IRS Audits on Research Expense Tax Credits are Increasing – Here’s How to Prepare
September 22, 2020 by Joshua Smeltzer
In February of this year the IRS announced a specific campaign regarding tax credits allowed for increasing research activities under Sections 41 and 174 of the Internal Revenue Code (IRC). The campaign specifically mentions “issue-based examinations” as part of compliance efforts. The COVID-19 pandemic delayed many audits already in progress and, likely, stopped some planned audit notices from being issued. However, as the IRS continues its attempt to return to full capacity and function, the audits of research tax credits claimed will certainly be included.
If a company engages in qualified research, it may be entitled to an R&D Tax Credit equal to 20 percent of the excess (if any) of: (1) its qualified research expenses (i.e. QREs) for the tax year, over (2) a statutorily defined “base amount.” Tax credits are viewed by the IRS, and the courts, as “a matter of legislative grace,” and they are allowed only if the statutory requirements are clearly met. This means that, as a taxpayer, if you don’t have sufficient books and records in sufficiently usable form and detail to establish that your expenditures are eligible for the R&D Tax Credit, you might be out of luck. If you have claimed these popular tax credits, here are some key questions to consider to prepare for any potential or current IRS audit.
- Do your financial statements count as sufficient evidence? On September 10, 2020 the IRS updated its previous 2017 guidance to allow tax credits, under IRC Section 41, for taxpayers expensing R&D costs on their financial statements. The IRS admits that determining the correct amount of research credits is time consuming. In an effort to ease the burden on examiners the IRS appears willing to accept certified audited financial statements as sufficient evidence of QREs. However, there are certain conditions that apply and it is only available to taxpayers with assets equal to or greater than $10,000,000. The full details are outlined on the IRS website. For taxpayers who meet the conditions this will save them a lot of time and effort justifying expenses.
- Is the research claimed “qualified” research? To establish its qualified research expenses, the taxpayer must prove that it performed “qualified research” during the tax years at issue. The taxpayer must show that the research was part of a process of experimentation intended to discover technological information that could be useful in developing a new or improved “business component” of the taxpayer. A business component is any product, process, computer software, technique, formula, or invention that the taxpayer is to: (1) hold for sale, lease, or license; or (2) use in a trade or business. The IRS doesn’t specify the necessary documentation for substantiating qualified research, so taxpayers can use anything that shows they are eligible for the credit. However, despite this documentation flexibility, you can be assured that if the evidence is unclear or disputable then additional explanations and legal arguments will be required.
- Is your research activity specifically excluded from “qualified” research? The Internal Revenue Code specifically removes certain activities from being included as “qualified” research expenses. These include funded research, adapting or duplicating existing business components, or any activity determined to be routine testing for quality control. What is an adaptation, duplication, or routine testing is a facts and circumstances test that has caused several disputes at the IRS and federal court levels. As part of the audit process the IRS may employ engineers to help them understand the specific expenses. These engineers may or may not have the required understanding of a company’s specific business. If not, a detailed explanation and supporting documentation will be required to help the IRS, or a court, understand specifically why an expense is qualified research.
- Do you have support for your based amount? Establishing the taxpayer’s qualified research expenses is only half the battle. The taxpayer must also determine the “base amount,” because the R&D Tax Credit is a function of the amount by which qualified research expenses exceed this baseline. The base amount is the product of: (1) the fixed-base percentage; and (2) the average gross receipts of the taxpayer for the four taxable years preceding the taxable year for which the credit is being determined. The fixed-base percentage is generally obtained by dividing the taxpayer’s aggregate qualified research expenditures for the tax years 1984–1988 by the taxpayer’s aggregate gross receipts during those years. However, a potentially favorable alternative calculation applies when the taxpayer qualifies as a “start-up company.” Either way, the calculation can be complex and, if wrong, could change or eliminate the credit entirely. The evidence supporting the calculation is equally important as cases have invalidated base amount calculations where the only evidence is inadmissible hearsay of consultants used to determine the proper calculation.
The research credit is designed to encourage businesses, large and small, to invest in research that will benefit their businesses, the economy, and the ultimate consumer. If a taxpayer qualifies, they are entitled to this important tax benefit. I’ve handled cases involving the research tax credit as both a government and private attorney and know that confusion over expenses, and the available support, results in longer disputes with the IRS and potentially costly court battles. The time spent considering these questions and gathering supporting evidence is time well spent. It may resolve an audit earlier than usual or, if necessary, provide you with the best argument possible in court. As with any tax law question, the specific facts and circumstances of the taxpayer are paramount. If you have a question regarding research expenses and available tax credits, please reach out to a Brown Fox attorney.