As a result of a recent IRS directive, taxpayers may be able to reduce the risk associated with claiming an R&D credit—and potentially generate an increased credit amount.
On September 22, 2017, the IRS publicly released guidance for large business and international (LB&I) examiners regarding the examination of certain R&D expenses under Financial Accounting Standards Board Accounting Standards Codification® Topic 730, Research and Development. The directive—LB&I-04-0917-005—indicates the IRS won’t challenge certain qualified research expenses (QREs) that are a taxpayer’s adjusted ASC 730 financial statement R&D costs.
With this guidance, taxpayers now have the option to reconcile ASC 730 with the QRE claimed on their tax return by adjusting ASC 730 financial statement R&D costs to arrive at the amount the IRS considers as qualifying for safe harbor. Safe harbor, in this instance, means the IRS won’t challenge the amount.
Here are some of the most common questions to help you navigate this topic.
Who can benefit from the new guidance?
The opportunity is for LB&I taxpayers that have more than $10 million in assets and follow US generally accepted accounting principles (GAAP) to prepare certified audited financial statements. This includes C corporations, S corporations, partnerships and LLCs that claim R&D tax credits.
Taxpayers who perform domestic-based R&D that’s self-funded and self-performed could benefit the most. Self-funded here means there’s no outside government funding or customer contracts, and self-performed means the majority of R&D expenses are allocated to internal employee costs rather than services by third-party contractors.
The directive could be most applicable to companies in the life sciences and tech and manufacturing industries, but it isn’t written to exclude any specific sectors.
What kinds of expenses are allowed in the new directive method? How is it different than a historic R&D credit calculation?
Here’s a breakdown of expenses allowed and excluded with historic R&D credits as well as under the directive.
Qualified Employee Wages
The historic R&D credit QRE calculation identifies a qualification percentage for each R&D employee. The directive, on the other hand, allows for inclusion of the following percentages of wages paid to the corresponding employee types:
- 95% of wages and stock options for each qualifying employee whose wages are charged to US ASC 730 cost centers, or those cost centers that are included in the company’s financial statement R&D.
This includes qualified individual contributors—those who don’t manage other employees—as well as first-level managers—those who directly manage qualified individual contributors only. These designations are role-based not title based, and taxpayers who choose the directive method should consider the availability of the necessary support for each employee’s designation.
- 10% of the calculated qualified individual contributors and first-level manager amounts or 100% of wages and stock options for upper-level managers, defined as those who directly supervise any employee other than qualified individual contributors and whose wages are charged to ASC 730 cost centers. Whichever amount is lower can be included.
Qualified Supplies & Qualified Computer Rental Costs
The directive also allows for inclusion of amounts expensed in ASC 730 R&D accounts related to development supplies used and consumed in the US, affording safe harbor treatment to these supply amounts.
Similarly, the directive allows for inclusion of amounts expensed in ASC 730 R&D accounts relating to development-based computer rental costs as covered by the safe harbor.
Qualified Contractor Costs
While historic R&D credits allow for a taxpayer’s inclusion of certain expenses for third-party contractors performing R&D services on their behalf, the directive specifically excludes these amounts as a qualified expense.
What steps must I take to benefit from this change?
You’ll file the same Form 6765 with the tax return to claim federal R&D credits, using the QREs from the taxable year. However, your company now calculates and reports QREs based on two components.
The first is ASC 730 Financial Statement R&D QRE, which includes items that will be protected from IRS challenge if calculated according to the new guidance.
The second component is non-ASC 730-based QRE. This is composed of the remaining QRE items that don’t meet the ASC 730 directive criteria nor come from non-ASC 730 accounts that you’d still like included in the R&D credit calculation.
Keep in mind that the safe harbor doesn’t apply to these second component QRE items, so they’re still subject to full IRS examination.
Are there any negative consequences for not acting on this information?
If you’re eligible and choose not to use the directive, all QRE components of any R&D credits claimed will be subject to IRS examination, which is how it has happened historically.
Depending on your company’s circumstances, this could be a missed opportunity to:
- Obtain protection from IRS examination of certain components of its R&D credits
- Potentially increase credit
- Possibly reduce future tax expense through overall increased R&D tax credits or reduction in reserves against this amount
Does the directive methodology apply to state R&D credits as well?
As of now, not all states have determined if they’ll adopt the ASC 730 method for calculating credits at the state level.
In February 2018, however, the California Franchise Tax Board announced that it will fully adopt the ASC 730 directive method, provided that additional adjustments are made to include only those costs incurred that relate to activities or services performed in California.
I prepare several R&D related schedules. Is there anything I need to do differently?
To figure out how to meet your specific needs, your company might benefit from consulting an assurance and tax provider for a recommended course of action. The solutions could be straightforward:
- Creating new general ledger accounts to track ASC 730 R&D QRE and non-ASC 730 accounts
- Creating additional columns to existing spreadsheets or report queries—such as title, cost center, or direct reports—to support qualifications for employee wages
Whether the use of the directive method increases a company’s QRE will depend on their unique circumstances. Taxpayers can consider conducting a feasibility assessment to determine if the safe harbor election could benefit by them and their potential savings.
If you’d like to pursue this opportunity, it’s important to consider both assurance and tax R&D aspects as you gather information and isolate R&D expenses to align with IRS expectations. This step should come before a financial statement audit takes place because the ASC 730 expenses are the starting point for the reconciliation exercise.
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