IRS Enforcement Resumes – Examinations of Section 41 Research Credits by CORY STIGILE
Under the People First Initiative, the IRS asserted it would generally not start new examinations, except for situations with short statutes of limitations. As the relief provisions of the People First Initiative waned after July 15, 2020, the IRS has resumed collection activities in earnest, and presumably will also begin new examinations. The IRS has been quite vocal on certain examinations areas such as high income non-filers, micro-captives, and conservation easements. The IRS has also signaled a re-invigorated fraud referral process in these areas.
While these areas of IRS and congressional interest will undoubtedly continue to get attention, the IRS is continuing to build on expertise to conduct examinations of other substantive areas, including Section 41 research credits. Last November at the California Lawyers Association Taxation Section’s annual meeting, Chief Counsel Michael Desmond described how the IRS has increased enforcement in the research credit space, in response to potentially aggressive positions taken by taxpayers. In describing these examinations, he noted the complexities in the statute, as well as the need to understand each taxpayers’ business to determine if the credits were appropriate. These are highly factual examinations.
Similarly, at last November’s CalCPA Committee of Taxation IRS liaison meeting, a group of Small Business/Self Employed and Large Business and International (“LB&I”) managers, and an IRS Counsel attorney, presented on the complexities involved with examining or developing research credits cases. As the IRS was dedicating resources to the research credit area, at least prior to COVID-19, we can anticipate that these examinations are not going away. Moreover, as the examinations involve non-traditional tax or accounting questions, and rely on principles of science, engineering, computer science, or other fields, experts will be involved in the examination, including IRS engineers.
In September 2017, the IRS released LB&I Directive I-04-0917-005 (the “Directive”), which provided guidance to LB&I examiners regarding examination of the credit for increasing research activities under Section 41. This Directive intended to provide an efficient manner of determining qualified research expenses (“QREs”) for LB&I taxpayers that meet certain specific requirements and to more efficiently manage LB&I’s audit resources. This Directive only applies to LB&I taxpayers who follow U.S. GAAP to prepare their Certified Audited Financial Statements which show as a separate line item on the income statement the amount of the currently expensed ASC 730 Financial Statement R&D. ASC 730 R&D is made up of the research and development costs currently expensed on a taxpayer’s Audited Financial Statements pursuant for U.S. GAAP purposes, and includes certain specified adjustments. Given the rigor applied in determining these classifications for GAAP purposes, the Directive permitted examiners to accept as sufficient evidence of QREs the ASC 730 Financial Statement R&D for the Credit Year, thus saving significant examination resources and permitting additional certainty for taxpayers.
While the IRS Directive provides clarity for some taxpayers, any additional amounts of QREs claimed by a taxpayer on its Form 6765 for the Credit Year over the ASC 730 Financial Statement R&D amount are subject an examination, if warranted. While many Revenue Agents have focused on working existing examinations, albeit with an appreciation for extended information document request deadlines, anticipate that new examinations will commence and the IRS will deploy the resources that it has signaled over the last few years, and in particular last fall.
CORY STIGILE – For more information please contact Cory Stigile – firstname.lastname@example.org Mr. Stigile is a principal at Hochman Salkin Toscher Perez P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at www.taxlitigator.com