The Treasury Inspector General for Tax Administration (TIGTA) recently released a report detailing their audit of the research and development tax credit as it applies to the qualified small business payroll tax offset. The report identifies deficiencies in the IRS programs and procedures which allowed erroneous claims, provides examples of erroneous claims, and suggests recommendations for improvement.
The research and development tax credit (R&D credit) was expanded by the 2015 PATH Act to allow qualified small businesses to utilize their R&D credit to offset the employer portion of their payroll taxes. Generally, to offset payroll tax with their R&D credit, a qualified small business must have:
- Filed a 2016 income tax return claiming gross receipts of less than $5 million for the tax year; and
- Had no gross receipts for any tax year before the five tax year period ending with the tax year for which the claim was made.
The maximum R&D credit allowed per year to a qualified small business is $250,000, for a total maximum limit of $1,250,000 over five years.
Because of the above changes to R&D credit claims, an audit was initiated by TIGTA. TIGTA’s objective was to ensure that both the correct taxpayers were claiming the payroll tax offset, and that those eligible were claiming the correct amounts.
What the audit found
Generally, the TIGTA audit found that the IRS does not have adequate processes in place to determine if a small business taxpayer meets the limitations on claiming an R&D credit as a payroll tax offset. The TIGTA audit also found that taxpayers were able to erroneously claim the payroll tax offset on a payroll tax return prior to the first period the payroll tax credit became available. Within the report, the IRS noted that verifying eligibility and amount of claims was difficult because it required access to information from sources other than the tax return and associated schedules.
In tax year 2017, more than 2,200 R&D credit claims were made by companies as qualified small businesses, translating to about $53 million in claims. Of these, 143 businesses claimed or received about $11.8 million in erroneous R&D credits. The audit identified 81 businesses with potentially erroneous claims amounting to about $2.8 million, and an additional 55 businesses that were able to erroneously claim a combined $586,000 on payroll tax returns for periods prior to the first period the payroll tax credit became available. The report also mentions additional claims with information and claim amounts that had been redacted.
In addition to the erroneous claims above, TIGTA identified a significant error in the IRS computation programs, which calculated almost $275 million in erroneous credits. This resulted from the IRS programs incorrectly allowing the R&D credit to equal the upper limit of a potential R&D credit claim. For example, if a taxpayer claimed a $50,000 R&D credit and the IRS computed that $200,000 was the upper limit that the taxpayer could claim, the IRS computation would incorrectly allow $200,000 as the amount of the claim. This IRS program has been corrected, and the IRS has already taken steps to correct the related erroneous claims.
Based on their findings, TIGTA recommended that the IRS:
- Review the businesses that were identified as ineligible to recover erroneously claimed R&D credits
- Review the businesses whose information was redacted to recover erroneously claimed R&D credits
- Implement post-processing initiatives to better identify businesses that do not meet eligibility or filing threshold requirements
- Adjust the accounts of returns filed prior to the first allowable period
- Implement procedures to stop filing of claims prior to the first allowable period
The IRS generally agreed with the majority of the report’s findings, and will implement the above recommendations in various forms between now and Nov. 15, 2020.
The upshot of the results of the TIGTA audit is that R&D payroll tax credit claims will be subject to more intensive IRS review. Qualified small business taxpayers wishing to take advantage of the R&D payroll tax credit should consult with a competent tax advisor to ensure compliance with the requirements.