Maximizing the Benefits of a Permanent Research Credit

In 1981 Congress enacted the Credit for Increasing Research Activities (the Research Credit) as an incentive to conduct research and development in the United States. The legislation was a temporary measure, aimed at preventing high paying R&D jobs from exiting the United States. 

Over the next 34 years that temporary legislation expired nine times and was extended 16 times, usually in one or two year increments and often with retroactive effect. On December 18, 2015, Congress passed the Protecting Americans from Tax Hikes Act of 2015, finally making the Research Credit a permanent part of the Internal Revenue Code. The legislation enhanced Research Credit benefits for qualified small businesses, but otherwise reinstated the research credit regime that last expired on December 31, 2014. That regime includes the regular credit at 20% of the qualified spend in excess of a base determined by data from 1984 through 1988, and the alternative simplified credit (ASC) at 14% of the qualified spend that exceeds one-half of the prior three-year average. 

If the existing regime has simply been made permanent, what has changed for most taxpayers? How should businesses respond to a permanent Research Credit? The primary complaint taxpayers lodged against the temporary Research Credit was the difficulty of planning for a short-term benefit. Financial forecasts and internal budgets could seldom rely on the promise of a reduction to a company’s taxes when the Research Credit was due to expire or had already lapsed. As a result, most taxpayers adopted reactionary look-back policies around claiming Research Credit benefits, documenting last year’s research activities to claim benefits with this year’s return, only after the Research Credit was a legislative certainty for the credit year.

The Weakness of Look-Back Studies to Substantiate Research Credit Claims

For three decades this reactionary approach to the Research Credit contributed to controversy between taxpayers and IRS. In May 2008, IRS published the Research Credit Claims Audit Techniques Guide (RCCATG). The RCCATG identified the lack of contemporaneous documentation of qualified research activities as one of the greatest weaknesses of look-back Research Credit Studies. If IRS informed taxpayers that contemporaneous documentation is the preferred support for Research Credit claims, why have taxpayers continued to implement look-back studies that document last year’s activity for this year’s return? 

The answer is that taxpayers have been reluctant to invest resources in developing a contemporaneous process while it was uncertain that Research Credit benefits would remain intact. As a result, credit eligible businesses fell into a familiar pattern of documenting research that occurred long ago, just in time to claim benefits by the extended filing deadline for the prior year’s return. Taxpayers would then argue with IRS about the sufficiency of their records if their claim was examined. The delay in documenting qualified research frequently extended to multiple years if the taxpayer was in a loss position and could only carry the Research Credit forward for use in future tax years. These practices were specifically targeted by the RCCATG, which questioned the reliability of estimates and support documentation created years after the underlying research occurred. Untold numbers of exam adjustments and taxpayer disputes have resulted from this disconnect between IRS preference and taxpayer practice. 

The Forward-Facing Model for Substantiating Research Credit Claims

Now that the Research Credit is a permanent benefit, there is good reason to re-evaluate reactionary policies that only result in increased controversy and reduced benefits. Eligible businesses have an opportunity to engage in real tax planning for long-term Research Credit benefits, and to adopt proactive policies and procedures that can minimize controversy and increase the percentage of claimed Research Credits that are sustained upon examination. Taxpayers can most effectively maximize benefits by giving IRS what it asked for in the RCCATG, namely contemporaneous documentation to support credits claimed. 

Contemporaneous documentation of qualified research activities is best obtained through real-time analysis of potentially qualified research activities. Taxpayers across all industries should inventory current research and development efforts, and conduct a qualitative analysis of credit-eligible activities as the research is conducted. A financial analysis of qualified research expenses should be paired with the qualitative study when annual figures are finalized at year-end. 

The advantages to a forward-facing model for substantiating Research Credit claims include:

  • Resilience to Organizational Change: Turnover in R&D personnel, upgrades to computer systems and structural changes through acquisitions or dispositions of business divisions diminish the quality of the data and documentation available to support the Research Credit if the information is first requested years after the qualified research was conducted. Real-time analysis of potentially qualified activities captures information that would otherwise be lost if not collected before organizational changes occurs.
  • Opportunities to Fill Gaps in Documentation: Research personnel face competing demands on their time. Documentation of credit-eligible activities can become a low priority. Real-time analysis of credit-eligible activities alerts the tax department to gaps in available records to support Research Credit claims. Genuine contemporaneous documentation can be created to support qualified research that would otherwise be documented much later through a look-back study, or not be documented at all. 
  • Enhanced Reliability of Estimates: If research personnel do not keep timesheets, or if cost accounting systems do not track material and supplies and contractor expenses associated with research activities, estimates are used to quantify the amount of qualified research expense that should be included in the Research Credit claim. Periodic estimates made during the credit year are inherently more reliable than a single estimate made years after qualified research occurred. 
  • Less Intrusive and More Efficient: Traditional look-back studies employ lengthy surveys and interviews followed by detailed document requests that cover multiple years’ worth of research activities. It can take days for research personnel to comply with these requests. The burden placed on R&D professionals can result in low levels of compliance with information requests, or data dumps of all documents in their possession. Neither extreme allows the tax department to efficiently compile contemporaneous support documentation for a Research Credit claim. Real-time analysis of qualified research only requires short periodic discussions with research personnel to take a few data points during the current tax year. Document requests relate to recent activities, making it easier to find and submit support documentation.          

Optimizing Processes to Maximize the Value of a Permanent Research Credit

Taxpayers have long awaited a permanent Research Credit. Now that it is here, tax departments need to critically evaluate their policies and procedures around claiming the Research Credit. IRS is currently rethinking its approach to auditing tax returns, promising a move to campaign-based examinations. A subset of those campaigns will almost certainly focus on the Research Credit. A reactionary approach to substantiating claims with weak documentation produced years after research is conducted is likely to receive greater scrutiny under the new IRS procedures. The certainty of a permanent Research Credit is deserving of an investment in evaluations of new processes that will minimize controversy and maximize sustained benefits in the future.