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:: Credit for Increasing Research Activites - Research Credit
Issues
10. RESEARCH CREDIT
ISSUES
a. Coordinated Issues
Currently, there are four
research credit Coordinated
Issue Papers (“CIPs”), available
on IRS.GOV.
(1). Technical writers and other
individuals who prepared end
user manuals or other
instructive documents for the
end user.
ISSUE: Whether the wages paid
to technical writers, editors,
illustrators, and others who
assist in the preparation of
user manuals, constitute a
qualified research expense for
purposes of computing the
research credit under section
41.
(2). Payments to a deferred
compensation plan or trust such
as a section 401(k) plan and
matching employer’s
contributions.
ISSUE: Whether contributions to
a deferred compensation plan
arrangement under section 401(k)
on behalf of an employee who
engages in qualified research
are qualified research expenses
under section 41(b).
(3). Internal-Use Software.
ISSUE: Are “X's” activities
related to the installation,
customization, enhancement and
maintenance of a vendor-supplied
software package excluded from
the definition of "qualified
research" within the meaning of
section 41(d)(1) because they
fail to satisfy the 3-part
exception to the exclusion for
internal use software contained
in the Conference Report to the
Tax Reform Act of 1986 (the 1986
Act)?
(4). Self-Constructed Assets
ISSUE: This Paper addresses
whether amounts paid or incurred
as depreciation expenses,
general and administrative
expenses, employee benefit
expenses, travel and
entertainment expenses, and
overhead and other indirect
expenses that relate to
"self-constructed supplies" are
qualified research expenses as
defined in section 41(b).
b. Awareness Issues
(1) Wage or qualified service
issues.
Common wages issues that are
usually found not to qualify for
the credit:
-
Direct
support : in-house
attorney- legal fees and
patent expenses,
secretary expenses
-
Direct
supervision: above
first-line manager
(2) Common supplies issues:
Prototype expenses. Carefully
scrutinize "prototype"
expenditures to determine
whether the "prototype" and/or
its subcomponents are property
of a character subject to an
allowance for depreciation. See
Treas. Reg. § 1.174-2. Note
that the word “prototype” does
not appear in the relevant
provisions of either the
Internal Revenue Code or the
Treasury Regulations; thus,
using this label is not
controlling.
Extraordinary Utilities. As a
general rule, utilities are not
QREs. Treas. Reg. §
1.41-2(b)(2)(i). However, a
taxpayer may claim extraordinary
utilities as QREs. The taxpayer
must establish the extraordinary
nature of the utility expense.
Treas. Reg. § 1.41-2(b)(2)(ii).
Merely comparing the square
footage electricity use in an
administrative building with a
research facility is
insufficient.
(3) Computational Issues:
Section 280C. If a taxpayer
claims the research credit for
qualified research expenses
(“QREs”), no deduction is
allowed for that portion
otherwise allowed as a deduction
in an amount equal to the amount
of the research credit. Section
280C(c)(3). The election of a
reduced research credit under
section 280C(c)(3) is required
to be made with the filing of a
taxpayer’s original return.
Tax Consequences of Reversing an
Invalid Section 280C(c)
Election: There are numerous
material federal income tax
consequences that may flow from
a taxpayer’s recomputation of
the research credit at the
regular 20 percent rate, with a
correlative reduction in its
deductions. Some of these
potential consequences are:
Increased regular or corporate
AMT tax liabilities, restricted
interest, adjustments to the
I.R.C. § 39 general business
credit carryover, foreign tax
credit limitation, and
adjustments to NOLs. Examiners
should make sure that all
computational adjustments
flowing from reversing an
invalid I.R.C. § 280C(c)(3)
election are addressed.
Section 280C and “protective
elections”. A valid section
280C(c)(3) election can only be
made by actually computing and
claiming the reduced (13%)
credit on taxpayer’s original,
timely filed tax return.
Taxpayer can not make a valid
election without claiming the
credit, by merely writing the
words "280C", or by making a
statement on the original tax
return that taxpayer elects
section 280C in the event that
they later determine that they
have research credit. If the
taxpayer files an amended return
claiming the reduced credit
under section 280C(c)(3), when
they did not claim credit at the
reduced rate on the original
timely filed return, the
election is invalid and the
claim should be returned to
taxpayer to correct.
Section 41(f)(3) provides rules
for computing the research
credit after the acquisition or
disposition of a trade or
business. Although the Service
has yet to issue regulations on
the application of this section,
many taxpayers fail to apply the
plain language of section
41(f)(3). The Research Credit
Technical Advisors strongly
recommend that examination teams
seek their assistance, in
conjunction with Issue Counsel,
on the application of section
41(f)(3).
Section 41(c)(5)(A) requires
that a taxpayer establish
consistency between the QREs
claimed in the current year(s)
and the QREs it paid or incurred
during its base years (December
31, 1983 through January 1,
1989). This issue should be
addressed with the taxpayer upon
commencement of the audit. See
I.R.C. § 41(c)(3)(C).
Section 41(f)(1)(A)(i) provides
that all members of the same
controlled group of corporations
shall be treated as a single
taxpayer. Likewise, all trades
or businesses (whether or not
incorporated) which are under
common control shall be treated
as a single taxpayer. Examiners
should verify that the taxpayer
has included all related
entities in its research credit
computation, regardless of
whether these other entities
have research expenses.
c. Development and
Presentation of Issues
(1) Notice of Proposed
Adjustment/ Revenue Agent Report
and Report Writing
The Notice of Proposed
Adjustment (i.e. NOPA - Form
5701) or Revenue Agent Report
(RAR) should include all details
as to why the projects were not
qualified for the credit, as
well as detail as to what the
project actually was.
Organizing the NOPA into
sections of small, mid-size, and
large projects, or other
categories, can be helpful for
the examiner to organize his/her
thoughts about the issue, and in
communicating with the
taxpayer. For cases going to
Appeals, take the extra time to
make the NOPA and RAR as
complete as possible, as this
will help the Appeals Officer.
Sometimes the workpapers go with
the RAR, other times they do
not.
Each report narrative should
contain a discussion explaining
the nature of each challenged
research project (or other
research credit related
adjustment, such as the base
year amount computation) in
plain English. It is important
to take the time necessary to
clearly state the facts of the
case, state why an adjustment
should be made, and to clearly
state why the taxpayer’s
position is not correct. Every
important fact or argument
should be clearly stated.
It
is imperative to get a good
handle on the facts involving
each research project that is
disallowed. Spending time
reviewing the research projects
that are worthy of examination
is essential, and helps to
isolate any factual
discrepancies that must be
resolved before applying the
law. A clear discussion of the
agent’s understanding of the
facts of the case is very
beneficial in properly applying
the law at the Appeals level.
All documents that an examiner
is relying upon regarding a
research project should be in
the RAR as exhibits or included
in the workpapers so they can be
easily accessed. The binders
presented by many taxpayers are
voluminous, and are often
impossible to work with
efficiently.
(2) Substantiation and
Documentation
It
is a perfectly reasonable
rationale for disallowance to
assert that the substantiation
supporting the claim(s) is
inadequate. However, such a
disallowance needs to be
supported by an analysis of what
is relied upon by the taxpayer
and why it is unreliable,
insufficient, irrelevant,
misleading, etc. That is, the
foundation must be enumerated in
detail to support the
disallowance.
If
a claim has been disallowed due
to inadequate substantiation, it
would further support the
determination if the examiner's
methodology were detailed.
Detailing the examiner's
methodology would start with the
identification of the taxpayer’s
cost accounting system and an
explanation why this is the
"best" evidence (or normally
would be the best evidence).
The explanation then could
identify the records maintained
(or not maintained) for this
system. (For example, how are
programmer/ engineer/
consultants "activities"
accounted for and where in the
workpapers is the IDR requesting
the records used to substantiate
these activities)?
It
is expected that examiners will
request the documentation
necessary to evaluate the
claim. If evidence is not asked
for, then it is presumed to be
immaterial to the conclusion
reached. If new documentation
is later presented, that is
related to a material issue
request, Appeals should/must
return this for evaluation by
the examiner. (IRM 8.2.1.2.2).
If new information is submitted
at Appeals that was not deemed
important (i.e. material) by the
examiner, then independent
evaluation and reliance by the
Appeals Officer is reasonable.
It is important to note in the
file if an item was requested,
and if the taxpayer chose not to
provide it, whether due to cost
or time involved, or
unavailability. Again, if the
item is material, the examiner
should get a statement in
writing from the taxpayer that
they do not have the information
requested; otherwise the
examiner should consider
summonsing the information.
This is to prevent taxpayer from
submitting the information later
if they go to Appeals. It is
not an Appeals Officer’s
responsibility to review
documentation that should have
been verified by the examiner.
Note that consistency and
computational issues not raised
by examiners are not raised at
Appeals (unless material, which
arguably, is relative and may be
subjective).
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