United States

A Practical Research Tax Credit

Recent Developments in R&D

INSIGHT ARTICLE  | 

“The IRS no longer identifies the research tax credit as a ‘‘high-risk’’ issue. Practical and timely regulations covering prototypes, internal-use software, and the ASC have been issued, providing much needed guidance. Improved examination procedures have opened up greater communications between revenue agents and taxpayers. Overall, those changes have reduced the tension between taxpayers and the IRS and put the research tax credit on a more practical footing...”

David Click and Ryan Carnes look at IRS developments and court cases that have affected the administration of the R&D credit in their commentary A Practical Research Tax Credit – Recent Developments in R&D, first published in Tax Analyst's Tax Notes.

After thorough discussion, Click and Carnes conclude that important developments in the administrative, regulatory, and case law arenas over the past three years have had a significant impact on the research tax credit. Administratively, the end of the tiered-issue process has greatly reduced the adversarial nature of research tax credit examinations. In its place, issue practice groups allow for examinations with technical advice and expertise, which has led to much less burdensome, contentious, and time-consuming examinations. The IRS’s implementation of a new policy on “issue focused” Information Documentation Requests (IDRs) has also created a less contentious environment by opening communications between the taxpayer and the examination team.

A lack of guidance on major issues greatly contributed to the adversarial nature of research tax credit examinations. However, within the past 12 months, the IRS has issued useful guidance including proposed regulations that clarify the meaning of internal-use software, proposed regulations that assist a taxpayer in understanding the proper treatment of prototypes, and taxpayer-friendly regulations that simplify the procedure related to the Alternative Simplified Credit (ASC).  After years of uncertainty, taxpayers may make the ASC election on an amended return.

Three recent judicial opinions have also clarified some important technical questions regarding the research tax credit. Following the seminal case of Fairchild, the Geosyntec court engaged in an in-depth analysis of contract types and whether they are ‘‘funded’’ or ‘‘not funded’’ for research tax credit purposes. In holding that fixed-price contracts are not funded, and therefore eligible for the credit, the Geosyntec opinion gives taxpayers a clearer understanding as to which types of contracts are eligible for the research tax credit. The Dynetics opinion adds clarity to the issue of funded versus not funded for government contracts subject to federal acquisition regulations (FARS) and the defense federal acquisition regulations (DFARs). Finally, in the Suder case, the Tax Court addressed a new issue regarding reasonable compensation and qualified research expenses, an issue the IRS is still developing.   

Read the full review to discover how the IRS has provided much needed guidance to create a less contentious research tax credit, minimize examinations, and generally help the credit deliver on its intention to reward business innovation.

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