Starting in 2022, taxpayers and tax preparers will need to be aware of important changes to the Research and Development Tax Credit (R&D Credit) documentation and filing process. Three major changes include new information required to file the R&D credit under a recent IRS Chief Counsel Memorandum (CCM), a mandatory requirement to capitalize Section 174 research and experimental expenditures, and improvements to the Payroll Tax Credit option. These changes will place new burdens on taxpayers and tax preparers need to keep a close eye on these changes to help them stay compliant.
The Research and Development Tax Credit (R&D Credit) helps incentivize companies to develop a new or improve an existing business component. A business component is any product, process, software, technique, formula, or invention. The R&D Tax Credit helps drive economic growth within the United States. For example, the federal credit is typically 5-8 percent of qualified costs, while Arizona offers an R&D credit equal to 24 percent of qualified expenses over a base amount. Arizona also offers a refundable credit so that taxpayers can benefit even if they owe no state tax (such as startups in early-year losses).
The IRS Chief Counsel Memorandum
The IRS released a CCM effective January 10, 2022 that requires additional information included as a statement in the tax return for a claim for a refund related to the R&D tax credit to be valid. The required information (shown below) can be quite extensive. This poses a challenge for smaller, unsophisticated taxpayers or taxpayers that have many smaller business components.
The CCM allows a grace period through January 10, 2024 during which the IRS will allow 45 days to perfect an otherwise incomplete refund claim. After this grace period, incomplete claims can simply be rejected, and if the rejection arrives after the statute of limitations expires for the tax year, the taxpayer will lose the credits requested in the refund application. Having a well-documented study that includes this information as a separate statement is more critical than ever.
Information Required under the Memorandum
A valid refund claim is required to include the following under the CCM:
1. Identify the following items:
- All the research activities performed for each business component;
- Identify the names of the people who conducted each activity;
- List the details of the information each person sought to discover.
- The entire claim year’s qualifying staff wages, supplies, and contract research expenses.
2. Submit a written statement (like Forms 1040 or 1120) that verifies the information and signed under the penalties of perjury, from the taxpayer.
3. Submit the refund claim within the allotted time (within the statute of limitations window).
The new CCM change is a clear indication of the IRS’s new direction in auditing R&D tax credit claims. Based on the new CCM, tax preparers should closely review their client’s R&D tax credit claims and engage a specialist as needed.
Adapting to the 174 Capitalization
As a result of the Tax Cuts and Jobs Act (TCJA), the treatment of research expenses under Section 174 is poised to change significantly. Historically, taxpayers had the option to deduct Section 174 expenses in the year they were incurred or treat the costs as deferred expenses and deduct them ratably over a 60-month period.
However, under the new requirement effective January 1, 2022, taxpayers will no longer be allowed to deduct the R&D expenditures under Section 174. Instead, these costs will need to be capitalized and amortized over 5 years for domestic activities or 15 years for foreign activities.
Notably, the Section 174 capitalization requirement captures far more activity than those activities that generate the R&D tax credit under Section 41. This means that taxpayers may be subject to the Section 174 requirement regardless of whether a taxpayer claims a R&D credit. For example, foreign research is specifically excluded from the Section 41 R&D tax credit, but any research performed overseas is required to be capitalized and amortized for 15 years under new Section 174.
Due to the broad nature of these rules, complying with the TCJA requirement will require substantial effort from taxpayers and tax preparers alike. It will be extremely important for taxpayers to properly identify all Section 174 research expenditures so that amounts are treated properly. Relying on qualified research expenses toward the R&D credit is insufficient for this requirement.
No guidance has been given as to whether a Form 3115 – Change in Accounting Method will be needed to be filed for all costs that will be changed from being expensed to capitalized. The Section 174 change was designed to meet reconciliation requirements at the time the TCJA was enacted, and few in practice expected this change to actually take effect. However, as the requirement has not yet changed, tax preparers should take into consideration how these changes will affect their clients estimated tax payments when tax planning for 2022.
The Impact of the Inflation Reduction Act of 2022 to the R&D Tax Credit
While everyone in practice hoped for a correction to the Section 174 capitalization requirement, Congress at least enhanced the Payroll Tax Credit for qualified small business startups under the Inflation Reduction act. Prior legislation allowed small business startups to use their eligible R&D credits to offset up to $250,000 of the 6.2 percent employer portion of Social Security payroll tax liability.
The act doubles the available offset to $500,000, providing an additional $250,000 to offset the employer portion of the 1.45 percent Medicare payroll tax liability. This may especially be helpful for qualified startup businesses (that have little or no income tax liability) to receive a more immediate tax benefit from their R&D tax credit.
To qualify for the R&D tax credit and benefit from the credit, a business must meet the following requirements:
- The entity must have gross receipts for less than 5 years.
- The entity must have gross receipts of less than $5 million in the year the credit is elected.
- The entity must conduct qualifying research and development activities.
The Bottom Line
With the changing landscape surrounding R&D tax credits, now is a good time to connect with a specialist in the area to ensure you are properly taking care of your clients. If you have any questions or would like to explore this topic further, please set up a free conversation with us.
Manager – Specialty Tax Services