Inflated R&D credit claims have been called out on the IRS dirty dozen list of scams for years. But R&D credits are a backbone of U.S. innovation. Let’s crack open the black box of R&D and shed some light on who benefits most and the pitfalls to avoid.
The research tax credit has a clear mandate; boost U.S. innovation for a globally competitive economy. This mandate began in 1981 and by 2018, $23 billion in research tax credits were at work in U.S. companies boosting research and development (R&D) investment and supporting the U.S. economy.
The availability of the credit and sheer dollars involved have attracted less savory practices, which the IRS has caught wind of and has called out on its annual list of “dirty dozen” list of scams since 2019. What this looks like is companies and third-party consultants being overly aggressive on claims, a surefire way to invite IRS audits, additional rules and the IRS disallows a claim.
What to Claim
The right amount of credits to claim is the amount a business can qualify and quantify—nothing more, nothing less. In the more than 20 years TaxOpsMin has been consulting on R&D claims, we’ve seen some egregious expenses and activities included in past R&D studies.
In a justifiable R&D study, the business or subcontractor creates a new product or process where there is technical uncertainty, using a process of experimentation based on hard sciences. Here’s some examples of where claims go wrong.
- No new product or process. A surgeon performing fairly routine procedures claims R&D credits, but fails to create any new process of product cannot claim R&D credits. If the surgeon had created a new medical device to use, that is qualified.
- Inclusion of 100% of a Controller’s salary as qualified wages. Accounting is considered a soft science. Rarely do the tasks of accounting or finance associates directly supporting the research team fit the definition of qualified activities. We’ve seen consultant try to include those hours, and the claim is rejected because 100% of the accountant’s time does not fit the definition of R&D activities. (However, laymen evaluating the user experience on a software product may be qualified as this falls under testing in the process of experimentation.
- Including activities where project was funded. In addition to meeting the definition of qualified research, the taxpayer must have rights to the research and risk in the outcome of the research or the research is considered “funded” and does not qualify for R&D credits. For example, if an engineer is being paid time and materials for design, it is funded and cannot be claimed for credit.
The most egregious R&D firms base their fee on a percentage of the credit claimed and/or guarantee through audit. Suspicious is pricing that includes an evaluation or feasibility study that estimates the fee based on the projected benefit including any audit defense. Audits can be long and time consuming, and one size does not fit all. Examiners are too unpredictable to estimate the efforts that will be required to complete an audit.
Some firms give their managers a bonus based on the credit of the project they are running. This incentivize managers to be more aggressive. Look for R&D audit controversary services that are priced by time and materials to make sure you are getting the best defense.
The IRS has published an audit technique guide, which we’ve seen every examiner use since 2009. We have seen state examiners use the same guide. The first item on the information document request asks whether the taxpayer engaged a service provider in making their R&D claim. If yes, the IRS demands to see the engagement letter. They are looking for payment terms or language that would incline the claim to be more aggressive. Examiners take a much more skeptical approach to an audit where these terms and language exist.
Bottom line, if it sounds too good, it probably it is. Seek a second opinion and claim the R&D that you are due.
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