On-Demand: R&D Tax Credit and IRS Update
In this webinar, participants will be able to understand and identify tax research claim opportunities, financial statement implications, and areas of IRS focus.
Miri Forster:Thanks, Bella, so much and welcome everyone. My name is Miri Forster and I'm a tax partner and leader of the Tax Controversy Practice at Eisner Advisory Group. And I'm delighted to be here today with you along with my colleagues, Tim Rankins and Allie Colman, to discuss the R&D tax credit.
Thanks, Bella, so much and welcome everyone. My name is Miri Forster and I'm a tax partner and leader of the Tax Controversy Practice at Eisner Advisory Group. And I'm delighted to be here today with you along with my colleagues, Tim Rankins and Allie Colman, to discuss the R&D tax credit. For today's agenda, we'll start off with an overview of the research credit under section 41 of the Code and the various opportunities it presents, such as the payroll offset. And then we'll provide an IRS enforcement update and discuss a new IRS memo that's likely to have a significant impact on the filing of research credit claims going forward. And we're also going to highlight some recent tax court cases in the area. We'll close out the session with a discussion of financial statement implications and some best practices for everyone. So now, I'm going to pass it over to Tim. Welcome again.
Tim Rankins:Thanks Miri. So what we'd like to do is start with just some of the basics as an overview. The R&D tax credit is governed by Section 41 of the Internal Revenue Code and there's a corollary expense section under 174. The credit was originally enacted in 1981 and it was typically updated every couple of years, sometimes retroactively. It was made permanent in 2016 as part of the PATH Act. So the credit is activity based and US based. It's incremental over a base amount, and historically the credits were only used against income tax liability. This was a big deal in 2016, where qualified small businesses could use the credits against future payroll tax liability. So the credit is governed by section 38 as a general business credit, and it can be carried forward it for 20 years and carried back for one year.
As part of the Tax Cuts and Jobs Act, a couple of years ago, what they did was they required amortization of R&E expense for five years beginning after January 1st, 2022. For any companies that were expending R&E expenses after January 1st, 2022, they were required to amortize it for five years. This is different than previous years under section 174, where you had to expense it. Current legislation is going to delay this effective for four years. I thought this was a pretty big deal and a significant update for companies expending R&E. The R&D credit, it's activity based. You must meet four elements, a new or improved product or process that's intended to improve either functionality, performance, quality or reliability. The work has to be technological in nature, meaning it fundamentally relies on the hard sciences. And then there must be a technical uncertainty related to either capability, method, or design and then in order to overcome the uncertainty and engage in a process of experimentation. So you engage in iterative process of trial and error.
There are four eligible costs for the credit, there's labor, supplies and contract research expenses as well as rental or lease costs of computers. So labor is based upon Box 1 W2 wages of employees performing, supporting or supervising qualified research, materials used in the testing effort and then 65% of amounts paid to any outside vendors performing research on our behalf. We can also claim cloud hosting costs as rental or lease costs of computers. So in addition to qualified research, we can also claim direct support and direct supervision of qualified research. Direct supervision would be immediate supervision, such as first line management. Direct support would be anybody contributing to the research effort process. So what industries are we looking at? We're looking at technology, software, life sciences, manufacturing is the largest contributor of research credits in the country, financial services to the extent that we are writing algorithms, writing software, coming up with new methods voice to generate alpha, and then also certain circumstances, architecture and engineering.
So as I mentioned before, the R&D credit is incremental over a base amount. So there's two methods. There's the simplified method and the regular method. The simplified method, the base amount is half of the average of your prior three year qualified expense. The regular method is a function of prior year revenues. The simplified method is a lower credit rate of 14% with the regular method, a credit rate of 20%. At the end of the day, the simplified method works out to about seven cents on the dollar versus the regular method can be between eight to 10 cents on the dollar. So the credit is governed by section 38 general business credits, the R&D credit is used after foreign tax credits. And then there is also some specific limitations that go into the R&D credit, which can kind of catch some companies by surprise if we're not using tax software. One of them being a limitation of 25% of regular tax over 25,000.
So if we are a company that has a bunch of carry forward credits, and we come into a situation where we have a ton of tax liability in a specific year, we're only able to use 75% of credits against tax liability plus 25,000. So there are some limitations out there that companies need to be aware of as they plan going forward. I see this in provisions where we are using Excel work papers to calculate potential tax liability and we don't take this into account. Also, section 382 deals with losses and loss limitations. There is section 383 that deals with credits as well. So if you're limited in NOLs, you are also limited in credits if there is any two change of ownership. Which takes us to our first polling question.
Bella Brickle:Poll #1
Tim Rankins:And while we do this, we did get some questions about what I referred to as the amortization of R&E costs. And so under current law effective January 1st, 2022, a company is required to amortize their R&E expense over five years to the extent that it was done in the US and over 15 years to the extent that it was done overseas. This was done as part of the Tax Cuts and Jobs Act. And in my opinion, it was sort of a stop gap to make it so that the legislation didn't look as pricey as it was. And I thought it was going to be either repealed or pushed back. Now we're at the time where it's mid-December 2021 and a decision has to be made. All the legislation that's been put forth recently as part of Build Back Better, another legislation. It has included this. I still believe that there will be a legislation pass that will push back this amortization requirement because the credit and the R&E expenses bipartisan and both sides of the aisle want to see that happen.
20 years. Okay. Excellent. Whoops. So the FICA payroll refund, that was part of the PATH Act in 2016, and this is one of the biggest developments that we've seen in the R&D tax credit area since I've started working in it in 2006. And what it allows for is companies to offset future payroll tax liability against R&D credits. So what is a qualified small business? A qualified small business is a company with less than five million of gross receipts of any kind in the current tax filing year and zero receipts prior to five years from the tax filing. So what does this mean when I read the language like that? Zero receipts prior to five tax year from the filing. So if we have our current filing year of 2021, we need less than five million in that year and then zero receipts prior to five years from the filing year and that includes 2021.
So the count will start in 2021. So we need zero receipts prior to 2017. So the way it's written is it's really for new companies, new qualified small businesses, not just qualified small businesses. The receipts here is receipts of any kind. So if we were formed in 2016 and we had interest of $5, that would exclude us from using the credits against future payroll tax liability. In terms of the mechanic of obtaining the refund, you have to file for an R&D credit and check the box online 41 of section D and show the amount that you want to elect up to $250,000. You file the return with the form in the election made and in the next quarter, you then file a Form 8974 with your payroll provider. And that reduces your payroll tax liability of 50% until those credits run out. So it's not a situation where you're getting a check, but you are saving future payroll tax liability until the credits go to zero. With that, I'll push it to Miri.
Miri Forster:Sorry, I was on mute everyone. So Tim, you always do a great job reminding me and everyone about the broad range of the industries to which the research credit is available and the potential benefits to consider like the FICA tax refund. And while the research credit does present some great opportunities, it's also been subject to high scrutiny by the IRS for many years. Some of you might remember back in the mid-2000s, the IRS classified research credit as a tier one exam issue. And that means that it had high strategic importance to the service. Now in 2012, tiered issues became a thing of the past, but IRS review of research credit claims continued and unsubstantiated claims can result in significant penalties. So fast forward to 2020, the large business and international division of the IRS, and that's the division that handles enforcement of tax payers with assets of 10 million or more, announced a research issues compliance campaign.
And they've been announcing various campaigns for several years. There are about 50 of them in total and they're focused on what the IRS views as high compliance risk areas. So the research issues compliance campaign is focused on the research credit under section 41 and the research and experimental expenditures issue under section 174. And according to the IRS, these two issues present some of the most prevalent tax issues within the large business and international division. And as a result, these claims consume significant IRS resources and taxpayer resources too. The research issues campaign includes issue based examinations and the IRS is using data analytics to select the taxpayers who are going to be part of the campaign, but it's also supposed to include updates to forms and requests for guidance as well. And other treatment streams are going to be continued as the IRS conducts these exams and receives feedback from the field on how they're going.
In addition to the agent and the manager to assign to these exams, it's important to know that there's a dedicated campaign team and each campaign has its own dedicated campaign team consisting of council attorneys, subject matter experts, engineers, and other specialists, and they're responsible for overseeing the campaign so that it's consistent across all taxpayers and all geographic locations. Tim, I know you've also done some of these research credit campaign exams. Do you have any additional insights you might want to share with the audience?
Tim Rankins:Yeah, my feeling on the campaign was it really formalized what was already been done in practice, which is your tax return goes under exam and R&D credit's claimed. And the examiner who might not have experience with the R&D credit, what they typically are doing is then passing it back to either a subject matter expert or an engineer within the IRS that does have experience. And they're waiting for them to bless it before then they can pass along the R&D creditor, allow it or disallow it or come up with next steps. So in my opinion, the campaign focuses on R&D and the formality of it was really already done in practice before. That's really what I've seen.
Miri Forster:I agree with you. And I think that if the IRS funding that's in the Build Back Better plan does get approved, the IRS is going to have more opportunity to hire more subject matter experts in this area so this focus on research credit will only continue. So let's move forward to the IRS's newest announcement. It came out in October and the IRS released the memorandum presenting minimum requirements for filing research credit refund claims beginning January 10th, 2022. Now currently when a taxpayer files a refund claim and it doesn't matter if it's a research credit refund claim or any other type of refund claim, it has to satisfy a specificity requirement. That's in section 6402 of the Code and in Treasury Regulation section 301.6402-2B1. And those provisions provide specifically. And this is a procedural requirement I think that's very important rather than the substantive tests that Tim talked about under section 41.
So procedurally, the specificity requirement is met if the claim for refund or credit details each ground upon which the creditor refund is claimed and provides sufficient facts to put the IRS on notice of the exact basis of the claim. So the question is what is enough to satisfy this procedural requirement? The IRS has disallowed a number of research credit claims on this procedural ground, but the courts have not always agreed. Recently in a district court case issued in July called Premier Tech VUS, and hopeful I'm not stealing your thunder, Tim, the IRS disallowed a claim that included a Form 6765. And that's the form that Tim talked about, where the taxpayer calculates the research credit. And they also included a short explanation on their amended return referencing the 6760 and stating that the return was being amended to claim a research credit under section 41.
According to the IRS, the claim didn't meet the specificity requirement because it didn't address each element under section 41. But the district court disagreed and said that the IRS was on notice of the nature of the claim from the Form 6765 and if the IRS thought its own tax form, the 6765, was insufficient, then it's responsible to fix it and that that shouldn't make it an invalid claim. There's also been other cases where the courts have held that the IRS has actually waived this specificity requirement, this procedural requirement where it audited the research credit claim over a number of years and had the opportunity to request and review additional information in support of the substantive issue under section 41. So what's happened to address these unfavorable outcomes, the memorandum that's been recently released by the IRS sets forth minimum requirements for research credit claims. And the memo says that to satisfy the specificity requirement, the claim needs to include the following.
And it's a lot of information. It has to identify all business components to which the research credit claim relates for the year. It needs to identify all research activities performed for each business component. It needs to include the names of all individuals who performed each research activity on each business component, as well as all information that each individual sought to discover from each business component. And then it needs to include total qualified employee wage expense, total qualified supply expenses, total qualified contract research expenses. And I mean, that's typical what you would've included on the 6765. The memo says that the claims would not need to incorporate a research credit study, but if it does, the taxpayer is required to specify the exact page or pages in the study where the information that satisfies the minimum requirements can be found. Now, and again, these new rules apply to claims filed beginning January 10th, 2022.
And after that, the IRS is going to provide a one year transition period giving taxpayers 30 days to perfect any deficient claims. Now, I understand why the IRS felt the need to issue this memo and to issue minimum requirements. I mean, they're inundated with research credit claims and they're using a lot of resources and their resources are clearly limited and they're losing in a number of cases, but there are certainly some concerns and unanswered questions from this memo. First, the memo appears to encourage the IRS to reject a deficient claim before initiating an audit to avoid waiver of the specificity requirement. And this is significant because the rejection could come after the statute limitation for filing a refund claim as expired. Typically, the refund statute is three years from when the original return was filed or two years from when the taxes are paid, whichever is later.
So you could find out that a claim has been rejected, the statute of limitations could have already expired and then you would be in a position that you cannot submit a new claim at that time. Also, it's unclear from the memo how to handle pending claims. So claims that were submitted before January 10th, 2022. I mean, I guess I would say to that as the best practice for any pending claims that are approaching the end of the refund statute. It might be worth revisiting them just to make sure they have sufficient information in them. Also, the memo doesn't specify how deficient claims are going to be communicated to taxpayers during the one year transition or whether there's going to be an appeals process if the taxpayer isn't able to update the claim within the 30 day period.
And last but not least, what about the fact that sampling is permitted for research credit claims, but when you look at the minimum requirements there are a lot of “all’s” there, right? All business components, all research activities, all individuals, all information, that's certainly contrary to a sampling approach. We are monitoring this, of course. In the meantime, the IRS has requested feedback from tax payers and tax practitioners and there's a dedicated email address that people can use. And the IRS had said that they intend to clarify some of these questions in the future, but certainly this is a big C change. So with that, Bella, I think we have a polling question.
Bella Brickle:Poll #2
Tim Rankins:Yeah. This is pretty interesting. I was curious to see what the results would be here, but identifying all research activities perform for each business component was the highest even though it was a little bit evened out. I think one of the difficulties that taxpayers have is this business component requirement and having all costs allocated by business component. When I talk to taxpayers and clients, and I give them the tests for the R&D, they say, "All right. 70% of this team's time, 30% of this team's time, 20% of this team's time." And what we have to do is we have to go back and define what's our project or business component and allocate to that, right?
So I can see why this would be one of the ones that the people here are concerned about is that business component level, defining it, allocating time where we don't have a project tracking system, it is problematic because we have to go back and we have to create that project list and allocate the time, and then create the narratives behind each business component as to why they meet that four part test that I had gone through initially. So what I wanted to do is go through some recent tax core cases. This gives everyone a flavor for the environment that we're in.
Miri went into some of the policies and procedures. And really what I've seen in my career is it's a pendulum between IRS winning cases versus the tax payer winning cases. About five to 10 years ago, you saw a lot more tax payer wins than you do now. And really those were at the district court level in the federal courts versus the tax court. And the tax court has gotten some significant wins over the past three years and I wanted to just highlight some of the facts for you all to give you an understanding of what are some of the hurdles that we're seeing. What I want to do is start with Siemer Milling Company.
That case came out in April 15th, 2019, and it involved two tax years, fiscal year ending May 31st, 2011 and May 31st, 2012. And the credits weren't very large comparatively speaking for cases that go to litigation in the tax court. There were only $120,000 a year. And what Siemer Milling did was they milled and sold wheat flour. And the subject matter expert that was used in the trial was the VP of production. And that is not uncommon. When I talk to manufacturers, we talk to the head of production, he has an understanding of all the operations, the different new product development efforts, the QA procedures and other directly supporting departments. So this company employed lab techs, lab supervisors, R&D managers and R&D staff. The court noted no engineers and no geneticists. So no one with engineering degrees in the chemical, mechanical or computer science field, but we had people with R&D titles, which for most would say, all right, they must be performing R&D.
And some of the projects that they went through in this case was developing new processes associated with heating flour, testing the composition, testing the functional characteristics, testing new equipment, trying to increase speed and testing different materials. They also try to create new concepts to milling process, to provide low microorganism flower derivatives. I mean, that sounds like research development to me, right? I think it probably sounds like R&D to you. And a couple of the arguments that the service made was there was no technical uncertainty because the projects lasted greater than one year and you couldn't have uncertainty if it went on for more than one year. I thought that was an interesting argument. I think that's one of those arguments that in my opinion lacks common sense that you might see on exam where the IRS examiner just believes that they're not going to buy it if it's more than one year.
So it was nice to see that the court found that argument unpersuasive. They also said that none of the people that were being qualified for the credit had engineering degrees, therefore none of the work was technological in nature. The court disagreed with the IRS on that. They said that was unpersuasive. He didn't per se need an engineering degree to be eligible for the R&D credit. The one that they found persuasive was the IRS argued that the activities did not constitute a process of experimentation. They said what the taxpayer did was recite the steps in their process, but it was not a scientific process of hypothesis and testing and results.
The IRS won this case. I think this case never should have got this far, never should have won to the tax court. I think the credits its involved were too small and it was bad precedent for taxpayers, for Siemer to lose against the IRS in this case. In my opinion, I think they got it wrong. I think what the company was doing, there was a level of R&D. I don't know if there was anything going on more behind the scenes in terms of defending this company and maybe they lacked some of the documentation that was necessary, but this just goes to highlight in my opinion, the need for documentation and the need for tracking time to project.
In my opinion, I think there was R&D, but because it wasn't defended well enough, they ended up losing out. There were no penalties put forth against this taxpayer, but it just goes to show that under the narrative that I read during the case, I really believe that they were going to win it. I read it initially, just so I wanted to hear the facts and then see what was the ultimate court determination. And I was surprised that the taxpayer lost this one. So now fast forward to this year, we have Leon Max that came out in March of 2021. Those were also for credits in 2011 and 2012. And there were larger credits about 425,000 for 2011 and 500,000 for 2012. Leon Max was a fabric designer who designed, developed, produced and sold clothing. And so the case goes through in detail, their process, a structured process of conception, design and development of garments, right?
Well, when you go through the four part test with fabric designers, you could argue that a lot of that work meets the definition. Now, the tax code and the IRS disagreed, they used some specific terminology that I thought was pretty interesting. They said that they were using common knowledge to the field. Cutting and draping of fabric was not investigative. It was common solutions to common problems, standard activities performed daily and the testing was merely quality control. They also referred to a high technology activities that was in a preamble of an amendment done in 1986 as part of the 1986 Tax Reform Act, which I had not seen in other cases. So I thought it was pretty interesting that they went that far in disallowing the Leon Max case. But I think what this case really does is it closed the book on a lot of the clothing designers. And going after the R&D credit for them, I've read memos before where the taxpayer was arguing there was technical uncertainty because there was measurement uncertainty.
And the measurement uncertainty was trying to figure out the measurements of the fabric of cloth and the specific design associated with that. In my opinion, I didn't think that met the threshold. I thought the Leon Max case was defended well and despite that it was still completely disallowed by the tax court. So that's just a couple of cases where we're setting up precedent where it's getting more and more difficult to claim the R&D credit. And I think with these as a backdrop, and then now you add in the directive, it becomes more imperative to get the claims on originally filed return and get the documentation in place. The last case that I wanted to go through was Little Sandy Coal company. That was also 2021, so that was in February. That was a ship builder.
And that was $1.1 million in credit. And that had to do with the design and development of 11 vessels. They stipulated to only look at two different vessels and apex tanker and a dry dock. And what you had was a lot of money being claimed as supply costs. The taxpayer said the cost of the ship, all the material that goes into the ship are eligible for the R&D credit if we have qualified wages where we're trying to design and develop the ship. To give you an example, the dry dock had 146,000 of qualified research expense from wages. So that would be the payroll associated with the design and development of the dry dock. They had two million of supplies just for the dry dock. So you have a tiny amount of time that's being claimed as qualified activity, and then a significant amount of supplies.
So the tax court went through the people and they said nobody's higher than 60% being qualified. There was never an uncertainty with regard to the ship for design and that it never met 80% of a process of experimentation. So substantially all of the activities related to the development of the ship, 80% of that was not there. It was less than that in the development and design of the ship. What I think was going on behind the scenes was you had too much supplies being cleaned for a tiny amount of wages. And I don't think it passed the sanity check, and I think the IRS sniffed it out and the tax code agreed with it.
And so what they were really saying was you can't have someone spend 30% of their time on the design of a ship and then go ahead and claim the entire ship as qualified research expense. So it's a little fact specific on that one, but it also just goes to show that the IRS is winning these cases when it gets to tax court. That's three where we are dealing with the definition of qualified research. There's other cases that's come out this year and the year before that's more specific related to either funded research or rights to the research or that specificity requirement, but these three really dealt with the definition of qualified research and how taxpayers need to get over that threshold. And I think we're going to pass it. Should we do my polling question or should I pass it back to Allie?
Miri Forster:Let's do the polling.
Alexandra Colman:I would say let's do your polling question.
Bella Brickle:Poll #3
Tim Rankins:And just real quick, I see a couple questions relating to internally developed software. Yes, there is a case on internally developed software. It's called the Davenport case. It was decided about 10 years ago that had to do with JD Edwards implementation. The Siemer Milling Company did use a third party to prepare their filing, and they used them for a few years and they were on originally filed returns.
Nice to hear everyone's listening and not just getting CPE.
Alexandra Colman:Or they're a bunch of luck guessers. Hi everyone. I'm Allie Colman. I am a tax partner in our large corporate group at EisnerAmper and I'm going to be talking about the financial statement implications of the R&D credit. So there was a lot of areas covered by both Tim and Miri this morning. So let's just start with the basics. So generally speaking, when a company has a research and development credit, they're either going to utilize the credit in the current period in which it's generated, or they're going to carry forward that credit to a future year when they hope to be able to use it. In the instance of you creating an R&D credit and utilizing it in the same period, it's going to be a reduction to your current period expense and it's going to end up on your rate reconciliation for those public companies that have joined us today.
It'll be shown as your rate reconciliation as a benefit, a reduction of your effective tax rate and everybody's goal, right? To reduce your ETR. To the extent that you are not able to use your research and develop credit in the current period, then you're able to carry forward that credit for a 20 year period. In that instance, you would create a deferred tax asset on your financial statements. Generally speaking, you wouldn't see a deferred tax asset sitting on your rate reconciliation, but in this instance you would, because this is a credit that you are expecting to carry forward, but there's no current tax implication of the credit. So you would create your deferred tax credit, deferred tax asset on your balance sheet and the offset to that would be your deferred tax benefit.
Then when you're dealing with your both current period utilization and the potential carry forward of a research and development credit, you need to consider whether or not the likelihood that that credit would stand up under an audit. And as Miri and Tim discussed, there are a lot of situations where those credits are not allowed under an IRS audit. So do we need to set up an uncertain tax position or a Fin 48 reserve? I can tell you that just because you hire a third party to complete your research and development credit, not all providers are created equal. So there are times where I have clients that have contracted out to a boutique credit calculator, and they'll send me a completed 6765 and said, this is what they gave me and me on the prepare side of the provision, I'm like, okay, where is the documentation?
I know from dealing with Tim on many clients, when he does the studies, he's interviewing the engineers, he's actually understanding the components and what is being performed by the engineers and what is the level of uncertainty. And not all of the credit providers do that. So I will say my general, if I have a client, that's just sending me, okay, these are my research and development wages, and this is my supplies and there's no substantiation for that, there generally should be an offsetting Fin 48 reserve for that credit. Because as Miri said, this used to be a tier one issue. Now it's still, if I have a client that has an R&D credit and they're under audit, it's getting looked at. So it's something that we should assess the need for a Fin 48 reserve or an uncertain tax position, whether or not we're using it in the current period, or whether we've created a deferred tax asset for this.
I also wanted to touch on the need for a valuation allowance. So when you are carrying four of these credits for a 20 year period, do you anticipate being able to utilize these credits. As Tim mentioned earlier, just because you're in a taxable income position doesn't mean you'll be able to offset a 100% of your tax with your R&D credit. There's an ordering rule, of course, where you need to consider your net operating loss utilization, and whether that's available to offset your income. You need to consider if you have foreign tax credits, because that's before R&D credits in the ordering rules. And then if you get to your R&D credit, is there a limitation on how much credit you can use in the period where you're expecting to generate income? So there's a lot of areas to consider on whether or not you anticipate to be able to have whether you need evaluation allowance against your R&D credits, or whether you need a Fin 48 reserve.
In addition, I'm skipping the capitalization of R&D expenses for now, but the payroll tax offset. For those of you that are qualified small businesses that are entitled to potentially offset your payroll taxes, when you're making that election, you then have a reduction to your payroll tax expense. The R&D credit no longer is providing you an income tax benefit, it's providing you a payroll tax benefit. Payroll taxes are an above the line item. So we then would need, you would be adjusting your pre-tax book income to the extent of the credit that you anticipate to offset payroll taxes, however, that benefit is not taxable. So it's interesting. If there's a lot of components, you need to adjust your pre-tax book income, but then you also have a permanent adjustment saying, okay, even though for under gap I'm paying less, my payroll taxes are less, for tax purposes you're not penalized for taking that credit and you're still allowed your full payroll tax deduction.
Then when we're talking about capitalizing R&D expenses, whether or not you do that already with the 589E election, or whether that is effective January 1st, 2022, or in four years from now, generally when you're capitalizing expenses for tax purposes, then you will have a deferred tax asset, because if these expenses are deductible for book purposes, for tax purposes, these expenses are going to be capitalized. So I would end up with a deferred tax asset because my basis for tax is going to be higher than that of book, which would be zero if they're expensed in the current period. So just something to consider, especially for public companies, this could potentially, if it is effective 1, 1, 2022, when you're looking at your Q1 2022 provisions, this is an item that could potentially put you into income where you wouldn't necessarily expect it.
So, I know generally a lot of us don't look at deferred tax attributes at each quarter because you're not required to, but in this instance with changes in law and things like that, you want to make sure that you have a full picture of what's going on. So definitely if this does stay effective January 1st, 2022, make sure that it's something that you remember to go through in your Q1 provisions. So with that being said, I am going to move it to the polling question.
Bella Brickle:Poll #4
Alexandra Colman:Thanks, Bella. I would say that I see the majority of my clients that have research and development credits that they've taken or are carrying forward do have usually I would say around a 20% uncertain tax position recorded related to those.
Sure. And Tim, I'm going to wing it and answer one of the Q&A that I think you've properly taught me the answer to, of whether or not the payroll has to be in the US. And I believe that answer is yes. That in order to qualify for the research and development credit, the wages, all expenses must be US expenses. Do you agree? Am I right?
Tim Rankins:Well done, I agree.
Alexandra Colman:Yes. Thank you.
Tim Rankins:I was writing down some of the questions because the box is kind of small. I was going to just answer them quickly rapid fire. 1099s would be the contract research expense, so you can claim 65% of amounts paid. And as Allie mentioned, that's to the extent that it was in the US. A couple other questions that I just wanted to address, I would look the threshold of credit to be about 10,000. That would be where you would want to go after it and spend the time to calculate it and substantiate it. If we're working in Canada, but it's for a US company, it's a boots on the ground test. So the work has to be done in the state. So if we're paying a company that's a US invoice but the work's being done in Canada or India, that would still be ineligible. The IRS is kind of on top of that one.
Gross receipts. When we went through qualified small businesses, that does include grant income that would be reported on your 1120 or your tax return is income. And so therefore that could disqualify you as being a qualified small business. And just a couple other ones real quick, from a partnership or pass through perspective, the credits can be utilized at the pass through level to the extent that the entity that incurred the qualified expense has income. So if we're a partnership and we're operating at a loss and we have large R&D credits, they're passed through to the partners, but they can't be utilized until there's income from that pass through entity to the shareholder or the partners.
And one final one, the directive that we went through and this gets to the best practices, that relates to amended claims for refund. So that's where we are amending a tax return and we're asking for money back, right? So to lead into best practices, the first and foremost is we should make our R&D tax credit claims on originally filed returns. We want to avoid the fact pattern of amending prior year returns and asking for a refund. I went into this before with project tracking. Contemporary nexus of timer expense to project or business component, to the extent that we're capitalizing time or using a project tracking system, that's always the best answer to demonstrate what the person's working on during that time period. And also from a supply and contract research perspective, if we're paying outside vendors or we're incurring material expense, if we have that tracked to those projects or business components, that's always the best result.
It's not required. We can go back and allocate those costs to business components, but that's the preferred method that we want to go after. Now, we talked a lot about documentation and substantiation. In my opinion, a product development life cycle, to the extent that we have that, is always helpful to show what departments are number one, performing the qualified research and then in what way would other departments support the qualified research? When we look at project documentation, what I see on IDR is this timing. When did the project start? When was it supposed to end? What was the scope? Were there team members listed on this information? What was the budget? When did the budget start? When did the budget end? From a qualitative perspective, how the project qualifies? What sort of documentation would be involved there?
We look at like release notes, design docs, requirement specs, preliminary design reviews, critical design reviews to the extent that we have meeting notes. That's always helpful as well. If you get into an exam, you never know how much detail they're going to want. Sometimes they even want reviews of the individuals that show what the commentary was about what their activities specifically were, right? That's why we're a project tracking system where we have our time to project or task. We can already show that without having to pull job descriptions or meeting notes, stuff like that that's much more detailed and it might not be that descriptive too. Miri, I don't know if you wanted to mention something else as well related to the burden of proof.
Miri Forster:Yeah. So I mean, it's so helpful that you gave the different examples of the documentation. It is very, very important because the burden of proof to substantiate the research credit is on the taxpayer. And not that anybody on the phone has unsubstantiated claims, but the IRS has actually included research credit as honest list of dirty dozens for tax scams. So they are getting unsubstantiated claims and in some cases they're even imposing the 20% erroneous claim for refund when a refund claim is for an excessive amount that's not substantiated. So the documentation component is critical to support the position in these cases.
Alexandra Colman:Tim and Miri, if I may just add one other thing that yes, of course we want these credits to be filed on originally filed tax returns. That is the objective. But Tim, I don't know if you wanted to talk a little bit about, there are certain elections related to the research and development credit, whether it be a 280C election or you want to use the alternative simplified method and those types of elections need to be made on originally filed forms. You can't make those elections if you file amended. Is that correct?
Tim Rankins:That's right. So the 280C election reduces the credit by the amount of the tax rate, because you're claiming the same costs as a deduction. This allows taxpayers to not have to adjust their deductions. And so it's really for administrative convenience purposes, this election, but where we didn't make that election on originally filed returns and we want to go back and amend, we're required to take what's called the gross credit. And when we do that, we have to change our deductions by the amount of the gross credit, we have to reduce our deductions.
And that also affects state tax liability or state tax income because it's a carryover from FED. So what you should be required to do then is amend state returns as well in that fact pattern. The other note is the qualified small business with the payroll offset, I mentioned that we have to file Form 6765, make that election on section D to use the credits against future payroll tax liability. That election has to be made on originally filed returns. So if you miss it, you're out of luck and you cannot go back and amend as a qualified small business unfortunately.
Tim Rankins:I was going to look at - One more question was on Form 3800. So the difference is the payroll credit versus income tax credit. So when you make that election to use the credits against future payroll tax, those credits then go through on a different section of Form 3800 versus the ones that would not be elected as against payroll tax. And that would be carried forward against future income tax liability. So that's the difference there. That's why there's two of them on Form 3800. And with that, I can pass it back to Bella.
Alexandra Colman:Thank you everyone.
Transcribed by Rev.com
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