IRS Issues Taxpayer Friendly Guidance for Research Credit Refund Claims

In October 2022, the IRS updated its FAQ webpage on the filing requirements for section 41 research credit refund claims, clarifying instances when the so-called five items of information on an amended return are not required.¹ The IRS separately announced an extension, through January 2024, of transition relief for refund claims that the IRS deems incomplete.² These are taxpayer friendly updates and are generally welcomed by the tax community. But they fail to address criticisms of the onerous new requirements for research credit refund claims imposed by the October 2021 release of Chief Counsel Memorandum 20214101F.

Update to FAQ Webpage

We previously described the new requirements for valid research credit refund claims in our November 2021 newsletter.³ The CCM states that for such claims to be valid, taxpayers need (at a minimum) to provide the following five items of information:⁴

1. All the business components that form the factual basis for the research credit for the claim year;
2. All research activities performed by business components;
3. All individuals who performed each research activity by business component;
4. All the information each individual sought to discover by business component; and
5. Total qualified employee wage expenses, supply expenses, and contract research expenses.

IRS officials claimed the changes were necessary because of “the poor quality of claims the IRS was receiving, which was challenging and resource-intensive for the agency.”⁵ But the CCM is controversial with many tax practitioners arguing that the requirements are unduly burdensome and not consistent with existing regulations.⁶

The IRS soon issued interim guidance⁷ and an FAQ webpage⁸ to address the implementation of the CCM. We previously described this guidance in our January 2022 newsletter.⁹ Relevant to this article, question 4 of the FAQ stated that if a taxpayer does not include the required five items of information on an amended return, then the amended return will be considered deficient in its entirety.¹⁰

In their recent update of the FAQ webpage, the IRS replaced question 4, clarifying instances when the so-called five items of information on an amended return are not required.¹¹ If a taxpayer’s amended return does not include a refund claim (even if it contains the research credit) or does not request an adjustment to the research credit claimed on the original return (even if it does include a claim for refund not involving the research credit), the five items of information are not required to be provided with the amended return. Such taxpayers may only be required to substantiate entitlement to the credit if they are examined by the IRS.

The new guidance is helpful in the instances where it applies. But for all other taxpayers the reporting requirements remain extremely burdensome and go against the original intent of the credit, which is to incentivize taxpayers to invest in R&D activities within the United States.

Update to Transition Relief

The IRS’s interim guidance and an FAQ webpage also provided that for research credit refund claims filed between January 10, 2022 through January 9, 2023, the IRS would give taxpayers 45 days to perfect claims that the IRS deems incomplete. Specifically, for claims the IRS determines to be incomplete, the IRS will issue Letter 6428, Claim for Credit for Increasing Research Credit Activities—Additional Information Required, allowing the taxpayer 45 days to perfect the claim. If sufficient information is received within 45 days, the IRS will continue to evaluate the claim under normal procedures. If sufficient information is not received, the IRS will reject the claim as deficient and issue Letter 6430, No Consideration, Section 41 Claim.

In a September 2022 post to their news webpage, the IRS extended the transition period another year, through January 10, 2024.¹² The extension will give taxpayers more time to work with the IRS and, in the absence of specific guidance, give both taxpayers and the IRS an opportunity to determine what information and documentation are sufficient for a valid claim.

Avenues for Challenging the CCM

While this recent IRS guidance is taxpayer friendly, it does not change the fact that the CCM has a questionable legal foundation. Treas. Reg. § 1.41-4(d) merely requires that taxpayers “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” Nowhere in the regulatory guidance is it stated that taxpayers must provide specific information and documents to the IRS with the filing of a tax return. Further, the CCM represents a significant shift in the interpretation of Treas. Reg. § 301.6402-2(b)(1), which provides specificity requirements for all administrative refund claims. It is unclear whether courts would agree that the IRS can require taxpayers to submit the five items of information for research credit refund claims to be valid. Finally, the rules contained in the CCM were not issued subject to the notice-and-comment procedures under the Administrative Procedure Act (APA).¹³ Taxpayers have successfully challenged similar IRS rulemaking for failing to meet the notice-and-comment requirements under the APA.¹⁴

Taxpayers should, to the extent possible, adhere to the requirements of the CCM. But the requirements are likely to be amended or eventually tested in court.

Endnotes

¹ See Internal Revenue Service, Research Credit Claims (Section 41) on Amended Returns, Frequently Asked Questions, Question #4, Oct. 4, 2022 (“October 2022 FAQ”), https://www.irs.gov/businesses/corporations/research-credit-claims-section-41-on-amended-returns-frequently-asked-questions.

² See Internal Revenue Service, IRS sets forth required information for a valid research credit claim for refund, Oct. 3, 2022, https://www.irs.gov/newsroom/irs-sets-forth-required-information-for-a-valid-research-credit-claim-for-refund.

³ Lawrence M. Hill and Richard A. Nessler, Controversial New IRS Requirements for Research Credit Claims, Focus on Tax Controversy Newsletter (Nov. 2021).

⁴ CCM 20214101F at 2.

⁵ Mary Katherine Brown, IRS Open to More Dialogue on Research Credit Changes, Tax Notes, Nov. 23, 2021.

⁶See e.g., Chandra Wallace, IRS Extends Research Credit Transition by a Year, Tax Notes, Oct. 10, 2022.

⁷ LB&I-04-0122-0001 (Jan. 3, 2022).

⁸ Internal Revenue Service, Research Credit Claims (Section 41) on Amended Returns, Frequently Asked Questions, Question #4, Feb. 9, 2022 (“February 2022 FAQ”).

⁹ Caitlin R. Tharp, IRS Issues Clarifying Guidance on Research Credit Claim Requirements, Focus on Tax Controversy Newsletter (Jan. 2022).

¹⁰ The February 2022 FAQ stated:

4. What will happen if my claim for refund includes the Research Credit and other items?

If your claim for refund includes the Research Credit and other items, you must provide the five items of information. If your claim is determined to be deficient, you will be mailed a letter providing 45 days to perfect your claim. If the IRS does not receive your information or the missing information is insufficient, your entire claim for refund will be rejected.

¹¹ The October 2022 FAQ states:

4. What will happen if my Amended Return contains the Research Credit and other items?

If your amended return does not include a claim for refund (even if it contains the Research Credit) or does not request an adjustment to the Research Credit claimed on your original return (even if it does include a claim for refund not involving the Research Credit), the five items of information are not required to be provided with your amended return. The IRS may, however, later require you to provide the five items of information to substantiate your entitlement to the Research Credit, if your return is selected for examination.

If your amended return includes a claim for refund related to the Research Credit (even if it contains other items), you are required to provide the five items of information with your amended return. If the IRS determines your claim for refund is deficient, for the one-year transition period, you will be mailed a letter providing you 45 days to perfect your claim for refund. If after the 45-day period, the IRS does not receive the missing information or if the IRS determines any additional information provided is insufficient, your entire claim for refund will be rejected.

¹² See Internal Revenue Service, IRS sets forth required information for a valid research credit claim for refund, Oct. 3, 2022, https://www.irs.gov/newsroom/irs-sets-forth-required-information-for-a-valid-research-credit-claim-for-refund.

¹³See 5 U.S.C. § 553.

¹⁴See e.g., CIC Services, LLC v. Internal Revenue Serv., 141 S. Ct. 1582 (2021).