On January 10, 2022, the IRS will officially change the documentation requirements for amended research and development (R&D) claims. The Chief Counsel Memorandum goes into effect, tightening up what the IRS will accept from companies that are trying to claim a portion of the $22B tax credit funds. There will be a one-year transition period, during which time, if the IRS deems the claim deficient, the Service will provide notice and taxpayers will have 45 days to perfect a research credit claim for refund. After this transition period, the IRS will have authority to outright reject a claim for R&D credits without notice if the additional documentation is not provided with an amended return. Strike anticipates that this move is an early indicator of future IRS direction on timely-filed returns in the R&D tax credit sector.
Don’t be caught unawares by a claim denial. Additional preparation today will provide you with the documentation you need to defend your claim in court.
Increased R&D Documentation Requirements
Additionally, recent court cases, like the McFerrin Decision, have broadened the definition of research and development. Previously, research and development had to be completely new in an industry to qualify for the R&D tax credit. Since the McFerrin Decision, companies have only needed to prove their innovations were new to them.
As a result, the IRS has responded to the new, more expansive definitions in the R&D industry by enforcing what it calls “the specificity requirement”. Essentially, claims on amended returns need to provide direct evidence that the research and development portion of the claim is tied to specific individuals. The IRS anticipates that this will weed out insufficient and inaccurate claims.
Five changes will occur after January 10th and will require an adjustment in how claimants document and track qualifying research activities (QRAs). According to the IRS, businesses claiming the R&D tax credit will need to:
- Identify all of the business components that form the factual basis of the IRC 41 credit claim for the claim year;
- Provide all research performed by business component;
- Identify all research activities performed and name the individuals who performed each research activity;
- Identify the information each individual sought to discover;
- Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year. This may be done using Form 6765, Credit for Increasing Research Activities.
Additionally, claimants must sign a declaration under penalty of perjury verifying that the provided facts are true. In the majority of cases, the signatures on Forms 1040X or 1120X are sufficient.
Before the recent IRS documentation change, the amount of documentation a company needed to substantiate its claim was often arbitrary. Claims typically weren’t reviewed until one, two, or three years after they were processed, so it gave companies time to come up with supporting documentation for R&D projects under audit.
Now the Internal Revenue Service (IRS) is reserving the right to generously and automatically reject claims that are not well-documented and substantiated at the time the tax return is amended and processed. Furthermore, this rejection will bar a taxpayer from being able to recover tax credits and refunds, and it will prevent future litigation over the matter.
Taxpayers who are unprepared to prove the validity of their claim could be shut out from the tax credits they’re owed.
Preparing to Make an Airtight R&D Claim in 2022
As Strike prepares claims in 2022, we’ll be adjusting a few things to make sure we’re in line with the more stringent requirements. Right now, we don’t know if the result of the tighter requirements means that the IRS will be auditing more businesses, or if they’ll just be taking longer to process the more in-depth claims. We assume it’ll be both. Either way, we’re prepared to put our clients in the best possible position.
What we do know is that the burden of proof for an R&D claim has been shifted onto the taxpayer. With the “specificity requirement” the IRS is planning to take on amended returns, the documentation and final reports will need to be completed at the time that we’re delivering credits. That means our focus will shift to a front-loaded claim process on amended tax returns.
We’ll remain dedicated to uncovering and documenting qualifying research activities, and expenses, for all of our clients. Our clients’ R&D tax credit studies and reports to the IRS will meet and exceed IRS requirements.
Improved Documentation Leads to Better Claims
Wages are one of the three main categories of expenses that qualify for the R&D credit. In the future, it won’t be enough to know which employee was involved in the R&D tax credit process so that their wages can be included in the credit claim. As Strike aligns our documentation process with the current IRS guidelines, we’ll be going several layers deeper for each study to prove the connection between employee activities and the innovative projects.
By focusing on the nexus of the employee activities throughout the discovery process, we’ll strengthen our clients’ cases. We’ll also be looking for answers to questions like these:
- At the employee level, what was the employee’s hypothesis, their uncertainties, or their technical challenges?
- What was the employee’s individual process of experimentation?
- Which of the hard sciences did the employee use?
- What were the start and end dates for the projects?
- For third-party contractors, what activities were they performing and how was it connected to the research and development phase?
- What activities were each employee involved in by year and by project?
This additional proof will protect claimants. If the IRS comes back to a client’s filing in a few years’ time, how prepared will they be to show additional documentation? With turnover and growth, will the people who worked on a project remember who did what and the problem or process they created? Relying on faulty human memory to prove a court case is an inadequate foundation to build a rebuttal to the IRS.
Using a tax firm with an established process that collects all the information you need to prove your claims from the get-go will protect your R&D funds. Strike has always made it a top priority to clearly document our clients’ research and development claims. Moving into 2022, claimants who meet the specificity requirements can continue to receive R&D refunds to redeploy into their company.
R&D Tax Compliance
Strike is ready to address the ever-changing IRS regulatory requirements. We ensure our clients are compliant with the most relevant case law. We haven’t lost a challenge yet, and our success-based fee structure guarantees that our success is tied to yours. While we anticipate that there might be a delay in the delivery of future tax credits as they undergo more scrutiny, we are confident that our future claims will remain successful. Feel more supported about your R&D claim by talking to one of our research and development tax credit experts.