Since 1981, the federal research and development tax credit has dovetailed with an exponential expansion of private investment in research and development, fueling the argument that it spurs growth in a broad range of private industries in the US.
The R&D tax credit has become a bastion of corporate American tax policy over the last 50 years, with large pharmaceutical, technology, and manufacturing corporations making substantial annual claims. As essential as it has been to R&D growth, the tax credit has sometimes gotten a bad rap. The complexity of the tax code, regulations, and case law tied to the incentive is enough to send even the most seasoned tax professionals running for the hills. Additionally, the tax credit’s reputation for being too complicated, fraught with fraud, and onerously enforced at times has kept many smaller businesses and startups at bay.
A paradigm shift started around 2015, when the PATH Act made the R&D credit a permanent fixture of the tax code and established provisions making it friendlier to small and mid-sized businesses and startups. The law’s clarity assured businesses that while complex, the R&D credit could lead to a potential windfall when pursued in earnest, stimulating innovation and growth.
These new provisions, along with some updated regulations, spawned a glut of consultants selling expertise on the R&D credit. Not surprisingly, claims skyrocketed to upward of $20 billion by 2022 from approximate projections of $12 billion in 2015. With the aid of consultants, more small and mid-sized businesses from more diverse industries sought tax savings under the credit’s law.
While many of these new claimants have used the tax credit as a tool to fund innovation as intended, a large number, often unwittingly, claimed the credit based on unsound advice of aggressive advisers seeking to stretch the bounds of qualification.
Efforts to police R&D have a rich history. The IRS started stringent documentation requirements in 2000, eventually labeling the credit a “Tier 1” issue in 2007, all while repeatedly and vocally calling the tax credit out. The credit’s occasional, if not frequent, appearance on the IRS’ “dirty dozen” list of potential tax scams and filing pitfalls adds to its aura of impenetrability. This is likely to have discouraged uptake with small and midsized businesses and their tax advisers.
The IRS published a chief counsel memorandum in October 2021 that heightened documentation obligations for R&D tax credit claims seeking a refund. Counteracting a decades-long trend toward reducing documentation and paperwork for submissions, the memo spelled out additional reporting responsibilities for such refunds. While the requirements don’t require a full review of a credit claim based on the merits, they do allow the IRS to reject claims that fail to meet certain documentation thresholds.
These new requirements and efforts to police the R&D credit should be viewed not with anxiety but with relief, in that they reflect the IRS’ desire to crack down on the “bad actors” who spoil the credit opportunity for others by stretching its application beyond reasonable bounds. These efforts make credits more reliably available for those who are truly deserving of the reinvestment dollars they deserve.
It is important to note that the IRS specifically warns not of the R&D credit itself but rather improper claims of similar business credits. In other words, when applied correctly, the R&D credit serves to spur innovation in the US and any business using science and technology to develop new or improve existing products should consider whether it might qualify for tax savings.
How to Keep Legitimately Due Credit
Often, consultants market R&D credits to non-standard R&D industries, such as dentists or breweries, based on aggressive interpretations of the laws and regulations. The potential availability of these credits starts to spread among industry chat groups, trade publications, and through general word of mouth until it becomes a trade trend governed by FOMO—the fear of missing out.
This is not to say that businesses operating in these industries never qualify; the tax law doesn’t disqualify any specific industry from the R&D credit. Claiming the credit, however, does warrant a serious discussion on the rationale for qualification prior to filing. In filing a claim, consider the following:
If it seems too good to be true, it just might be. For exmaple, if you have clients practicing dentistry who want to include a claim on their return for installing crowns, you might want to pause before filing that claim regardless of what the buzz might be.
R&D credits generally are reserved for non-routine work and, since crowns and implants fall into the general rubric of routine dental procedures, they’re unlikely to qualify. Certain arguments stretching the rules for qualification might highlight the experimental nature of customization required for each crown. However, these procedures are generally “common solutions to common problems” in the industry and don’t qualify under precedent established in Leon Max v. Commissioner.
Be honest in the assessment of business activities. The R&D tax credit requires an analysis of specific facts and circumstances of a given business. It’s incorrect to assume that because other industry peers are claiming a credit that any business in the same industry will qualify, too.
The credit requires an independent evaluation of each business activity to determine if it meets the statutory requirements for qualification. While there is subjectivity in the requirements, existing regulations and case law can shed light and offer guidance on navigating the gray areas.
Beware of any consultant that avoids discussing risk. Any review of a tax position or claim should always include a discussion of the potential risk tied to that position. Given the IRS’ heightened scrutiny of R&D tax credit claims, this is especially true for positions tied to the credit.
It is important to understand how the IRS reviews the R&D tax credit, what common questions the service poses during review, and what type of substantiation can support a claim. During the credit calculation process, discuss what types of support you can reasonably gather to back up or support claims tied to the activity or expenditure.
In the end, the policy tool that is the R&D tax credit provides important fuel for the US economy, but it’s important to claim credits where they’re properly due. The ongoing qualification tango between taxpayers and the IRS likely will continue due to the subjective nature of R&D.
But don’t despair—making a proper and prudent claim is manageable in the current environment. By following a few commonsense rules, avoiding the IRS taking away your tax credit well is within your grasp.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Brandi Price is a director of tax with ADP’s Tax Credits division with 15 years of experience in the incentives field. She has consulted with companies of all sizes, from Fortune 50 enterprises to closely held companies, helping to realize over $100 million in tax savings for her clients.
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