R&D credits have a history of being included in various IRS enforcement programs. R&D was a high-priority tier one examination issue during the early 2000s and more recently was included among the excess business credits on the IRS’ annual list of “Dirty Dozen” tax scams. Based on IRS focus in the past, the issues that likely will receive extra scrutiny under the R&D campaign include:
- The adequacy of documentation related to R&D activities
- The use of employee testimony and estimates to quantify qualifying research activities
- Internal-use software
- The nexus between qualified research expenses and the business component to which those expenses relate
- Contracts with third parties, specifically focusing on whether claimed expenses derive from nonqualifying funded research
- Depreciable property claimed as a pilot model under IRC Section 174
The addition of R&D to the list of LB&I campaigns comes as LB&I is transitioning from the Coordinated Industry Case program, in which the same large taxpayers were examined every year, to the Large Corporate Compliance (LCC) program, in which large taxpayers and issues will be selected for examination based on centralization and data analytics. It also is interesting to note that revisions to the Compliance Assurance Process (CAP) program include a special R&D questionnaire. While LCC and CAP generally are directed at the largest taxpayers in LB&I, issue selection and lessons learned from these examinations are sure to influence R&D examinations of all taxpayers. In addition, focused examinations under the R&D campaign could provide more transparency for taxpayers regarding which types of taxpayers and issues are of greatest interest to the IRS.
Given the increased focus the campaign will bring to R&D, taxpayers should review their processes to ensure that they are correctly categorizing expenses and maintaining contemporaneous and complete documentation of qualified research activities. To prepare for a potential examination of R&D credits, taxpayers can take the following steps now:
- Verify that the tax department understands the R&D activities engaged in by each component of the organization to confirm that qualifying research expenses are claimed when eligible.
- Work with a tax adviser to prepare for an IRS examination of R&D credits.
- Review work papers to determine adequacy, and take steps to remediate any deficiencies.
- Use data to analyze business trends and their impact on the qualifying research expenditures.
