The IRS released a Directive dated September 11, 2017 (LB&I-04-0917-005) that provides guidance to Large Business & International (LB&I) Division examiners concerning Internal Revenue Code Section 41 credit for increasing research activities (Research Credit) examinations. The Research Credit is based, in part, on qualified research expenses (QREs) paid or incurred by a taxpayer, and the Directive allows LB&I taxpayers to apply a “safe harbor” where an adjusted amount of their GAAP ASC 730 research and development (R&D) expenses can determine a certain portion of QREs that will not be challenged if the requirements of the Directive are followed.
The stated purpose of the Directive is to provide an efficient approach for determining the amount of QREs for taxpayers while also reducing the burden of doing so on examiners.
The Directive only applies to LB&I taxpayers – those with assets equal to or greater than $10 million – that follow U.S. GAAP to prepare certified audited financial statements and report ASC 730 R&D costs on their financial statements, either as a line item or in a separately stated note. The guidance outlines a safe harbor approach taxpayers can follow to determine certain QREs in the credit year that will not be challenged by the IRS.
The QREs not to be challenged are the adjusted ASC 730 R&D costs reported on the taxpayer’s certified audited financial statements as described in detail in the Directive and include adjustments related to:
- Foreign entities;
- Schedule M-3 amounts;
- GL Accounts or items specifically excluded from Section 174 (i.e. management studies and advertising);
- GL Accounts such as travel, overhead, and other expenses not eligible as QREs under Section 41;
- Costs incurred under contracts/agreements to perform research;
- Contract research expenses;
- Cost for R&D performed outside the U.S.;
- Prototype overhead expenses, patent costs, and severance pay;
- Certain stock-based compensation; and
- Certain wage amounts for Qualified Individual Contributors, 1st Level Supervisor Managers, and Upper Level Managers.
Any additional amounts of QREs over the adjusted ASC 730 R&D costs claimed by the taxpayer are subject to risk assessment to determine the scope, if any, of an examination.
Eligible expenses included in the safe harbor
The Directive identifies the ASC 730 R&D expenses that may be eligible under the safe harbor, and claimed as QREs for the Research Credit, including:
- Certain employees whose wage costs are charged to ASC 730 Financial Statement Cost Centers, including (a) 95% of Qualified Individual Contributors – employees who do not manage any other employees and (b) 1st Level Supervisor Managers – managers that directly manage only Qualified Individual Contributors;
- The lesser of 10% of the sum of (a) and (b) above or 100% of the taxable wages for Upper Level Managers – managers that directly supervise any employee other than Qualified Individual Contributors, which are charged to ASC 730 Financial Statement Cost Centers. If a taxpayer wants to claim more than this limit, then 100% of these costs is considered $0, and any amount claimed for Upper Level Managers would be subject to risk analysis and examination;
- Amounts paid or incurred for supplies used in the conduct of qualified research; and
- Amounts paid to another party for the right to use computers during the conduct of qualified research.
- Contract research expenses paid to another party other than an employee of the taxpayer for the performance of qualified research on behalf of the taxpayer are not eligible for inclusion as QREs under the safe harbor.
The taxpayer must sign the certification statement, under penalties of perjury, included in the Directive and agree to retain and make available documentation (the underlying books and records) that support the amounts claimed. If the certification statement and appendices provided in the Directive are not attached to the taxpayer’s tax return, the audit team will request these at the beginning of an examination if they determine the taxpayer followed this Directive.
The terms of the Directive can be followed on timely filed original returns, including extensions, on or after the date of the Directive.
LB&I taxpayers should:
- Assess whether this approach would be beneficial compared to their current approach of determining QREs;
- Consider whether they can efficiently comply to the Directive with their current operations, processes, and resources and if not, whether they should invest the resources to do so; and
- Review their documentation to ensure its availability upon request.
For questions related to the matters discussed above, please contact us.