions for credit recovery.
What's new for R&D tax credits?
IRS Chief Counsel Memorandum
Each year, the IRS receives thousands of claims for credits in the hundreds of millions of dollars from corporations, businesses, and individual taxpayers. The recent IRS Chief Counsel Memorandum, requires additional documentation be submitted for all amended tax returns which include the R&D tax credit claim. This documentation will be used to help the IRS identify R&D tax credit claim issues up front to better screen credit claims.
Specifically, the Memorandum provides that for an IRC Section 41 research credit refund claim on an amended return to be considered valid, taxpayers are required to provide the following information at the time the refund claim is filed with the IRS
- Identify all the business components to which the Section 41 research credit claim relates for that year and all associated research activities performed as part of each business component.
- Identify all individuals who performed each research activity as well as the information they each sought to discover.
- Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year.
In order to ensure that the amended refund claim is accepted, the information detailed above must be submitted as part of the amended return.
This guidance went into effect on all amended refund claims filed on or after January 10, 2022. After this date, there is a two-year transition period during which taxpayers will have 45 days to perfect a research claim prior to IRS determination.
While the IRS Chief Counsel Memorandum provides an internal tool to help the IRS identify potential R&D tax credit claim issues, it is important for businesses to be additionally aware of Section 174, Amortization of Research and Experimental Expenditures.
The 2017 Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 174 law requires capitalization and amortization of research and experimental (R&E) expenditures and software development costs, effective for the tax years beginning after December 31, 2021. TCJA also amended Sec. 41, the research credit, to define "qualified research" as research for which expenditures may be treated as "specified research or experimental expenditures" under Sec. 174.
Accordingly, how Sec. 174 costs are defined also has implications for the research credit under Sec. 41. While there are bi-partisan efforts to delay or repeal this amortization requirement, until that time, this requirement is still in effect.
To date, there is no additional guidance that suggests that section 174 Amortization will otherwise affect the Section 41 R&D credit. However, since R&D expenses currently must be capitalized and amortized starting in tax year 2022, any qualified research expenses used to calculate the credit will likely need to also be capitalized and amortized as part of section 174.
In accordance with this section, before 2022, a qualified business could either:
- Deduct expenses in the year incurred or paid, or
- Capitalized and amortized over at least 5 years.
For 2022 and after:
- Capitalize all R&E costs & amortized over 5 years for US based activity
- Over 15 years outside the US
What do these shifts mean?
In regard to tax amortization and duration, pay close attention to:
- The elimination of early deduction of expenses (year incurred or paid)
- Required amortization reporting
- The acceleration of US domestic expenses and costs vs. external expenses and costs
Also of importance is a generally higher administrative and documentation burden. Greater tracking and supporting detail of documentation and expenses includes, but is not limited to:
- Where the effort was completed (in the US, outside the US)
- What activities were included
- What were the associated costs
Tax credit compliance is a challenge that is impacted by the dynamic nature of federal legislation and regularly updated IRS guidance— a challenge that is easily overcome and overshadowed by the potential financial benefits.