The Research & Experimentation Credit: New Issues on the Horizon; Are you current on the latest administrative, legislative, and legal developments?

• Author: Stogiannes, Diane

The Internal Revenue Service's Large Business and International Division (LB&I) has recently turned its focus back to the research tax credit by announcing new campaigns and directives. LB&I's efforts aim to centralize review and assessment of issues, promote increased compliance, and provide consistency across the nation with respect to examinations. Most taxpayers have experienced challenges during IRS examinations when they claim the research tax credit, and the changes that will soon be implemented may offer insight into what might be in store for future audits as well as help to arm taxpayers with the latest tax controversy techniques. Understanding the outcomes of substantiation-related court cases provides insight into potential exposures that the IRS will try to exploit as a path to disallowing or denying claims. Taxpayers should consider using tools and techniques, such as automated data collection, to support the qualifying nature of their activities.

LB&I Newfound Focus on Research Tax Credits

RESEARCH ISSUES CAMPAIGN

In February 2020, LB&I announced a new compliance campaign on research issues, indicating that taxpayers can expect an increase in examinations of their claims. Section 41 (Credit for Increasing Research Activities) and Section 174 (Research and Experimental Expenditures) are the source of some of the most common tax issues in LB&I audits and are often time-consuming for both the taxpayer and the IRS. The campaign's objectives are to promote voluntary compliance, focus resources on the highest-risk research issues, and increase consistency of examinations.

DIRECTIVE ON THE CENTRALIZED RISKING OF RESEARCH ISSUES

Following the campaign announcement, LB&I then issued a directive in March 2020 that describes the requirements and processes for evaluating, on a centralized basis, the risks associated with potential issues related to research credits. (1) This directive identifies the research risk review team (RT) as a "national strategy to improve the identification of the highest risk research issues under IRC Sections 41 and 174." The RT is not new; it has already been helping examiners to assess research credit issues in compliance assurance process cases. However, it appears that this team will be used more often, formally, to help LB&I to identify high-risk research issues and presumably offer updated forms and guidance documents.

Concurrently, in March 2020 LB&I also announced that it is adding 500 new employees. The agency's workforce has significantly and steadily declined over the past five years, so this hiring announcement may be aimed at rebuilding staffing levels. However, it is more likely tied to the upcoming and increased scrutiny of campaign issues and the directive.

WHAT TAXPAYERS SHOULD PREPARE FOR

The IRS campaign designation and the new LB&I directive are important reminders regarding the preparation of all research tax credit claims, and audits, including:

* establishing that all four-part tests (and additional three-part tests for internal-use software) for qualifying research have been met;

* establishing a nexus or connection between claimed qualified research expenses (QREs) and qualified research activities (QRAs); and

* having detailed work papers identifying the amounts and types of all QREs and the overall credit calculation.

It is premature to conclude that the examinations will be better for taxpayers. Historically, the use of a more targeted approach by the IRS has resulted in more efficient examinations. More focused and targeted examinations often result in similar savings for taxpayers. However, the addition of a significant workforce, who will need to be trained and exposed to various issues, will take time, and the new team is bound to make mistakes--at the taxpayers expense.

Recent Research Credit Cases

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