IRS Agents Tighten The Thumb Screws On R&D Credit – Tax

United States:

IRS agents tighten the thumbscrews on R&D credits

September 16, 2021

Dickinson Wright PLLC

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Recent taxpayer experience suggests that IRS agents are becoming more aggressive in denying R&D tax credits by narrowly interpreting the so-called “essentially all” test of Code Section 41 (d) (1) (C), which requires the research activities are “elements of an experimental process”.

Under Treas. Registration number. §1.41-4 (a) (5), an experimental process must be a process aimed at evaluating one or more alternatives in order to achieve a result, with the ability or method of achieving that result at the beginning of the taxpayer’s research activities is uncertain. Therefore, the IRS requires a process that is generally based on the principles of physical or biological science, engineering, or computer science to:

• Identification of uncertainties related to the development or improvement of a business product or business component;
• Identify one or more alternatives that will remove this uncertainty; and
• Identification and implementation of a process to evaluate the alternatives (e.g. by modeling, simulation or systematic trial and error methodology).

However, according to the IRS, a taxpayer can conduct research, and the research can actually develop or improve the function, performance, reliability, or quality of a product. However, such activities may NOT count towards the “essentially all” test, since a taxpayer who has not proven his activities also represents “elements of an experimental process” in the narrower sense of the applicable treasury regulations.

The question of whether a taxpayer’s activities meet the narrower “elements of an experimental process” test is inherently “factual” and taxpayers and the IRS often disagree on which activities constitute elements of an experimental process. In addition, the IRS appears to be raising this issue more frequently and was expected to be required to substantiate credit for its research by its recent victory in the 2021-15 TC Memo from Little Sandy Co., Inc.

The content of this article is intended to provide general guidance on the subject. Expert advice should be sought regarding your specific circumstances.

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