Section 41 Research and Experimentation Tax Credit Audit Considerations - March 2008 - Tax Law

• Publication year: 2008
• Pages: 49
• Citation: Vol. 37 No. 3 Pg. 49

37 Colo.Law. 49 Colorado Lawyer 2008.

2008, March, Pg. 49. Section 41 Research and Experimentation Tax Credit Audit Considerations - March 2008 - Tax Law

The Colorado Lawyer
March 2008
Vol. 37, No. 3 [Page 49]

Articles
Tax Law
Section 41 Research and Experimentation Tax Credit Audit Considerations
by Kreig Mitchell

Tax articles are sponsored by the CBA Taxation Law Section to provide timely updates and practical advice on federal, state, and local tax matters of interest to Colorado practitioners.

Article Editors

Adam Cohen, Denver, of Holland & Hart LLP - (303) 295-8000, acohen@hollandhart.com; Rachel James, Denver, of Davis, Graham & Stubbs LLP - (303) 892-7214 rachel.james@dgslaw.com; Steven Weiser, Denver, of Levin & Weiser, LLC - (303) 504-4242, sweiser@lw-law.com

About the Author

Kreig Mitchell is a sole practitioner who focuses on business, individual, and estate tax planning and tax controversy matters - kreig@irstaxtrouble.com, (303) 521-0053.

The IRS has stepped up its efforts to review Internal Revenue Code § 41 research and experimentation tax credits This article describes the challenges taxpayers face when attempting to secure the significant tax savings associated with these tax credits.

The Internal Revenue Code (Code) § 41 research and experimentation tax credit(fn1) was enacted in 1981 to provide a significant tax incentive to encourage taxpayers to increase domestic research and experimentation spending.(fn2) However, recent Internal Revenue Service (IRS) audit initiatives and procedures frustrate this goal, forcing many taxpayers to make a difficult business decision: claim the Code § 41 tax credit as provided by Congress and face the almost certain prospect of a costly and time-consuming IRS audit, or forego the Code § 41 tax credit altogether

This article discusses the recent IRS initiatives and current audit procedures related to Code § 41 tax credits. The article also explores the initial audit considerations and potential audit hazards that taxpayers encounter during Code § 41 audits. Finally, an overview of the IRS's research credit recordkeeping agreement program is provided.

IRS Initiatives

Code § 41 tax credits have been designated a Tier One issue.(fn3) Pursuant to the IRS Large and Mid-Size Business (LMSB) operating division's Industry Issue Focus initiative, the IRS identifies and ranks high-risk tax issues using a tier ranking system.(fn4) High-risk tax issues are those that are most prevalent across industries and that present the most compliance risk.(fn5) Tier One issues have the "highest strategic importance" for the IRS.(fn6) An IRS issue owner executive is assigned to each Tier One issue.(fn7) Each Tier One issue owner is tasked with coordinating IRS resources and issuing guidance to ensure that Tier One issues are "resolved in a consistent manner across all LMSB cases involving similarly situated taxpayers."(fn8)

Code § 41 tax credits also have been designated as a Compliance Coordinated Issue (CCI).(fn9) CCIs include specific issues that arise in one or more industries.(fn10) CCIs are identified by the IRS exam function to establish uniform positions within industry or issue areas.(fn11) Examination function technical advisors draft coordinated issue papers for CCIs.(fn12) The IRS has published four coordinated issue papers that address specific Code § 41 tax credit issues.(fn13)

Code § 41(d) has been designated as an Appeals Coordinated Issue (ACI).(fn14) ACIs include broad issues or categories of cases identified by the appeals function that have "service-wide impact or importance" and that require "coordination to ensure uniformity and consistency nationwide."(fn15) An appeals technical guidance coordinator is selected for each ACI.(fn16) The appeals coordinator consults with appeals officers on individual cases and prepares and updates appeals settlement guidelines, which are not released to the public.(fn17)

IRS audit personnel are required to "review and follow" the issue owner executive's guidance.(fn18) Audit personnel generally "cannot deviate from" positions developed in coordinated issue papers.(fn19) They are allowed to settle coordinated issues at the IRS administrative examination level, as long as the settlements comport with the appeals settlement guidelines.(fn20) Both the appeals technical guidance coordinators and the audit technical advisors must review and consent to examination-level settlements.(fn21) Conversely, appeals officers are not required to follow CCI guidance.(fn22) Appeals officers must consult with and "get review and concurrence from" the appeals technical guidance coordinator prior to finalizing Code § 41 tax credit settlement agreements with taxpayers.(fn23)

Current Audit Procedures

The IRS audit team for Code § 41 tax credits includes a revenue agent, one or more engineer agents and their manager, technical advisors, and possibly a computer audit technician and an attorney.(fn24) The revenue agent's role is limited to serving as a liaison between the taxpayer and the IRS audit team.(fn25) The engineer agents and managers - most of whom have no tax, accounting, or legal experience - gather and analyze the taxpayer's Code § 41 tax credit documentation.(fn26) The technical advisors serve as the IRS's resident experts for Code § 41 tax credit audit issues.(fn27) Computer technicians assist the engineer agents in developing statistical sampling techniques and reviewing computer-based records.(fn28) An IRS attorney may provide legal assistance to the technical advisors and engineer agents.(fn29)

The Code § 41 portion of an audit consists primarily of providing documents in response to IRS information document requests (IDRs). The engineer agents issue an initial IDR for Code § 41 tax credit audits; this IDR consists of a standardized response questionnaire containing seventeen "yes-or-no" questions.(fn30) The engineer agents issue subsequent IDRs based on the taxpayer's responses to the initial IDR.(fn31) The engineer agents also may conduct initial meetings with the taxpayer, tour the taxpayer's facilities, and spend a day or two conducting employee interviews.(fn32) Other than these brief in-person contacts, the taxpayer generally is not invited to present information outside the IDR response process.

The Code § 41 tax credit audit generally ends when the revenue agent sends the taxpayer a formal thirty-day letter. In most cases, the thirty-day letter is sent to the taxpayer with a notice of proposed adjustment report prepared by the engineer agents. The report typically proposes a full disallowance or significant downward adjustment to the Code § 41 tax credits claimed by the taxpayer.(fn33) The taxpayer then can agree with the notice of proposed adjustment, request an appeals conference, or proceed with litigation.(fn34)

Initial Audit Considerations

There are several audit considerations that taxpayers must address in every Code § 41 tax credit audit. These considerations include: (1) presenting sufficient records to substantiate the taxpayer's Code § 41 tax credits; (2) determining whether appropriate records are available; and (3) addressing estimates the taxpayer used to determine the Code § 41 tax credits.

Substantiating § 41 Tax Credits

Identifying and presenting sufficient records to substantiate Code § 41 tax credits continues to be the most contentious issue between taxpayers and the IRS with respect to Code § 41 tax credit audits. The two items that the taxpayer must substantiate for purposes of Code § 41 are the taxpayer's gross receipts and the expenses for qualified activities. Most of the controversy between the taxpayer and the IRS usually involves substantiating expenses for qualified activities.(fn35)

The government has provided little guidance to taxpayers for documenting expenses for qualified activities.(fn36) The former Code § 41 regulations required the taxpayer to prepare and retain written documentation before or during the early stages of the research project that described the principal questions to be answered and the information the taxpayer sought to obtain that exceeded, expanded, or refined the common knowledge of skilled professionals in the relevant field of science or engineering to document expenses for qualified activities.(fn37) Congress deemed this requirement too burdensome for taxpayers and, as a result, the Treasury Department amended the regulations to abandon this requirement.(fn38) The current regulations state merely that a "taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit."(fn39) There are two sources of records the taxpayer can use to substantiate its qualified activities: its accounting records and its other business administrative or operations records.

Accounting records. Accounting records generally are kept using a cost-center or project-based system of accounting.(fn40) Cost-center accounting refers to tracking expenses by department or other expenditure category.(fn41) Cost-center records are based on a logical grouping of activities that follows the organizational structure of the company and tracks costs based on where within the company structure the cost was incurred.(fn42) Examples include engineering, sales, and manufacturing departments, or supply, contract cost, and payroll expense categories.

With cost-center accounting records, there is not necessarily a direct relationship between particular costs and activities within the cost-center accounting system.(fn43) As such taxpayers who maintain cost-center accounting records must demonstrate...