Two important changes to Research and Development (R&D) expenses are here and prudent taxpayers should begin preparing now. One modification relates to altered criteria for reporting prior year R&D credits, while the other is a revision to capitalization rules that require expenses to be amortized rather than immediately deducted.
R&D Credit Changes
On October 15, 2021, the IRS issued IRS Memo: IR-2021-203, alerting taxpayers that if they wish to claim R&D credits on prior years’ amended returns, they must include more thorough supporting paperwork and justification than previously required. Refund requests must now include a breakdown of all business components that are subject to credits under IRC Section 41.
Taxpayers must at a minimum:
- Identify all business components to which the R&D credit claim relates for that year.
- For each business component, identify all
- research activities carried out;
- personnel responsible for each research activity; and
- describe the information each individual sought to discover.
- Provide the entire cost of employee wages, qualified supplies, and costs associated with qualified contract research using Form 6765, Credit for Increasing Research Activities.
Taxpayers should submit Form 6765 with their total qualified expenses for employee wage, supplies, and contract research for the claim year. The IRS has announced there will be a one-year transition period beginning January 10, 2022, during which taxpayers will be given 30 days to perfect their refund claim. After that period has expired, the IRS will issue a definitive conclusion, which will not be subject to appeal.
When Will the Changes Take Effect?
The new guidance takes effect on January 10, 2022, which means the process of compiling the essential data will require significantly more effort to ensure a tax credit application is approved. Not only does this provision raise the effort and data required to submit for prior-year credits, but it may also increase the risk associated with amending returns to claim R&D credits.
If a taxpayer intends to claim credits retrospectively, it is recommended he/she check with their provider to ascertain the amount of additional time required to gather this evidence.
It’s critical to note that this does not apply to timely filed returns. Rather, it applies to refund requests for earlier tax years such as 2018, 2019, and 2020, which are now designated open years for amending.
R&D credit claims do not have an abnormally high audit rate – only a modest increase in the audit rate relative to the ordinary tax return is observed. However, scrutiny has intensified in recent years, and this provision may empower the IRS to make executive decisions regarding research credit claims without judicial monitoring. As a result, thorough documentation and analysis are more critical than ever to ensuring that refund requests are upheld upon examination.
Maintaining Records of R&D Credits
Poor documentation can severely undermine a taxpayer’s eligibility for R&D tax credits. Supporting paperwork that is meticulously detailed is required. Ascertain that your documentation fulfills IRS standards for detail. Additionally, taxpayers may want to evaluate their R&D tax credits to verify they are claiming the maximum amount possible.
Deductions for R&D Expenses Must Be Amortized
The second change to research and development expenses takes effect for taxable years beginning after December 31, 2021. Historically, taxpayers could immediately deduct the cost of R&D expenses that were not reduced by R&D credits taken. However, the Tax Cuts and Jobs Act (TCJA) of 2017 repeals immediate expensing of R&D spending and requires that expenses be amortized. The expenses will be amortized over a five-year period, whereas international expenses will be amortized over a fifteen-year period.
There was some hope of repealing this TCJA change in H.R. 1304, the American Innovation and R&D Competitiveness Act of 2021, which attempted to repeal the TCJA ruling. Repeal is included in President Biden’s planned Build Back Better Act and would delay the amortization rule until 2026. Unfortunately, neither of these Acts have been enacted as of this publication.
Prepare Yourself for Changes with Windes
Taxpayers should be prepared for the changes to the research and development tax credits and amortization of expenses. Windes can assist you in this regard. Connect with us to learn more about our tax credit services.