The research credit: Using statistical sampling.

Date01 February 2022
AuthorSong, Tae

This item discusses the Sec. 41 research credit and how statistical sampling can be used to efficiently satisfy the four-part test that governs whether research activities qualify for the credit. The focus here will be on guidance recently provided by the IRS's Large Business & International (LB&I) division in Field Attorney Advice (FAA) 20212501F.

The FAA makes clear that taxpayers must analyze the requirements for qualified research activities under the four-part test of Sec. 41(d)(1) separately for each business component that a taxpayer uses as a factual basis for a research credit claim. Further, the FAA explains that a taxpayer's use of statistical sampling in accordance with Rev. Proc. 2011-42 does not change the requirement that the four-part test must be satisfied separately for each business component. The FAA also states that the application of the four-part test to business components does not change when the IRS uses a statistical sample to audit a research credit claim.

The discussion below provides a basic overview of the research credit and then explains how to efficiently satisfy the IRS requirements for the credit, using statistical sampling, considering the guidance contained in the recently issued FAA.

Business components, qualified research, and the four-part test

Sec. 41 and the regulations thereunder provide a nonrefundable credit for increasing research activities. The research credit is generally computed based on the amount of qualified research expenses (QREs) exceeding a base amount that is derived from historical taxpayer data. Taxpayers compute the research credit either under the regular method as described in Sec. 41(a) or the alternative simplified credit (ASC) method in accordance with Sec. 41(c)(4). The mechanics of the research credit calculation are dependent upon the method elected by the taxpayer.

Due to the constantly evolving IRS audit environment and the contentious nature of qualified research, it is critical that taxpayers maintain sufficient records to substantiate research credit claims. Substantiation sufficient to satisfy an IRS audit can be extensive, which is why statistical sampling is an attractive approach. When performed properly, statistical sampling provides an accurate estimate of QREs while reducing the need to review extensive contemporaneous documentation. However, the analysis of sampled records still requires an evaluation of the four-part test at the business-component level.

As summarized in the FAA, Sec. 41(d)(2)(A) and Regs. Sec. 1.41-4(b)(1) generally require taxpayers to determine qualified research activities separately for each business component. Sec. 41(d)(2)(B) defines a business component as any product, process, computer software, technique, formula, or inventory that is held for sale, lease, or license, or that is used by the taxpayer in its trade or business. For example, a motorcycle engine builder may identify a new engine product as a business component.

Further, the FAA observes that qualified research activities must generally meet the four-part test, which consists of the following requirements:

* Sec. 174 test: Research expenditures must qualify as research or experimental (R&E) expenses under Sec. 174. R&E expenses are costs associated with activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product (see Regs. Sec. 1.174-2(a)).

* Technological-information test...

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