In recent guidance, the IRS has imposed strict new documentation requirements on businesses that file refund claims for federal research credits. These tax breaks are often referred to as “research and development,” “R&D” or “research and experimentation” credits.
Currently, businesses may claim the research credit on an originally filed return or an amended return. The new requirements apply to the latter, although it’s possible that the IRS will attempt to enhance the documentation requirements for originally filed returns down the road.
Overview of the credit
While the research credit and related regulations are complex, in a nutshell, they allow a business to claim a credit for a portion of its increased expenses attributable to qualified research activities (QRAs). Generally, QRAs are activities that:
- Are incurred in connection with the taxpayer’s trade or business,
- Strive to discover information that’s technological in nature,
- Relate to a new or improved business component, such as a product, process, computer software, technique, formula or invention, and
- Are part of a process of experimentation.
Historically, a business claiming the research credit — whether on an originally filed return or an amended return — didn’t need to include specific documentation with its filing. Rather, the business was required to “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”
The new guidance is based on the specificity requirement in the IRS regulations. Under this requirement, a taxpayer claiming a refund must “set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.” Accordingly, for a research credit refund claim to be valid, a taxpayer must, at a minimum, follow these three steps:
- Identify all business components to which its 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 (for example, using Form 6765, “Credit for Increasing Research Activities”).
This is a significant departure from previous guidance. Previously, businesses had to retain records to substantiate the research credit, but they weren’t required to include such documentation with their amended returns. Not only does the new guidance place additional burdens on businesses filing refund claims for the research credit, but it also increases the risk that the credit will be denied.
Suppose, for example, that a business files a refund claim shortly before the statute of limitations expires (generally, three years after the original filing or two years after the tax was paid, whichever is later). If the IRS rejects the claim for failure to meet the new documentation requirements, the business will lose the opportunity to refile its claim to supply the missing information.
The new requirements apply to refund claims postmarked after January 10, 2022. During a one-year transition period that runs through January 9, 2023, the guidance provides some relief for taxpayers that file deficient claims.
These taxpayers will receive a letter from the IRS detailing the missing information and providing them with 45 days to “perfect” the filing. So long as the initial refund claim was filed on a timely basis, a claim that’s perfected within this 45-day period will also be considered timely, even if the statute of limitations has expired.
Get your papers in order
If you plan to file an amended return to claim the research credit, familiarize yourself with the new documentation requirements and be sure you have all the information to include with your return. Once the transition period ends, there will be no do-overs. Contact your tax advisor for assistance.
What’s happening with research expense deductions?
Traditionally, there have been two distinct tax benefits for businesses that conduct research: the research credit and the deduction for research expenses. Previously, businesses had the option of deducting these expenses immediately in the year they’re paid or incurred. But under the Tax Cuts and Jobs Act (TCJA), starting this year, most research expenditures must be capitalized and amortized over at least five years (15 years for research conducted outside the United States).
This requirement will affect not only the deductibility of research expenses but also the value of the research credit. Be aware, however, that legislation pending in Congress would delay the requirement until 2026. Stay tuned.