More Scrutiny of Research Credit Refund Claims Expected Following IRS Memo
The IRS Office of Chief Counsel recently issued a memorandum detailing the information required where a taxpayer files a refund claim for the research credit under IRC Sec. 41.
Taxpayers are required to satisfy a “specificity requirement” for a refund claim to be valid. This specificity requirement applies to all refund claims and not just to research credit claims. Under Treas. Reg. § 301-6402-2(b)(1), a claim must, under penalties of perjury, detail each ground upon which a credit or refund is claimed and provide sufficient facts for the IRS to know the exact basis for the claim. If the refund claim does not meet this requirement, it is considered deficient and may be rejected by the Service.
The IRS is inundated each year with taxpayer claims for refunds associated with the research credit. When a taxpayer files a refund claim, it is required to provide an explanation for amending and will include Form 6765, Credit for Increasing Research Activities, calculating the credit.
Where such refund claims have been adjudicated, the IRS has, at times, unsuccessfully argued the refund claims were deficient because the taxpayer did not meet the specificity requirements under Treas. Reg. § 301.6402-2(b)(1). The IRS has also publicly stated some research credit refund claims include minimal information and require the IRS to devote additional resources to examine the return to determine whether the claim is valid. As a result, the IRS’ latest memorandum sets forth purported minimum requirements for a valid refund claim.
For a refund claim for the research credit to be valid, the taxpayer must, at a minimum, set forth the following five essential pieces of information:
- All business components to which the research credit claim relates for that year.
- All research activities performed for each business component.
- The names of all individuals who performed each research activity on each business component.
- All information each individual sought to discover for each business component.
- Total qualified employee wage expense, total qualified supply expenses, and total qualified contract research expenses for the claim year (this may be done on Form 6765).
A taxpayer is not required to submit documentation or a research credit “study.” However, if the taxpayer does include either or both, the taxpayer must specifically identify on what page(s) in the documents or study the minimum facts can be found.
According to the IRS announcement, the new rules apply to research credit claims for refund filed beginning January 10, 2022. While not explicit in the announcement, the IRS has stated publicly the new rules only apply to amended returns, and not to claims reflected on original tax filings. After that, the IRS will provide a one-year transition during which taxpayers that fail to meet the minimum requirements will have 30 days to perfect their refund claims prior to the IRS’ final determination on the claim. The announcement provides no information on whether claims filed before January 10, 2022 will be subject to the new rules, how taxpayers will be notified that their claim is deficient or whether appeal rights will be available for taxpayers with deficient claims.
As noted above, the Service has previously argued, unsuccessfully, that taxpayers have failed to meet the specificity requirement for a valid IRC Sec. 41 research credit refund claim. Generally, taxpayers provide an explanation of changes on their amended return and include Form 6765 showing the research credit calculation. The IRS memorandum details the arguments made by both the taxpayer and IRS in two cases, United States v. McFerrin, 492 F. Supp. 2d 695 (S.D. Tex. 2007), and Harper v. United States, 123 AFTR 2d 2019-1660 (DC CA, Apr. 25, 2019), reversed by 127 AFTR 2d 2021-1027 ( (9th Cir., Feb. 25, 2021).
In McFerrin, the district court ruled in an erroneous refund suit that the taxpayer met the specificity requirement where the “basic issue is evident from the record, and the IRS is aware of the nature of the claim.” The district court concluded the amended return explained the amendment and included a Form 6765. Therefore, the amended return put the IRS on notice of the nature of the claim, the taxpayers claiming the credit, and the legal theory on which the claim was based. The district court highlighted the government provided no indication of what additional information was needed to satisfy the specificity requirement of Treas. Reg. § 301.6402-2(b)(1).
In Harper, the district court dismissed a refund suit because the taxpayer did not meet specificity requirement in Treas. Reg. § 301.6402-2(b)(1). The explanation for the taxpayer’s claim only noted the change was due to a claim for the research credit (without identifying the business components of the credit, the research activities performed, and the individuals involved) along with the applicable amount and a Form 6765. As a result, the district court determined the taxpayer failed to provide sufficient facts to notify the IRS of the basis for the claim. On appeal, the 9th Circuit overturned the decision, on the ground the IRS waived its right to enforce the specificity requirement because it performed a substantive review of the refund claim at examination, where it was provided over 100,000 pages of documents to perfect any defects to the original claim filing.
The memorandum effectively creates a two-tiered review approach to research credit refund claims where a taxpayer must (1) demonstrate in detail the claim is valid pursuant to Treas. Reg. § 301.6402-2(b)(1) and then, if the claim gets examined, (2) demonstrate it meets the merits of the four-part test under IRC Sec. 41.1
The Chief Counsel memorandum encourages the IRS to reject a deficient refund claim before initiating an audit to avoid a waiver of the specificity requirements. This is significant as the statute of limitations for filing a refund claim (generally, the later of three years from when the original return was filed or two years from when the tax was paid) may have expired by the time the claim is rejected, thereby resulting in the taxpayer losing the opportunity to file a new refund claim with the additional information required. Therefore, the minimum requirements outlined in the memorandum compel taxpayers to provide the entire basis for their research credit claim at the time of filing in contrast to providing the IRS with notice through a description of research activities performed by the taxpayer.
The IRS has provided an email address to provide comments on the new rules and intends to issue additional clarifying guidance in the future. While the burden of administering the large number research credit refunds in a given year is appreciated, taxpayers and tax practitioners should watch closely how this memorandum is used and whether it deters otherwise meritorious claims from being allowed and/or adjudicated.
1In general, he term “qualified research” means research — (A) with respect to which expenditures may be treated as expenses under IRC Sec. 174(b), which is undertaken for the purpose of discovering information — (i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and (C) substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3). Treas. Reg. § 1.174-2(a)(1) states that expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.
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