In Part 1 of this article series, we discussed the Chief Counsel Memo and the requirements for the Statement questions for refund claims related to the Research Tax Credit. The IRS has maintained that having these questions answered is a way to help them gain clarity on claim validation for taxpayers as a way to de-risk taxpayers from the audit or examination pool.
Keep in mind that historically, and up until this time, taxpayers have only had to put a set of numbers on a form for the RTC claim. This set of numbers did not provide any context to the IRS, or any authority for where the numbers came from, how they were derived, nor if the numbers were aligned with the size of the credit being asked.
Having some indication of 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.
When does ‘Validity’ move into ‘Claim Substantiation’?
It has now been a year since the additional information with the statements have been required from taxpayers. The IRS has received more information than they have ever had to review in the past for any RTC claim, and they have received it in multiple formats and templates. By now, the IRS would have had to train their exam teams on how to quickly ascertain the validity of a claim.
The IRS has begun to integrate these questions and the concept of this level of validation into other areas, such as examinations. In effect, claim validation is moving into claim substantiation. Standard IDRs issued at the start of examinations have questions that are aligned with the questions from the Chief Counsel Memo, asking taxpayers to now substantiate the current claim (not just amended claims). In fact, in most cases, additional questions regarding evidence of individual timecards or time-tracking of qualified research activities are being requested.
What we’ve seen since the CCM was announced is a gradual encroachment of these questions into other aspects of Research Tax Credit examinations and claims. Specifically, the IRS are issuing standardized IDRs (information document requests) where the first questions are closely aligned with the nature of the questions from the CCM, with additional questions pushing towards the substantiation line, as they move into examination territory.
Chief Counsel Memo (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).
What is the IRS looking for?
The IRS is looking for reasonable and complete substantiation of the claim.
- They are looking for how the taxpayer’s qualified research activities meet the four-part test.
- They are looking for contemporaneous documentation with substantiate reports to defend or back up the nature of the claimed activities and costs.
- They are looking for evidence of a planned approach to research activities.
- They are looking for nexus between qualified research activities and qualified research expenses.
- They are looking for proper application of the exclusions:
- Was there any routine research after commercial production claimed? (i.e. quality control)
- Was funded research considered?
- Was shrink back applied on pilot model or prototype costs?
What isn’t the IRS looking for?
The IRS is not looking for general legal arguments and general reference to the regulations with no factual reference to the taxpayer.
- They are not looking for documents where they need to infer conclusions.
- They are not looking to rely solely on oral testimony.
- This can support evidence and provide context, but it cannot be the only thing provided as substantive evidence.
How do taxpayers ensure their claims are substantiated?
- Be prepared.
- Collect and retain your documentation throughout the claim year, if possible.
- Identify key individuals or subject matter experts (SMEs) who can help describe and obtain the documentation and record-keeping for your development activities.
- These SMEs will also be able to provide the oral testimony to fill in the gaps and provide context to the qualified work done.
- Keep it simple and short.
- When answering IDR questions, just answer what the IRS is asking. Avoid adding too much information.
- Ensure good communication with the Exam team, and review the information being requested.
- If you are unable to provide the information requested, or are unsure as to why it is being requested, ask for a call.
- The IRS does not know your process or systems, and sometimes a quick call and conversation to find out what they need can change the nature of the request to make it much more manageable.