Editor: Mo Bell-Jacobs, J.D.
The IRS has struggled and vacillated in its various attempts since 2000 to police the Sec. 41 research and development (R&D) credit. At the turn of the 21st century, the Service issued regulations with significant documentation requirements. Then, in 2007, it labeled the topic a "Tier 1" issue. And each year from 2016 to 2019, it placed the matter on its annual "Dirty Dozen" list. Most recently, after years of trying to perform costly and lengthy audits of R&D tax credits, the IRS on Oct. 15, 2021, issued Field Attorney Advice (FAA) 20214101F, which attempts to require specific and extensive documentation for any R&D credit refund claim. The IRS has attempted to review and audit R&D credit claims through various techniques and strategies over the years, and the FAA harks back to recordation requirements of the late 1990s and early 2000s.
On Dec. 2, 1998, the IRS published a notice of proposed rulemaking relating to the research credit, with specific documentation requirements. In these proposed regulations, the IRS claimed that the documentation required for the credit would not change taxpayer behavior but would "identify taxpayers who engage in a bona fide process of experimentation and thus may be eligible for the credit" (preamble, REG-105170-97, Explanation of Provisions, Documentation). The proposed regulations did so by requiring that, for an R&D tax credit claim, the taxpayer must include the recording of the results of the experiments (Prop. Regs. Sec. 1.41-4(a)(5)(iii)).
These proposed regulations were modified in the January 2001 final regulations to minimize the documentation burden on taxpayers but still required that "taxpayers must prepare and retain written documentation before or during the early stages of the research project that describes the principal questions to be answered and the information the taxpayer seeks to obtain that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering" (preamble, T.D. 8930, Explanation of Provisions, V. Recordkeeping Requirement). While these requirements were rejected in proposed regulations issued in February 2001 (REG-112991-01) and 2004 final regulations (T.D. 9104), they demonstrated the IRS's specific vision of the documentation required to sufficiently support an R&D credit claim.
Perhaps partly in response to the demise of the substantive documentation requirements, the IRS in 2002 labeled research credit cases as an IRS Appeals coordinated issue (ACI), which meant that any settlement offer or closing agreement that Appeals proposed had to be approved by the research credit Appeals technical guidance coordinator. One apparent result of the new process was that IRS exam agents increasingly turned over more of their work to Appeals. This in turn led to a backlog, and so in 2010 the IRS introduced a pilot program temporarily granting several Appeals team case leaders the authority to resolve some research credits without review and concurrence. The plan was to permanently expand the pilot program to more Appeals officers (Elliott, "IRS Appeals Chief Discusses Details of Research Credit Appeals," 128 Tax Notes591 (Aug. 9, 2010)).
A few years after the ACI designation for the credit, the IRS designated R&D credits (along with other tax matters) as a Tier 1 issue — i.e., an issue of high strategic importance that the IRS asserted had a significant impact on one or more industries (IRS Large and Mid-Sized Business (LMSB) Division, Industry Issue Focus (March 2007)). For the various Tier 1 issues, the IRS hoped to increase coordination and executive oversight to ensure examination coverage, consistent development, and issue resolution by issuing in April 2007 "Rules of Engagement" Internal Revenue Manual (IRM) amendments for LMSB examinations (IRM §4.51.1). The tiered approach focused on national standards rather than industry- and client-specific decision-making, which frequently frustrated both local agents and taxpayers and increased the time and costs of exams (see Johnson, "The Demise of the IRS Tiered Issue Program," JD Supra (Dec. 3, 2012)).
In a follow-up to the 2007 Tier 1 designation, the LMSB Division (now known as the Large Business & International (LB&I) Division) issued a Research Credit Claims Audit Techniques Guide,which suggested the IRS was frustrated concerning R&D credit claims even after the credit was designated a Tier 1 issue: "There is a growing trend among taxpayers, and their representatives, to submit prepackaged material to support research credit claims" (LMSB-04-0508-030 (May 2008)).
Perhaps in recognition of these problems, Rev. Proc. 2011-42 provided taxpayers with guidance regarding the use of statistical samples for tax return positions. While previous field directives and revenue procedures had authorized the use of statistical samples, the revenue procedure stated that statistical sampling was authorized for broad use by taxpayers, including for purposes of claims for refund or credit. Due to frustration over the tiered process, and perhaps because the problems that the tiered process was supposed to address were partially addressed by statistical sampling, effective Aug. 17, 2012, the IRS decided to no longer use the tiered management process to set examination priorities for any issue (LB&I-4-0812-010 (Aug. 12, 2012)).
To replace the tiered approach to audits, the IRS developed issue practice groups and international practice networks, which provide local IRS examination teams with specific technical advice. The issue practice groups still exist but are now referred to as practice networks (IRM §126.96.36.199.2(1)(a)).
There are parallels in the histories of these programs: IRS Appeals wished for greater uniformity in research credit cases and so designated the research credit as an ACI. Similarly, IRS Exams wished for greater coordination and consistency and so designated the research credit as a Tier 1 issue. But both programs had frustrating backlogs, leading to the decentralization of the ACI research credit program and to the demise of Tier 1.
Bottlenecks due to overcentralization may have decreased, but ongoing difficulty in examining research credit claims did not. So, the IRS sought to streamline its reviews of research credit claims through a 2017 directive, Guidance for Allowance of the Credit for Increasing Research Activities Under I.R.C. Sec. 41 for Taxpayers That Expense Research and Development Costs on Their Financial Statements Pursuant to ASC 730, LB&I-04-0917-005 (Sept. 11, 2017) to allow LB&I taxpayers to use R&D costs reported on financial statements under FASB Accounting Standards Codification (ASC) Topic 730, Research and Development, as sufficient evidence of qualified research expenditures (QREs). This directive allowed the IRS to minimize review of research credit claims by relying on the work performed by auditors to create a safe harbor for some of the key aspects of the R&D credit. For a specific group of large businesses that follow U.S. GAAP to prepare their certified audited financial statements, the ASC 730 directive relieved a substantial burden relating to documentation and quantification of R&D QREs.
As initially proposed in 1980 by Sen. John Danforth, R-Mo., the research credit would have explicitly defined qualified R&D expenditures in the same way as accountants define R&D in preparing financial statements (seeS. 2906, 96th Congress; seealso "Danforth Introduces Research and Development Credit," 11 Tax Notes 88 (July 14, 1980)). However, this explicit connection with financial statement R&D was done away with in the legislative process because of an objection from FASB, which did not wish to be the target of lobbying campaigns (Statement of David J. Kautter (former Sen. Danforth tax legislative assistant) to internal RSM R&D Credit Practice, via video teleconference (Sept. 22, 2021)). The remarkableness of the IRS's partially relying on ASC 730/FASB for research credit purposes — especially in light of FASB's earlier stated preference not to be involved — highlights the ongoing struggles the IRS has had in examining research credit claims. It may also show the desire of the IRS to pass the difficulties of auditing the research credit to someone else.
In September 2020, the IRS issued additional guidance relating to the ASC 730 directive that restricted the directive's applicability (LB&I-04-0820-0016 (Sept. 10, 2020)). The restrictions as part of the additional guidance included:
- Requiring taxpayers to remove all ASC Topic 350 internal-use software and website development costs from their claim;
- Creating new documentation requirements, which included a written narrative of the methodology and calculations; and
- Restricting the eligibility to LB&I taxpayers who meet additional criteria regarding their income statements and their book income reconciliation to federal tax income on Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More.
This may have been the first sign that the IRS's pendulum was swinging back to requiring more documentation — and that Danforth may have been right in his ultimate decision not to base the credit on financial accounting R&D.
Now, with FAA 20214101F, the IRS has once again revised its examination approach for research credit claims, leveraging the specificity requirement to reject claims that do not meet its guidelines. Perhaps the new FAA will minimize full audits, relying on the initial paperwork provided with refund claims to reject any claim that the IRS deems to not have substantial basis. This approach focuses on rejecting claims "if the taxpayer fails to provide sufficient facts in the manner required by the specificity requirement, and it may be rejected by the Service as such." In a January 2022 clarification, the IRS stated that if a refund claim is based both on a research credit and on some other matter(s), and the research credit claim lacks sufficient specificity, then the entire claim (including matter(s) not relating to the research credit) would be rejected (Research Credit Claims (Section 41) on Amended Returns Frequently Asked Questions). Could fear of "poisoning" a valid refund claim for some other matter(s) discourage taxpayers from even seeking a research credit refund?
The IRS has tried to minimize aggressive R&D claims through recordation requirements, a tiered issue management approach, statistical sampling, and the ASC 730 directive. The most recent action shows that the IRS has moved to an approach whereby it will not fully review R&D credits based on their merits but will reject any that do not meet its specified documentation requirements in the refund claim upfront, increasing the taxpayer's burden to cross an initial hurdle of specificity. The specificity requirements of the FAA are similar to the proposed and final regulations of 1998 and 2001, respectively.
This latest approach may send more taxpayers to court with their research credit refund claims. The courts may or may not defer to the FAA in determining whether a taxpayer has met the specificity requirement. Given the FAA's informality — its lack of a notice-and-comment period; that it is not signed by the Treasury secretary or assistant secretary for tax policy, the IRS chief counsel, or the IRS commissioner; that it is not published in the Federal Register or Internal Revenue Bulletin; and that it is not authority for substantial-authority analysis purposes — the IRS should consider the possibility that the courts might not defer to it (see Kisor v. Wilkie, 139 S. Ct. 2400 (2019)).
IRS exam agents have struggled with the research credit — and, given the lack of bright lines in the definition of qualified research, who can blame them? When strict documentation requirements to streamline their work did not stand, they have attempted to hand a good amount of their work to IRS Appeals, to statisticians, to FASB, and perhaps now even the courts. In an effort to ensure uniformity, the IRS has attempted various techniques driving toward centralization, which in turn led to bottlenecks, which in turn led to decentralization efforts. It remains to be seen whether this latest effort will result in more litigation and, if so, how the courts will respond.
Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.
Unless otherwise noted, contributors are members of or associated with RSM US LLP.