Research credit refund claims: New documentation requirements

Editor: Greg A. Fairbanks, J.D., LL.M.

On Sept. 17, 2021, field attorneys from the IRS Office of Chief Counsel issued memorandum 20214101F to key IRS personnel within the Large Business & International (LB&I) and Small Business/Self-Employed (SB/SE) divisions of the IRS. The Chief Counsel memorandum advises that taxpayers must provide additional information to make a valid Sec. 41 research credit refund claim on an amended tax return. In the memorandum, the IRS describes the minimum level of factual detail required to be included with the return to establish a valid refund claim, including these essential pieces of information:

• Identify all the business components to which the Sec. 41 research credit claim relates for that year.
• For each business component:
  • Identify all research activities performed;
  • Identify all individuals who performed each research activity; and
  • Identify 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 (this may be done using Form 6765, Credit for Increasing Research Activities).

Further, the taxpayer must submit with a claim a declaration signed under the penalties of perjury verifying that the facts provided are accurate.

Under this guidance, failure to include the required items listed above will result in a deficient or invalid refund claim, which permits the IRS to reject the claim without being subject to review by any federal court. Inclusion of the required information only establishes a procedurally valid claim but does not prevent the IRS from examining the claim in its normal course, either before or after payment of the requested refund.

The motivation behind these new requirements is to avoid paying refunds to taxpayers with frivolous claims lacking factual support and to assist the IRS in allocating its limited resources. The Chief Counsel memorandum also recommends that examining agents ensure the requirements have been satisfied before further examining the claim, so as not to waive the ability to enforce these requirements under Regs. Sec. 301.6402-2.

In a separate news release, the IRS clarified that these new requirements apply to any claims filed after Jan. 10, 2022. Additionally, after the expiration of the grace period, there will be a one-year transition period during which taxpayers will have 30 days to perfect a research credit claim for refund prior to the IRS’s final determination on the claim.

Editor’s note: In January, the IRS posted FAQs and issued a memorandum to IRS staff in which it expanded the period for perfecting a claim from 30 to 45 days and provided details on how the IRS will process claims under Sec. 41.

Legal requirements for a research credit refund claim

In the Chief Counsel memorandum, the IRS cites Regs. Sec. 301.6402-2 as its legal basis to require these additional disclosures. The regulation section provides procedural and formatting requirements for making a claim of refund, including when the claim can be filed, the forms to be used, the filing location, signature requirements, and other filing requirements. Also, under Regs. Sec. 301.6402-2 lies the “specificity requirement,” which requires taxpayers to set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the IRS of the exact basis of the claim.

The aim of the specificity requirement is to provide the IRS adequate notice of both the nature of the claim and sufficient facts to support the basis of the claim. As the term “sufficient” is subjective in nature, taxpayers filing a refund claim for the research credit have historically opted only to attach a statement to the amended return indicating the reason for the amendment, along with an amended Form 6765. As such, taxpayers have not historically provided the level of detail suggested by the IRS in this guidance, nor have they attached entire studies (which could include thousands of pages of quantitative support, project descriptions, and other technical documentation gathered to support the research credit).

Case law regarding research credits and the refund process

To support its stance, the Chief Counsel memorandum cites a number of U.S. appeals court cases that uphold the IRS’s interpretation of the specificity requirement, such as Stoller, 444 F.2d 1391 (5th Cir. 1971); Nick’s Cigarette City, Inc., 531 F.3d 516 (7th Cir. 2008); and Beckwith Realty, Inc., 896 F.2d 860 (4th Cir. 1990). Although these cases reiterate the validity of the specificity requirement, they do not define what constitutes “sufficient facts” as they pertain to research credit refund claims. For that perspective, the memorandum cites a number of lower court cases such as McFerrin, Harper, and Premier Tech.

In McFerrin, 492 F. Supp. 2d 695 (S.D. Tex. 2007), the court rejected the government’s argument that the taxpayer’s claim was “impermissibly vague” and opined that the specificity requirement is satisfied “if the basic issue is evident from the record, and the IRS is aware of the nature of the claim.” In this instance, the court concluded that the nature of the claim was established, given that the taxpayer in this case included in its amended returns a supplementary page explaining that “the taxpayer is amending their return to additionally include Form 6765, Credit for Increasing Research Activities.”

The recent Chief Counsel memorandum discounts the McFerrin ruling, explaining that “although the McFerrin court held adversely to the government, that case is readily distinguishable from the majority of refund cases the government litigates” because it was an erroneous refund suit (which carries a different burden of proof) and because it was decided on a motion for summary judgment based largely on the fact that the IRS had “provided no indication of what additional information it need[ed] to satisfy the requirements.”

In Harper, No. 18-cv-02110 (S.D. Cal. 4/25/19), rev’d, No. 19-55933 (9th Cir. 2/25/21), the taxpayer filed an amended return under the traditional method (i.e., statement attached to the amended return, along with an amended Form 6765). The district court concluded that the taxpayer did not provide enough information within an amended return to provide the IRS any factual bases to examine the refund claim.

On appeal, however, the district court’s decision was overturned, with the Ninth Circuit concluding that the government had waived its ability to enforce the specificity requirement once it began a substantive examination of the merits of the Harpers’ refund claims. This waiver doctrine effectively means that the IRS is considered to have conceded the procedural validity of a claim once it progresses to the stage of examining the claim on its merits. The recent Chief Counsel memorandum discounts the Harper ruling, explaining that the “Ninth Circuit did not opine on whether the taxpayers’ attachment of a Form 6765 to the Form 1120X was sufficient to satisfy Regs. Sec. 301.6402-2(b)(1) or whether the taxpayers had perfected an imperfect claim.”

Perhaps the most taxpayer-friendly case is Premier Tech, Inc., No. 20-cv-00501(D. Utah 7/15/21), which the Chief Counsel memorandum only footnotes. The case follows a similar fact pattern as McFerrin, in that Premier Tech filed a claim for a refund by filing an amended tax return with an attached statement indicating the reason for the amendment, along with an amended Form 6765. As in McFerrin, the government asserted that the refund claim lacked specificity because it did not spell out the qualification and quantification for the research credit in detail. More specifically, the government asserted the claim did not satisfy the specificity requirement because “Premier did not attach additional documents addressing every single element in Sec. 41, such as describing the research conducted, explaining how that research worked to develop a business component, detailing on whose wages and what supplies the money was spent, and proving the amount spent on research in the prior three tax years.”

The federal district court ruled against the government, stating that this level of detail is not required and that the taxpayer provided the necessary information requested on Form 6765. The court held that “if the IRS wants more information about the research tax credits, the IRS could require that information on Form 6765,” implying that if Form 6765 is insufficient, then it should be modified by the IRS. In a footnote, the Chief Counsel memorandum simply acknowledges the existence of the Premier Tech case and that the “Service and Counsel are evaluating the opinion.”

Basic requirements for the research credit

Because, as noted earlier, recourse through examination and judicial relief will likely be unavailable, the Chief Counsel memorandum indicates that taxpayers should be familiar with the basic requirements for the research credit and should take extra precaution to substantiate their credit for a refund claim. When determining whether activities are qualified research activities (QRAs), the taxpayer must identify each business component and determine that each component satisfies the four-part test of Sec. 41(d) and is not subject to any exclusions. Under the four-part test, qualified research must satisfy the Sec. 174 test, the technological-information test, the business-component test, and the process-of-experimentation test.

The first of the four, the Sec. 174 test, requires a taxpayer to show that the expenses related to the research were incurred in connection with the taxpayer’s trade or business to eliminate uncertainty through research and development. Next, taxpayers must satisfy the technological-information test, which requires that the research be “technological in nature” (i.e., it relies on principles of physical or biological sciences, engineering, or computer science). The business-component test requires taxpayers to show that the information obtained through research is intended to develop a new or improved business component of the taxpayer. Lastly, the process-of-experimentation test requires that substantially all (i.e., 80% or more) of the taxpayer’s research must constitute elements of a process of experimentation related to a new or improved function, performance, reliability, or quality of the business component.

Each of the taxpayer’s business components must satisfy all four-part test requirements separately. Taxpayers can include certain in-house expenses (wages and supplies) and contract research expenses related to a qualified business component. Sec. 41 allows taxpayers to claim a nonrefundable credit for incremental qualified research expenses (QREs) over a base amount. Also, the IRS Audit Techniques Guide for research credit claims (LMSB-04-0508-030) discusses the concept of nexus as the process of connecting qualified activities (specific business components) to the underlying QREs. The Audit Techniques Guide states that research credit studies lacking this relationship have failed to establish nexus and, therefore, are disallowed.

Requirements for a valid refund claim

The Chief Counsel memorandum does not purport to modify any of the underlying requirements for qualification of a research credit claim on the merits. It does, however, establish an initial procedural threshold that, if not met, will allow the IRS to reject claims as being invalid without any administrative or judicial recourse. This new procedural hurdle will effectively represent a fatal flaw to any claim that is determined to be invalid after the statute of limitation has expired and perfection of the claim is no longer permissible.

When submitting a refund claim, taxpayers should continue to comply with the basic requirements for the research credit as previously discussed. Considerable uncertainty exists under the new rules, however, regarding the exact level of detail needed to make the claim procedurally valid. While the Chief Counsel memorandum lists certain elements of detail that taxpayers must provide, it fails to precisely describe the level of detail that the taxpayer must provide to establish “sufficient facts” under the specificity requirement.

It is also concerning that the memorandum requires the taxpayer, for each business component, to identify all the information each individual performing research sought to discover, which implies that the four-part test should be applied and evaluated at the individual level rather than the business-component level. It is uncertain what detail would be required for individuals who are directly supporting or directly supervising the performance of qualified research. It is also surprising that the IRS would not require the nexus detail, discussed above, when evaluating if a taxpayer provided details for all business components and all employees.

These requirements could also present a further burden for taxpayers with claims comprising a significant number of business components and employees. Although taxpayers should have already gathered the detailed information necessary to support the claim, the supporting detail may not be presented in a way that would clearly address each of the factual details requested by the memorandum. In short, taxpayers with hundreds of business components and thousands of employees could expect to spend significant amounts of time preparing summarized reports just to satisfy these requirements. The IRS has not addressed how onerous this would be to smaller taxpayers who may not have the resources to handle this type of administrative burden.

These requirements for a valid refund claim further hinder taxpayers, as the IRS states that a taxpayer that voluntarily provides documents with the claim must specifically identify where in the documents the facts responsive can be found. As such, the IRS has shifted the obligation onto the taxpayer to provide documentation exceeding what was originally required to file a refund claim, while delegating the IRS’s responsibility of review to the taxpayer through the requirement of specific identification of required facts. Finally, taxpayers will need to evaluate their methodology for computing and substantiating a research credit refund claim. This is particularly true for taxpayers that employ a cost center or hybrid approach (i.e., a combination of business component and noncomponent) for determining QREs.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.