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New IRS Requirements for R&D Credit

6 minute read

Did you know there are new requirements for companies looking to take advantage of the R&D credit? The IRS wants more information if you’re submitting claims because they want additional proof it’s valid. What does this detailed information look like?

First, all the business components for which the research credit is claimed should relate for that year. Secondly, for each business component, a business needs to identify all the research activities they’ve performed and name the people who performed each research activity — including the information each individual sought to discover.

The claims will need to:

  • Detail the total qualified employee wage expenses
  • Detail the total qualified expenses
  • Detail the total qualified contract research expenses

All this can be done using Form 6765.

Why Is the IRS Getting Stricter With the R&D Credit?

The IRS is increasing efforts to manage what have been ongoing issues related to the R&D credit. It often appears on the IRS’s annual list of the “Dirty Dozen” tax scams and is exploited by many taxpayers who have claimed the R&D credit for doing very little in the way of innovation. The IRS believes getting stricter with regard to what information taxpayers should provide with their claims will help them make quicker decisions on whether specific R&D claims are valid or if further review is necessary.

Every year, thousands of R&D claims — from businesses and individuals — for credits worth hundreds of millions of dollars pass through the offices of the IRS. Many claims are examined, and it takes a large amount of time and resources for the IRS. By enacting stricter standards, the IRS hopes to cut down on the time spent reviewing cases and reduce the amount of fraud happening.  

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When Will the New Standards for the R&D Credit Take Effect?

The IRS is offering a grace period until January 10, 2022. Until this date, they won’t be requiring the inclusion of the extra information with Section 41 research credit claims. After January 10, 2022, there will be a one-year transitional period where taxpayers will have a month (30 days) to strengthen a research credit claim before the IRS makes a determination on the claim. 

More details will come, but it appears in January 2023 the new R&D standards will be in full effect. Currently, businesses can opt to deduct R&D expenses in the year incurred or paid. Or, they can capitalize and amortize the costs over at least five years. The new rules will require businesses to capitalize all of their R&E costs incurred in tax years beginning after 2021.

Practically speaking, what this means is that in 2022, a company can no longer deduct R&D expenses in the year they are incurred. Instead, these costs will be amortized over five years.

Could all this be delayed further? A budget reconciliation bill Section 138153 has been introduced that could delay the implementation of the requirement to capitalize R&D costs until 2026, but as of now, businesses should plan as if the new tax treatment will take effect in 2022.

Prepare for R&D Capitalization Changes

A company that incurs R&D costs and has been expensing those costs on tax returns should consider the following activities:

  • Cash flow planning — consider the potential cash flow impact any new tax burden will have.
  • Technical accounting — consider favorable accounting method changes or technical accounting to identify costs that can be recategorized.
  • Documenting of R&D tax credits — consider what additional documentation you’ll need to support your R&D credits.
  • FASB ASC Topic 740 — consider the impacts of accounting for income tax (ASC 740) if you capitalize R&D costs.

Quick Summary of the R&D Credit

As a general overview of the R&D credit — one of many potential credits for small businesses — remember that “research” can include:

  • Product development, which includes new prototypes or models
  • Improving a product’s quality or function
  • Improving the business performance, such as a manufacturing process

Sole proprietors, partnerships and non-public corporations are all eligible and can use Form 6765. This credit can be applied to payments to outside researchers or employees who do research, as long as you’re able to show a connection between the expenses claimed and the research activity (in addition to the new rules outlined above).

The R&D tax credit can be worth up to 20% of qualified research expenses, up to $250,000 annually. Science, medical and technology businesses are most often eligible for it, but many other types of businesses can engage in research activities. 

The new rules heading into 2022 highlight the even greater need for businesses to document their R&D.

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