During 2016, our cost segregation team attended several tax conferences where we received feedback from other tax practitioners around the country regarding their experience with claiming research and development tax credits for their clients. In many cases, the CPA firm commissioned an outside consultant to perform a research credit study, and in other cases their client commissioned the research credit study without their CPA’s knowledge. In both cases, issues arose with those studies upon examination by the IRS.
The tax practitioners we heard from overwhelming agree that research and development tax credits (R&D tax credits)—a tax credit for engaging in qualified research activities (QRAs)—can result in significant tax savings for their clients and are worth their time and effort.
R&D tax credits may be claimed by companies based on qualified activities and not necessarily based on the industry in which they operate. For example, CPA firm clients generally interact with customers over the internet, which requires the development of computer software. The IRS recently clarified that the development of customer-facing computer software does not need to achieve a high threshold of innovation test that applies to computer software developed for such internal use as administration functions. This development expands the universe of potential clients for research tax credits significantly.
Issues with R&D Tax Credit Studies
The tax practitioners we heard from shared troubling experiences they have had with studies performed by outside consultants that arose during an IRS examination. The issues we heard relate to research credit studies that were prepared on a contingent fee basis, studies that didn’t establish the requisite nexus between qualified activities and expenses, studies that were commissioned before performing the requisite due diligence to determine whether credit limitations apply, and studies that failed to address the requisite rights and risks in contracted research.
A contingent fee is a fee arrangement in which the amount of the fee is dependent on the amount of the R&D tax credit that is generated by the outside consultant. The IRS stated the following when they added research credit claims as a Tier I examination issue: “Thus, a taxpayer faces limited risk when claims are prepared under a contingency fee agreement. Audit teams expend enormous resources perfecting these claims and generally disallowing a large portion of a claim.” As a result, IRS agents are highly skeptical when they are handed a pre-packaged report that was prepared under a contingent fee arrangement.
We heard of a R&D tax credit study that was prepared under a contingency fee arrangement and, after the IRS examination concluded, the contingent fee that was paid for the study exceeded the amount of the research credit that was sustained.
IRC Section 41 requires the taxpayer to identify Qualified Research Expenses (QREs) by business component. Although an outside consultant is not required to use a project-by-project methodology to claim the R&D tax credit, such a methodology provides an accurate measurement of QRAs and direct nexus with QREs, the essential elements of qualifying for the credit. Other cost-capturing methodologies used by outside consultants may not establish the required nexus between QRAs and QREs, and may not be sufficient to meet the taxpayer’s record-keeping requirements under IRC Section 6001.
A common example of the nexus problem is in the case of qualified wages established by capturing W-2 wage amounts by cost center and multiplying a qualified percentage to individual employees' wages or department total wages. The determination of a qualified percentage may be based on time estimates or selected manager’s recollection and may not be supported by measurable corroborative records. In some cases, the percentage is determined and applied to total department wage costs rather than to individual employees.
R&D Tax Credit Due Diligence
Before engaging an outside consultant to perform a R&D tax credit study, the consultant must determine whether any limitations apply. Certain consultants only address QRAs and QREs and ignore the client’s tax situation. In fact, we heard of an instance where a client commissioned a R&D tax credit study directly with an outside consultant without consulting with their CPA. Had the client consulted with their CPA first, they would have learned they couldn’t use research credits due to limitations based on their individual tax situation. Unfortunately, the client paid for a R&D tax credit study that had no monetary value.
Rights & Risk
Clients may engage outside contractors to perform research on their behalf. The payments made to these outside contractors are included in QREs when the client retains rights to use the research and is at economic risk. Therefore, it is imperative that the outside consultant commissioned to prepare a research credit study review contracts with outside contractors to determine who retains the rights to the research and who is at economic risk.
We heard of an instance where the outside consultant didn’t review the contracts and generated a research credit on a contingency fee basis. Upon IRS examination, the IRS agent reviewed the contracts and disallowed over one-half of the original credit. A settlement was reached for the remaining amount.
Research Credit Studies
Now that R&D tax credits are a permanent part of the Internal Revenue Code and the PATH Act enhanced the ability of small businesses to use research credits, the popularity of research credits will continue to grow. However, research credit studies must be prepared in accordance with Treasury regulations to withstand an IRS examination. That means more time must be spent before the study begins to determine whether the client has qualified activities and expenses, has documentation sufficient to meet the requirements of IRC Section 6001 and has requisite rights and risks in contracted research, and whether the client will benefit from claiming research tax credits.
An outside R&D tax credit consultant should always provide a Phase I feasibility study and be commissioned through the CPA firm who has knowledge of the client’s tax situation.
CSP360 partners with CPA firms by providing a Phase I - scoping the potential for research and development tax credits, Phase II - detailed analysis and credit calculations, and Phase III - preparation of the research credit study report in accordance with Treasury regulations. Call Don Warrant at 716.847.2651 or connect with us here to learn more about R&D tax credit services.