When the IRS Thinks It Owns Your R&D Credit
For ten years, one software company waited. Not for a product launch or a market shift, but for the IRS to stop insisting that its externally facing, customer-used software was “internal use software.” The government itself was a paying customer on the platform. The examination still dragged on for a decade, accruing a decade of interest along the way. That story, and several others like it, anchors the second volume of the TaxOps conversation on R&D credit war stories with the IRS.
In this episode, TaxOps professionals Mark Dunning and Sean Espy trade hard-won field notes on what it actually takes to claim and defend the research credit. The through line is uncomfortable but useful for any CFO, controller, or VP of tax: the law is broad, the credit is legitimate, and the fight to keep it is often less about the code than about who is sitting across the table from you.
Guardians of the Treasury, or Gatekeepers of the Law
Dunning’s ten-year software examination captures a mindset that tax leaders will recognize. When his team pushed back on a full disallowance, the response from the agency was that they were “the guardians of the treasury for the government.” His rebuttal reframed the entire premise.
“We also are Americans,” Dunning recounts telling them. “And you are not allowing the law to be what it should be and allowing the treasury funds to be where they should be.”
The point is not anti-government. It is that the R&D credit exists by design. Congress built it to incentivize companies to keep engineers in the United States. When an examiner stalls, delays, or disallows reflexively because “it’s your money,” they are not protecting the treasury. They are ignoring the intent of the statute. As Dunning puts it: “It’s not your money. It’s the government’s money. It’s the treasury money. It’s America’s money.”
Aggressive Versus Conservative Is Not a Marketing Slogan
Much of the conversation turns on a distinction that gets blurred in sales pitches: the difference between a firm doing a more complete job and a firm simply taking a more aggressive position.
Espy, who has worked inside two of the Big Four, a large firm, and now a boutique, walks through where that aggressiveness actually lives. It shows up in fee structures, where the Ridgely v. Commissioner case created a narrow, fact-specific opening for contingent fees after Sarbanes-Oxley effectively killed them in 2002. It shows up in how firms read the software regulations, including the two competing 2001 rule sets that the IRS once let taxpayers choose between, and the later regulations that freed much software from the internal use software three-part test. And it shows up in engineering and construction, where the “prototype” argument, borrowed from fields like aerospace, gets stretched to cover a first-of-its-kind building.
The problem, Dunning notes, is that VPs of tax and tax directors rely on their advisors to tell them the truth about risk. An aggressive firm reframes caution as incompetence:
“Oh, you’ve got a small firm like TaxOps doing it. What do they know? We’re a big four firm. We can double the credit.”
In one case, a new VP of tax “was drinking the Kool-Aid” of a Big Four firm that promised to double a long-standing, fully documented credit, without even reviewing the existing study. TaxOps had time-reporting systems and a full listing of every credentialed engineer and technician in the company. “There is no way they could double the credit,” Dunning says. Two simultaneous IRS examination teams began comparing notes, and the agents signaled they found the conservative, well-supported study reasonable. TaxOps still got removed from the engagement before the outcome played out. The lesson for tax leaders is blunt: listen to everyone, and learn to spot who is aggressive and who is not.
The States Are Their Own Battlefield
If the IRS feels inconsistent, the states are a genuinely mixed bag, and budgets often drive behavior more than the technical merits.
● California’s Franchise Tax Board is described as aggressive, on par with the IRS, chasing high-dollar credits even in cases the IRS had already reviewed and passed on.
● Texas has swung from disallowing software, statistical samples, and anything that was not a tangible product, toward revised regulations that now allow more to qualify.
● Ohio stood up an R&D task force to review claims and began disallowing more credits against its CAT tax.
● Arizona long refused the alternative simplified credit despite conforming language, until cases forced the issue and it was finally codified. Utah traveled a similar road years earlier.
Then there is Iowa. A refundable credit meant the state paid taxpayers back even when they owed no tax. When Google built server farms in the state, companies with almost no Iowa headcount suddenly generated large lease computer cost credits, because that is where the developmental work was physically running. Iowa pushed back, then changed its law to disallow leasehold computer costs entirely. As Espy’s broader point makes clear, “you have to really stay up to date with the states, and understand that they may change their positioning for various reasons.”
Reserve the Gray, Fight for the Clean
The most practical takeaway is a strategy Espy used on a cement company audit. The team identified roughly 25 percent of the credit as sitting in the more aggressive bucket and reserved for it. During the exam, they answered the IRS information document requests as expected, defended the clearly qualifying activities, and let the agency focus on the gray. The audit settled at 75 percent, exactly what the reserve anticipated.
The philosophy: do not play the audit lottery. Build the study as if the IRS will show up, because “more likely than not” is a standard you meet up front, not later. And know what you are paying for. If your provider does not identify and organize your work by business component, you are exposed. As Dunning notes, the first IRS information document request for an R&D credit is organized by business component. “If your study is not being done by business component, you didn’t pay for anything.”
Why This Conversation Matters
The credit is real. It belongs to companies that do qualifying work, and the gray areas of Section 41 are worth claiming when the law supports them. But hiding under the cloak of a big-name firm does not insulate a taxpayer. Preparer penalties can bust the provider, and the taxpayer still absorbs the consequences, including years of continuous audit. The durable advantage is trust built with the IRS by doing the right thing, then outlasting an agency that acts as if it has unlimited time.
Mark Dunning and Sean Espy cover far more ground than any summary can hold, from Circular 230 obligations to deliverable timing and the real cost of overhead you never see. Listen to the full episode of TaxOps at tax-intelligence.captivate.fm/listen and bring sharper questions to your next R&D credit conversation.Visit https://taxops.com/ to learn more.
About the Hosts
Mark Dunning — Partner, Tax Ops Minimization. Mark Dunning is the managing partner of TaxOps Minimization, where he leads an experienced team in implementing tax-saving projects. He has developed deep technical knowledge of the research credit across all industries, including automotive, engineering, medical, manufacturing and software. Mark is an accomplished negotiator with the Internal Revenue Service and state tax authorities, and has built a positive rapport with field agents across the country. He managed four of the 23 Pre-Filing Agreement projects granted and closed by the IRS in the research credit area. He has also consulted and closed on several IRS and state audit and appeals cases, including the successful completion of two IRS research credit record-keeping agreement projects.
Sean Espy — Sean is a Partner at TaxOps Minimization, bringing more than 25 years of consulting experience spanning public accounting, legal, and industry settings to complex tax minimization engagements. With his experience at top tier public accounting firms, Sean brings a rare combination of technical depth and practical insight to research credit studies. In addition to his consulting, Sean has represented clients before the IRS and state tax authorities in California, Colorado, Kansas, Kentucky, Minnesota, Montana, Ohio, Texas and Utah.
Listen to the full conversation now on Tax Intelligence, or watch on YouTube.
Tax Intelligence with TaxOps
This is the podcast where experienced tax professionals share clear, practical insight on today’s most complex tax issues–from SALT and federal tax strategy to ASC 740, tax minimization, and investment fun considerations. Each month, our experts break down what matters, what’s changing, and how to think strategically about tax–so you can make informed decisions with confidence. Listen today!
About TaxOps
At TaxOps, business tax is all we do. Our teams have the knowledge and focus to solve tax problems with practical tax answers. By hiring our Big Four-veteran leaders and experienced teams, you get tax strategists on your side supporting your strategy wherever business takes you. We deliver the strength, experience, and resources of a national tax brand with the hands-on client engagement of a boutique firm in federal, corporate, state and local and international tax as well as tax minimization strategies for businesses. For an introductory call, visit TaxOps.com/contact.
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