The IRS’s LB&I Commissioner released a new directive about how certain qualified research expenses will be audited. We have already received inquiries as to whether clients should attempt to comply with the directive. For most clients, the answer is a “no.” The guidance is limited and provides little to no audit protection.
Context for this New Directive
Before considering the terms of the new directive itself, it is helpful to review the IRS’s prior guidance and policies as context for understanding this new directive.
Those who have worked with the research tax credits audits over the years know that the IRS has struggled with auditing research tax credits. This is largely a function of how the research tax credit is structured.
The credit is based on activities and expenses tied to activities. This combination of activity and expense is specifically set out in the Code. The Code also defines what activities do and do not qualify. The definition is knowable and identifiable, but it represents a body of activities carried out by employees and contractors that are not set out in a report or record that can be easily printed, examined, and audited.
By way of analogy, identifying qualified activities is a process that often involves reviewing time sheet data. This analysis is like picking out one color of Play-Doh from a blob of Play-Doh that was mixed together by a child. If you get to the Play-Doh timely and if it is preserved in manner that you can work with, it is possible to carefully remove sections and bits of one from the other. But that process takes time. The same can be said of identifying qualified research activities from time records. And the same can be said of auditing research tax credits.
How has the IRS dealt with this difficulty? The IRS initially focused on helping auditors identify and deny any and all research tax credits. This focus is chronicled in the Treasury’s issuance and removal of controversial discovery-test regulations, the IRS’s former Tier 1 designation for the research tax credit, the IRS’s questionable “audit techniques guides,” the IRS’s imposing a mandatory requirement that auditors and appeals officers defer to IRS technical guidance advisers despite obviously incorrect determinations, the IRS’s reliance on case law that was known to be erroneous and later rejected by the courts, and the IRS’s subsequent steps to distance itself from these practices.
As part of this, to a lesser degree, there has also been a focus within the IRS on trying to get taxpayers to self-report enough information so that the IRS can identify which research tax credits it would audit and disallow. This is a more focused use of IRS audit resources. This has included the Schedule UTP, Uncertain Tax Position Statement; the Schedule M-3, Net Income (Loss) Reconciliation; and the IRS’s research tax credit recordkeeping agreement pilot program. The information reporting did not provide the information the IRS had hoped it would and the recordkeeping agreements proved to be too consuming and difficult for the IRS to roll out for more than a handful of taxpayers.
This new guidance is somewhere in the middle of the IRS’s “identify-and-deny” and “self-report to reduce IRS audit burden” policies.
The New Directive
With this context, what does the new directive do? Like the prior recordkeeping agreements, it offers an incentive for taxpayers disclose information to the IRS in exchange for the possibility that the IRS will not dispute the taxpayer’s current year wage QREs.
The directive relies on the taxpayer’s research expenses set out in its audited financial statements and certain adjustments to those statements. This includes a certification signed under penalties of perjury that can be included with the tax return or provided to IRS auditors directly.
Limitations of the New Directive
We won’t go into the specifics of the details here, as you can read the directive for those. Instead, here are some of the limitations and things that are not covered by the new directive:
1. LB&I Taxpayers Only. The directive only applies to LB&I-sized taxpayers with audited financial statements, i.e., whose credits would otherwise take up a lot of the IRS’s resources.
2. Non-credit year QREs. The directive only applies to non-credit year QREs. So it would seem that the IRS would still be free to challenge the non-credit year QREs on audit. For those not familiar with the research tax credit, the current year credit is computed based on “base period” QREs and credit year QREs. So the new directive really provides little audit protection as it excludes half of the calculation.
3. Contract QREs. The directive excludes contract QREs. While contract QREs often make up a smaller percentage of QREs for most taxpayers, they may make up the bulk of all QREs for others. Those with any significant contract QREs will get little in the way of audit protection from the directive.
4. Internal Use Software. The directive does not cover internal use software, as ASC 730 requires these costs to be expensed.
The complexity of trying to comply with the directive has to be considered too. The directive warns that audit protection is only granted if the IRS determines that the taxpayer complied with all of the requirements of the directive. The requirements are lengthy. They are detailed. Their application to real-world fact patterns will create ambiguities. The ambiguities will result in LB&I auditors saying that taxpayers did not comply. In those cases the taxpayers will have provided a roadmap and detail to the IRS that can be used to disallow the very credits they sought to protect.
But there are some taxpayers who may benefit from the directive. This would include the largest taxpayers (who are under continuous audit anyway), and who engage in extensive research by several divisions or subsidiaries. This might include taxpayers like Bayer, who have had difficulty in documenting their QREs on audit.