For C corporations, S corporations, and partnerships with assets greater than $10 million, claiming and providing proof to substantiate the credit for increasing research activities (US Code Sec. 41) can now be much less difficult and time-consuming. New guidance released by the IRS Large Business and International Division (LB&I) instructs examiners to accept the Adjusted Accounting Standards Codification (ASC) 730 Financial Statement disclosures as proof for the amount of qualified research expense (QREs) claimed. The purpose of the directive is to provide an efficient method for determining the amount of QREs for taxpayers, in addition to reducing the burden on IRS examiners by introducing a safe harbor approach. “Safe harbor,” in this instance, means that the IRS will not challenge the amount reported as the credit. Since many companies report GAAP ASC 730 R&D costs on their certified audited financial statements already, this is good news.
The ASC 730 Financial Statement for R&D includes research and development costs expensed per U.S. Generally Accepted Accounting Principles (GAAP) standards. ASC 730 applies to all entities and to “activities aimed at developing or significantly improving a product or service or a process or technique whether the product or process is intended for sale or use.”
Normally, LB&I examiners have to independently determine the correct amount of the research credit claimed. This includes determining which costs are qualified expenses for the credit (QREs). As you can imagine, this is a resource-intensive task. With the new directive, LB&I examiners will just use the amount of QREs reported on the audited financial statements, as long as the company complies with ASC 730.
The following self-funded R&D expenses, which must relate to activities occurring in the United States, will qualify for safe harbor under this guidance:
- Wages: A total of 95% of taxable wages for qualified individual contributors and first-level supervisor managers. 10% of this amount can be used for upper-level managers.
- Supplies: All supplies used in the R&D process other than prototype overhead expenses.
- Computer rentals and leases: Amounts paid by a taxpayer for the right to use computers during the conduct of qualified research. This may include qualified cloud-computing costs associated with R&D.
Any R&D activities required to be performed to meet the terms of a contract are not eligible for safe harbor. Taxpayers that decide to apply for safe harbor aren’t excluded from including additional expenses as part of their R&D tax credit calculation. However, these expenses won’t receive safe harbor treatment. Additionally, expenses related to contract research, research performed to fulfill contract terms, and additional upper-level employee wages may still be considered qualified R&D expenses and treated accordingly. To apply for safe harbor treatment under this directive, a taxpayer must complete and sign a certification statement claiming its adjusted ASC 730 financial statement R&D as QRE on its federal income tax return. Two appendices detailing the reconciliation between ASC 730 and R&D expenses must also be included in the application in order to provide the IRS with further details on what’s being included in a taxpayer’s overall R&D expense calculation, not just its safe harbor calculation.
The taxpayer may also submit the certification and related appendices to an IRS examiner at the commencement of an audit. Separate certifications must be completed for each year in which a taxpayer wishes to apply for the safe harbor. This guidance only applies to returns filed on or after September 11, 2017.
If you own or run a business that performs significant levels of R&D, the professionals at Cerini & Associates can help you understand if you’re taking full advantage of the tax-preferential treatment afforded to R&D. Often times, we determine that past tax returns may be amended, resulting in significant tax refunds and ongoing savings for our clients.