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IRS Is Looking for Claim Validity – What Does This Mean and how is this Different from Claim Substantiation?

By January 11, 2023No Comments

Over the past few years there has been increased focus on the Research Tax Credit and examinations from the IRS. It began with the IRS announcing that the Research Tax Credit (RTC) was an active campaign issue. Since then, a directive was issued describing the requirements and processes for evaluating, on a centralized basis, the risks associated with potential issues related to research credits. 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. Then, in October 2021, the IRS issued the infamous Chief Counsel Memo (CCM) requiring additional information to be provided for any refund claims for the research tax credit, on amended returns. 

There has been much debate with respect to the legal aspects of this Chief Counsel Memo (CCM), specifically around the question of whether the service can enforce this level of request onto a taxpayer through a CCM, or if they must go through and change the regulations and Section 41 itself.  Regardless, if we assume the service has the best of intentions, one can infer that the purpose of the CCM is to allow the service to validate a RTC claim quickly and efficiently, and not substantiate it.  

Let’s examine this further. Up until this point, the only thing that the IRS knew about a taxpayer’s Research claim when it was filed was a set of numbers provided on the F6765.  There is no information provided about the nature of the taxpayer’s business, about what type of people they employ, about the types of products they make or customers they service.  It is impossible to infer anything about the actual nature of their business and if the reported qualified research expenses and subsequent claim amounts are reasonable. 

Having some indication as to the nature of the qualified work, and who is performing it, would allow more claims to be quickly validated and processed for approval.  By contrast, simply having the answers to these questions does not mean that a taxpayer will not be chosen for an audit, nor does it mean that you have met the qualification requirements for the Research Tax Credit, under Section 41.  It simply means that your refund claim is valid or is in the state of being acceptable.  No inference can be made about the substantiation of the claim having met the technical requirements of Section 41. 

What is the IRS looking for?

The IRS is looking for overall compliance

  • They want to see that taxpayers have put some time, effort, and thought into answering the questions concisely. 
  • They want to know that taxpayers have some right to the claim. 

What isn’t the IRS looking for?

The IRS is not looking for complete justification and substantiation of the claim. 

  • They are not looking for how every activity meets the four-part test. 
  • They are not looking for pages upon pages of substantiate or reports to defend or back up the study. 

What can Taxpayers Prepare?

Keep in mind the IRS’ goal and desired outcome; they have become overloaded with refund claims, and they are looking for a way to validate claims quickly and accurately and place claims into one of two risk categories.

  1. Valid claim / Low risk – the taxpayer has provided enough information that shows there is a right to the credit. 
  2. Invalid claim / High risk – the taxpayer’s information either seems suspicious or there is not enough information to make a determination. 

If the claim is put into the second pile, the IRS will then take a closer look at the claim, most likely resulting in an audit.  By targeting claim validity, the IRS is looking for context. They want to be able to answer the following questions easily and quickly:

  • Do these numbers make sense given this taxpayer’s facts?
  • Do these numbers and the claim size make sense given the taxpayer’s industry? 
  • Does there need to be a full-blown audit?

If a taxpayer can provide enough credible information in a concise, efficient, and clear manner, then the claim should be able to be moved quickly into the “valid claim” pile and essentially eliminated from the IRS’s scrutiny. 

How do taxpayers ensure claim validity on their CCM Statements?

  1. Don’t go at it alone. Work with experienced professionals, like DST advisory Group, who have Tax Engineers who can quickly tell a concise and credible story.
  2. Keep it simple and short. When completing a CCM Statement, just answer what is being asked.
  3. Be mindful of the statute of limitations (SOL) and timing of filing the amended return for the research tax credit. Be careful of amending the return for multiple reasons if the SOL is running close to expiring.
  4. Be careful of providing too much information that can open the door to more questions from the IRS.

Quick Facts of the CCM 20214101F 

On October 15, 2021, the IRS released a Chief Counsel Memorandum that calls for taxpayers to provide the following additional information when filing for the RTC for credits on amended returns:  

  • Identify all business components to which the I.R.C § 41 research credit claim relates for that year.
  • For each business component, 
    • identify all research activities performed; 
    • all individuals who performed each research activity; and
    • identify all the information each individual sought to discover.
  • Provide total qualified employee wage expenses, total qualified supply expenses, and total qualified research expenses (this may be done using Form 6765, Credit for Increasing Research Activities).

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