New IRS Guidance - Tax Treatment of Research Expenses

By Jeff Piha, CPA | Nov 18, 2021

white arrow

ResearchFor many businesses, research and development (R&D) costs are a major expense—and a source of potentially significant tax questions. Two recent developments have complicated these questions. One is a new IRS memo announcing more stringent reporting requirements for some taxpayers claiming a widely-used tax credit; the other is a potential change in the deductibility of research expenses.

New Information Requirements for R&D Credit

The Credit for Increasing Research Activities, commonly referred to as the R&D credit, was introduced in 1981 to encourage innovation by U.S. businesses. Under this provision, Section 41 of the Internal Revenue Code (IRC) allows businesses to claim a tax credit for a portion of their R&D expenditures, subject to a number of qualifications and limitations.

Although the R&D credit was originally intended to be temporary, the Protecting Americans from Tax Hikes Act of 2015 made it permanent, and modified it to allow qualified small businesses to use the credit to offset some of their social security taxes for up to five years. This made the credit more advantageous to many start-up businesses, which often have little or no income tax liability in their early years.

To counteract what it says is a growing number of fraudulent claims, the IRS’s Office of Chief Counsel recently issued a memo detailing new requirements for companies submitting R&D credit claims. For now, the new requirements apply only to taxpayers filing amended returns using the R&D credit to request a refund for previously paid taxes. But there are concerns the agency might eventually expand these requirements to include R&D credits filed as part of regular tax filings.

Under the new requirement, which goes into effect January 10, 2022, a company filing a refund claim based on the R&D credit will need to submit a statement that details and documents the research activities each business component performed, the individuals who performed each activity, and the specific information each individual sought to discover. This new requirement is in addition to other claim information such as the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses.

R&D Credit Limitations and Exclusions

IRC Section 41 requires companies to perform a series of complex calculations to determine a base amount and other limitations on the credit. In addition, only certain types of research are eligible. To qualify, research activities must satisfy a four-part test:

    1. Expenses must be connected to the company’s trade or business and must represent R&D costs “in the experimental or laboratory sense,” as defined under IRC Section 174.
    2. The research must seek to discover technological information that “relies on principles of the physical or biological sciences, engineering, or computer science.”
    3. The information discovered must be “useful in the development of a new or improved business component.”
    4. Substantially all research activities must involve a “process of experimentation that relates to a new or improved function, performance, reliability, or quality of the business component.”

Some types of research are specifically excluded from the R&D credit. These include research conducted after the beginning of commercial production; research to adapt an existing product to a particular customer; duplication of an existing product or process; surveys or studies; research relating to certain internal-use computer software; research funded by another organization; research in the social sciences, arts, or humanities; and research conducted outside the United States, Puerto Rico, or a U.S. possession.

Deductibility of Research Expenses

Another long-standing tax incentive to encourage innovation could also be changing soon. Since the 1950s, companies have been able to deduct certain qualifying research expenses from their taxable income under IRC Section 174. But the 2017 Tax Cuts and Jobs Act (TCJA) changed that, calling for the direct deductibility of R&D expenses to end after 2021.

Instead, the TCJA requires that such expenses be capitalized and amortized over five years (15 years for research conducted outside the U.S.). The Build Back Better legislation currently pending in Congress includes a provision to delay this mandatory amortization for four more years, but for now it is scheduled to take effect in January 2022.

We will continue to monitor these issues but as long as the fate of that legislation remains unsettled, businesses with significant R&D expenses would be prudent to prepare for higher taxable income in the coming year. In addition, they should be prepared to adapt their bookkeeping procedures to separate R&D expenses from other expenses that remain immediately deductible.