2021 was quite a year. It started with much hope that we were approaching the end of a pandemic, a new administration in the White House, and a return to life as we once knew it. It ended with disappointment. Unfortunately, the world of the R&D tax credit was no different. We anticipated significant court rulings, potential legislative changes, and increased opportunities to maximize tax savings, and ended up with disappointment, but also with few planning opportunities.
Here’s what happened.
There were several decisions in 2021 focusing on activities that are technological in nature, funded research, direct research, and specificity.
R&D Costs and TCJA
By far, the most significant legislative R&D tax change was actually enacted back in 2017 and will initially take effect in mid-2022.
As part of the Tax Cuts and Jobs Act of 2017, IRC §174 was amended to eliminate the option for taxpayers to deduct R&D expenses, beginning in 2022, and are required to capitalize those costs. Domestic R&D costs must be amortized, on a straight-line basis over five years, and global R&D costs must be amortized over a period of 15 years.
- Impact: This change will have a significant impact on present value of R&D tax assets as well as current year taxable income. Although a temporary difference, it minimizes the value of R&D expenses over, at a minimum, a five-year period.
2022 Planning Opportunities: Historically, companies would make a concerted effort to categorize costs under IRC §174, as long as they are valid costs, to maximize their current tax deduction. Today, companies may want to reevaluate the assignment of these costs to determine if they are eligible for an alternative tax treatment that may avoid mandatory capitalization and allow for current deduction. Alternatively, if those costs remain classified as R&D costs under IRC §174, taxpayers must plan for a potential strain on cashflow as a result of the delayed timing of the tax benefit.
That said, there is still a glimmer of hope that taxpayers will not have to immediately deal with this change. There have been several proposals in congress to postpone, or even eliminate altogether, the implementation of mandatory capitalization. As of the date of this blog, the latest iteration of the Build Back Better (H.R. 5376) plan, for example, has postponed when this change would go into effect until 2026.
R&D Must Be Technological
In Leon Max v. Commissioner, Leon Max, a clothing designer, argued that their trial and error-based fashion design and prototype process was a qualified activity to claim an R&D credit. The IRS argued several factors including that the taxpayer failed the IRC §174 test, that the uncertainties in play were not technological in nature, and the development process was not an actual process of experimentation. The court ultimately agreed with the IRS that the uncertainties involved were not technological in nature, but rather based on style, taste, cosmetic, or seasonal factors, and the elimination of the uncertainties did not constitute a systematic process of experimentation.
- Impact: Apparel and textile companies must be careful that they are, in fact, performing qualified activities when claiming R&D credits. This case will likely call into question claims made by apparel and textile companies, regardless of qualification.
- 2022 Planning Opportunities: There are many potential activities that are conducted by apparel and textile companies that may meet the requirements of the R&D credit, however those claimed in this case clearly did not. The law is clear as to what can and cannot be considered technological in nature. The activity must rely on the principles of the physical sciences or engineering in order to ensure your R&D credit claims can be sustained if ever questioned under audit or directly challenged in a tax courtroom.
R&D Tax and Funded Research
Last year started with a tax court decision, Tangel v. Commissioner, which related to funded research. Tangel, sole shareholders of Enercon Engineering, Inc. (an S-Corporation), argued that a broad IP clause indicating that technical information and tooling developed as part of the contract could not be used for future buyers, did not preclude them from using gained engineering institutional knowledge in the future, and therefore they retained substantial rights to IP. The IRS and, unfortunately, the tax court disagreed with Tangel.
Although technically not in 2021, there was an unpublished decision in late 2020, also related to funded research, which likewise was taxpayer unfriendly. The Meyer, Borgman & Johnson v. Commissioner case involved a company claiming credits for fixed fee contracts that did not specifically tie payment to the success of the contract. This proved to be a costly oversight. The IRS and the courts pushed back with arguments that have been consistent with precedent and regulations by claiming that in order for activities to avoid being considered funded, the payment must be contingent on the success of the project. This is not a test based on the budgeting expertise of the contractor, it’s based on the project being accepted by the customer based on technological performance.
- Impact: These decisions make it more difficult for taxpayers to claim R&D credits in situations where there is a standard broad IP clause in the contract, and/or where the contract is based on a fixed price.
- 2022 Planning Opportunities: Often, major contracts are negotiated without the involvement of tax at early stages or sometimes at all. In many cases by the time the contract hits the tax desk, it is too late to make changes to the terms and possibly the project is already underway or even completed. Taxpayers should always involve the tax function when reviewing contract terms to ensure they include proper verbiage in order to maintain the ability to claim tax benefits related to the work performed.
When Qualified Research Isn’t Qualified Research
Little Sandy Coal Co v. Commissioner was a significant change in how the “substantially all” test is implemented. In addition, it was in direct conflict with precedent and the judge didn’t hide that fact when delivering his ruling. He stated in his decision that he did not agree with the precedent setting case “Trinity Industries v. United States”.
To be credit eligible, qualified activities must be conducted for a permitted purpose associated with the development or improvement of a business component. In addition, for the costs to be qualified, the regulations require that “substantially-all”, which means 80% or more of the activities associated with the development are activities that constitute a process of experimentation. The regulations, however, are not clear on how to determine this 80% threshold has been met. In the past, among other methods, taxpayers have looked at all qualified wages (including direct research, direct supervision, and direct support) as part of the numerator in determining the 80% test. In this case the judge ruled that only the activities directly engaged could be included.
- Impact: The impact of the decision could be a significant shrink-back or even denial of claims for taxpayers that have material direct support and/or direct supervision costs.
- 2022 Planning Opportunities: Taxpayers should conduct a detailed assessment of the actual activities employees conduct. For example, simply because an individual holds a supervisory title, does not mean their activity is supervision; it may in fact be direct research. In addition, if available, taxpayers should elect to use the ASC-730 Directive to avoid a detailed analysis of business components and rely on it as a safe harbor for their inclusion of qualified wages.
Meeting the Specificity Requirements
Three cases in 2021 hit on the topic of specificity. So much so, that – spoiler alert – a chief counsel advice memorandum was published later in the year to address these decisions.
In Harper v. United States, Premier Tech, Inc. v. United States, and Intermountain Elec. Inc. v. United States, the IRS argued that the taxpayers’ refund claims were not specific enough to satisfy the requirements for a refund. In other words, they didn’t provide enough detail on the refund claim, and therefore the claim should ultimately be rejected.
In all three cases, the courts rejected the IRS arguments and ruled that if there in fact was specific information required to file a refund claim, it should be specified on the tax form (in this case, Federal Form 6765, “Credit for Increasing Research Activities”).
- Impact: The full impact of these decisions is pending for taxpayers. On the Government side, we’ve seen the impact in the form of the Chief Counsel Advice Memorandum (CCA Memo) described in the next section.
- 2022 Planning Opportunities: Due to the release of the CCA Memo shortly after these decisions were published, taxpayers filing amended returns for a refund should plan to meet the requirements of the CCA Memo.
R&D Tax Administrative Changes
In what appears to a be a response to three consecutive losses in the courts on the matter of specificity, on October 15, 2021, Treasury published a CCA Memo directing a significant change in how future R&D tax credit refund claims will be handled.
The CCA Memo details specific information required to be submitted with a refund claim while instructing the IRS to reject any claim which fails to include the necessary information with the filing. The CCA Memo requires detailed substantiation for the qualified research expenses (QREs) being claimed by business component. The requirement took effect on January 10, 2022, with a one-year implementation period that allows time to perfect the submission prior to rejection. After the first year, there will not be time to amend the submission unless the statute of limitations has yet to expire.
- Impact: The CCA Memo introduces significantly higher documentation requirements to claim an R&D tax credit refund. Prior to the CCA Memo, taxpayers filed an amended Form 6765 that included the QREs by category, and the credit calculation. Now, for a refund claim, taxpayers will have to include detailed information about what activities each individual performed, and how that activity meets the requirements of the credit. This new requirement will likely prevent many taxpayers from claiming tax refunds based on R&D credit claims because the cannot produce the required substantiation in a cost-effective or timely manner.
- 2022 Planning Opportunities: There are two key planning strategies related to this change. First, simply claim credits on an original return, as opposed to an amended return seeking a refund. This eliminates the impact of the CCA Memo completely. Second, if claiming a refund on an amended return, start collecting detailed substantiation sooner rather than later. The effort will take considerably more time than it has in the past if that taxpayer previously filed the Form 6765 and only collected documentation if audited.
There are two ways that the CCA Memo’s impact may be averted. First, if a taxpayer challenges it in court and wins – as it is in direct conflict with three recent decisions. This is possible – but will take a considerable amount of time. Second, if there’s a legislative change to the language provided within IRC §41 to clarify specificity requirements.
2021 was an eventful year for the R&D tax credit world. An important takeaway from the year is that the frivolous claims, often encouraged by overly aggressive service providers, will not stand up in court. Even if they do, Treasury will undoubtedly come up with creative ways to circumvent those decisions. In the end, these claims negatively impact all taxpayers as they increase scrutiny and filing requirements for legitimate credit and refund claims. Taxpayers should expect to spend more time substantiating their claims, as well as seek to make use of methods available to facilitate claiming R&D like opting to utilize the ASC-730 Directive, and introducing automation to the credit claim process.