Plan now for two major changes to R&D credits

On the horizon right now are two very significant changes to the world of research & development tax credits under Section 41, and wise taxpayers should be preparing now for that eventuality. One change has to do with reporting standards for amended returns, the other is a potential revision to capitalization rules that could trigger amortization of the credit, rather than make it available for immediate expensing.

The first change is a certainty. On October 15, the IRS, via IRS Memo: IR-2021-203, gave taxpayers only a three-month warning (to Jan. 10, 2022) that if they intend to file retroactively to capture the research credit on an amended return for prior years, they must include much more detailed supporting documentation and substantiation.

All claims for refund are now required to identify all business components where Section 41 relates, along with the tax filing. For each component, taxpayers must:

• Identify all research activities performed;
• Identify all individuals who performed each research activity;
• Identify all information each individual sought to discover;
• Provide total employee wage expenses;
• List total qualified supply expenses; and,
• Report qualified contract research expenses.

Taxpayers should use Form 6765, Credit for Increasing Research Activities to provide their total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year. But again, the support for each of those numbers must be included with the filing. And in rare form, the IRS has stated that taxpayers will be offered only 30 days to perfect their refund claim. After such time, the IRS will make a final determination — which will not be eligible for appeals, an extraordinary precondition to impose on taxpayers.

Since the new guidance takes effect very soon on January 10 next year, the process to compile the necessary data will take considerably more effort if a tax credit application is to pass review. This provision not only increases the effort and data needed to file for prior-year credits, but it could also increase the risk in filing amended returns to claim R&D. If a taxpayer is considering claiming credits retroactively, they are advised to consult with their provider to determine any additional time that will be needed to compile this documentation.

Because the formal rules were announced on October 15 with an effective date of Jan. 10, 2022, taxpayers were only being given a three-month advance warning period when this will take effect. But the IRS does state in the memo that taxpayers can begin including this data retroactively with each refund claim anytime.

It’s important to remember that this does not include timely filed returns; it is only applicable to requesting a refund for prior tax years such as 2018, 2019, and 2020, which are currently considered open years for amending.

R&D credit claims do not have an unreasonably high audit rate; we see only a slight increase over the average tax return audit rate. However, in recent years, scrutiny has increased, and this provision could allow the IRS to make an executive decision about research credit claims, without the oversight of the courts. Therefore, proper documentation and analysis are now more important than ever to ensure that refund requests are upheld under scrutiny.

Goodbye immediate expensing, hello amortization?

The second change to R&D tax credits may or may not be coming, but there is a chance that it will become a reality on Jan. 1, 2022. Historically, taxpayers who are granted the R&D credit have been allowed to claim R&D credits and expense the qualifying research activity and supply costs against their current tax liability (there is an expense add-back to prevent double dipping). However, the Tax Cuts and Jobs Act of 2017 eliminated the immediate expensing of R&D costs, starting in 2022.

If this regulation remains in force, taxpayers will no longer be permitted to enjoy immediate expensing of research costs. For costs incurred in U.S.-based innovation, it will be amortized over five years. Costs incurred internationally will be amortized over 15 years. This change would seriously impact income levels.

There was hope in the form of H.R. 1304, the American Innovation and R&D Competitiveness Act of 2021, which seeks to repeal the TCJA ruling; it is part of President Biden’s proposed Build Back Better Act, and it’s designed to delay the amortization rule until 2026. The Build Back Better package looks to have been postponed until early 2022, unfortunately.

A case study will enable us to discern the difference this new legislation could make. Let’s say a corporation has invested $100 million in offshore software development, but has only reaped $10 million in revenue. Under current laws, the taxpayer would be judged to have suffered a $90 million loss. But if the TCJA rule kicks into effect and is not stymied by H.R. 1304, the IRS would declare that the taxpayer gained a $76.7 million profit instead. What a difference a law makes!

Unintended consequences

The outcome of this legislative tussle is by no means certain. We may well witness a delay on this amortization rule, since pending drafts of the Build Back Better Act have included the delayed application of amortization until 2026.

If amortization becomes the law, what recourse does taxpayers have? There are five strategies taxpayers should be marshalling now to counteract for this possibility:

1. Cash flow planning. Optimizing cash flow tax planning can offset a potential tax burden. In this case, federal and state loss carryforwards may be helpful. Note that federal loss carryforwards may be subject to 80% taxable limitations. Taxpayers with loss carryforwards in California may benefit from Assembly Bill 85; for taxpayers with taxable income of more than $1 million, net operating losses are suspended.
2. FASB ASC Topic 740. Under FASB ASC Topic 740, businesses are required to analyze and disclose income tax risk, so their income tax expense for financial reporting are recognized according to U.S. GAAP.

Accounting for income tax under ASC 740 affects how a taxpayer capitalizes R&D costs, regarding:

• Deferred tax assets;
• Cash taxes;
• Effective tax rate; and,
• The bottom line when assessing new White House tax proposals.

3. Documenting R&D tax credits. Nothing nullifies a taxpayer’s chances of obtaining R&D tax credits more than insufficient documentation. Meticulously detailed supporting documentation is non-negotiable! Ascertain that the level of detail in your documentation meets IRS standards. It can also be smart for taxpayers to review their R&D tax credits to ensure they can capture the greatest dollar amount.
4. Accounting methods. Savvy taxpayers may also want to consider adopting alternative accounting methods, such as by accelerating deductions or deferring revenue, for instance. By changing their accounting method, if a taxpayer has been employing an inadmissible method of accounting, they can correct it by deferring the correction’s cost over four years, while protecting against prior-year audit adjustments subject to interest and penalties. As a rule, accounting method changes should be considered part of a taxpayer’s overall cash flow strategy.

5. Technical accounting. Technical accounting for R&D cost centers and accounting policies can identify costs that could be recategorized as other general and administrative costs.

Get ready

Yes, change is coming to the R&D tax credit landscape — but taxpayers and their providers can prepare for it. There is only a short time to comply with the more exacting documentation rules for amended returns. As for whether the amortization rule will become a reality next year, only a soothsayer would know, but in the meantime, being forewarned means becoming prepared. This is where providers can best help their clients.