United States: IRS agents tighten thumb screws on R&D credit
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Recent taxpayer experience suggests that IRS agents are increasingly aggressive in denying taxpayers the right to claim research and development tax credits through a narrow interpretation of the so-called “near miss” test. totality ”of the Code § 41 (d) (1) (C) which requires that research activities constitute“ elements of a process of experimentation ”.
Under Treas. Reg. §1.41-4 (a) (5), an experimentation process shall be a process designed to evaluate one or more alternatives to achieve a result when the capacity or method to achieve that result is uncertain at the start of the research activities of the taxpayer. Thus, the IRS requires a
to treat which is fundamentally based on the principles of physical or biological sciences, engineering or computer science for the following:
- Identification of uncertainty regarding the development or improvement of a product or commercial component;
- Identification of one or more alternatives intended to eliminate this uncertainty; and
- Identification and conduct of a process for evaluating alternatives (through, for example, modeling, simulation or a systematic methodology of trial and error).
However, in the view of the IRS, a taxpayer may perform research activities, and research activities may, in fact, develop or improve the function, performance, reliability, or quality of a product. However, such activities may still NOT count in the “substantially all” test because a taxpayer has failed to establish their activities. too constitute “elements of an experimentation process” in the narrow sense of the applicable Treasury regulations.
Whether a taxpayer’s activities meet the narrower test of “elements of an experimentation process” is inherently “factual,” and taxpayers and the IRS often disagree on which activities constitute elements of an experimentation process. Additionally, the IRS appears to be raising this issue more frequently and to have been encouraged by its recent victory in Little Sandy Coal Co., Inc. 2021 TC Memo 2021-15, advising taxpayers that additional care, planning and record keeping will likely be required to establish eligibility for credit for their research activities.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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