Increased focus on and potential ramifications of R&E expenditures.

• Author: Coleman, Ryan R.
• Position: Research and experimentation

The IRS has generally audited claims for the Sec. 41 research and experimentation (R&E) tax credit with a highly coordinated review. This is evident by its Tier I review status, to which the IRS elevated it in 2007, identifying it as a "high risk transaction." The underlying expenditures often deducted as R&E expenditures as defined by Sec. 174 have generally not received the same level of review upon audit. However, many taxpayers may have noticed a recent increased IRS focus on R&E expenditures. As a result of this increased focus, it is time for taxpayers to increase their focus as well.

R&E expenditures can have a potential impact on other tax attributes as well. For example, Sec. 174 R&E expenditures can generally affect the Sec. 41 R&E tax credit; cross-border cost-sharing arrangements governed by Sec. 482 and Temp. Regs. Sec. 1.482-7T; the Sec. 901 foreign tax credit (FTC); and the Sec. 199 reladomestic production activities deduction (DPAD), among others.

Observation: Schedule M-3, line 35, uses the term "R&D costs"; however, this item uses the term "R&E expenditures" throughout for consistency and discussion purposes.

What Constitute R&E Expenditures?

R&E expenditures are defined in Regs. Sec. 1.174-2 as

expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense ... Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. R&E expenditures may be either currently deducted under Sec. 174(a) or treated as deferred expenses and deducted ratably over a period of not less than 60 months under Sec. 174(b). Current deduction treatment is assumed for purposes of this item. Sec. 174 is the first threshold requirement the expenditures must meet to be eligible for the R&E tax credit. As such, there are many expenditures that may qualify for deductibility but may not qualify for the R&E tax credit. For example, "the costs of obtaining a patent, such as attorneys' fees expended for perfecting a patent application" will typically qualify for deductibility under Sec. 174 (Regs. Sec. 1.174-2), but generally not for the credit under Sec. 41.

Recent Examples of Heightened IRS Scrutiny

Schedule M-3: The IRS introduced two new line items to Part III of the 2010 Form 1120 Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, one of which is for R&E expenditures. The new instructions for the R&E expenditure line (line 35 in Part III of Schedule M-3) requires a supporting schedule to be attached reconciling the R&E expenditures computed for financial statement purposes to the R&E expenditures deducted on the tax return. Different reporting requirements apply in 2012 for Sec. 174(a), current deduction method, and Sec. 174(b), deferral and amortization method.

The IRS recently announced that it removed the requirement for a supporting schedule to be attached for both the 2010 and 201 I tax returns. However...