New IRS directive provides safe harbor for claiming the R&D tax credit

Written on Dec 14, 2017

Qualifying taxpayers may avoid a challenge to their credit

By Michael Krajcer, JD, CPA

There’s a new, favorable change coming to the R&D tax credit. Issued on Sept. 11, IRS Directive, LB&I Memorandum No: LB&I-04-0917-005, creates a new safe harbor whereby the IRS will accept as sufficient evidence of Qualified Research Expenses (“QRE”) the adjusted ASC 730 financial statement R&D expensed for the credit year.

The purpose of creating this safe harbor is to address the significant burden that taxpayers and the IRS face in determining the correct amount of R&D credits. The directive is intended to relieve some LB&I audit resources that have been historically devoted to auditing this area, and to create an efficient manner for determining QRE for applicable taxpayers.

Although this safe harbor may be greatly desired by taxpayers in this area, there are some restrictions on its application and limitations to the expenses that it will cover. Below is a quick overview on these requirements and limitations:

Directive requirements:

The directive does not apply to all taxpayers. Specific requirements identified include:

  • The taxpayer must be an LB&I Taxpayer with assets equal to or greater than $10 million.
  • The taxpayer must follow U.S. GAAP to prepare certified audited financial statements.
  • The taxpayer’s financial statements must identify on a separate line item on the income statement or in note to statement, the amount of expensed R&D per ASC 730.

For taxpayers meeting these requirements, the directive is optional. The decision to elect the directive will likely require a balancing of the certainty the safe harbor offers with the QRE limitations that the directive demands. These limitations are listed below:

QRE limitations:

  • For qualified individual contributors, QRES are limited to 95% of W2 wage amount included under ASC 730.
  • For 1st level supervisor managers, QRES are limited to 95% of W2 wage amount included under ASC 730.
  • For upper level managers, QREs are limited to the lesser of 10% of the amount claimed for qualified individual contributors and 1st level supervisor manager QRE, or 100% of the actual upper level managers W2 compensation included as R&D under ASC 730.
  • Contract research expenses are explicitly excluded from the directive safe harbor.

Effective date:

The provisions described in this directive may be claimed on original returns, timely filed (including extensions) after Sept. 11, 2017.

Conclusion:

It is encouraging that the IRS is addressing the significant resource burden that both taxpayers and the government are expending in the related compliance efforts associated with the R&D credit. A safe harbor provision will allow eligible taxpayers to enjoy some level of certainty in the amount of their claimed credit amounts. Qualified taxpayers would be wise to consider this directive and weigh the benefits of this certainty and saved compliance costs versus the cost of the limited QREs that the safe harbor election will require.

Michael Krajcer is the President of Tax Credits Group, a Cleveland-based R&D tax credit consulting firm. He has more than 25 years of experience in research tax credit consulting and related IRS/state tax controversy resolution. You can contact him at michael@taxcreditsgroup.com.

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