Innovative Medicine: IRS Guidelines To Maximize Your R&D Tax Credits

Written by Taz Singh, CPA. Updated Apr 21, 2016.

Innovative_Medicine_IRS_Guidelines_To_Maximize_Your_RD_Tax_Credits.jpgDrug discovery and development in the pharmaceutical industry is a complicated and complex process involving significant time, energy and resources with individuals developing new or improved medical products and drugs involving new research, the discovery of new development processes, preclinical and clinical testing, and high-tech drug manufacturing processes. Using R&D tax credits is one way companies can continue investing in innovative medicine. 

The pharmaceutical industry has a number of qualified activities and expenditures eligible for the R&D tax credit. And, the following guidelines suggest certain segments of research activities are easier to claim in the eyes of the IRS.

IRS Large Business & International Guidelines For R&D

Many pharmaceutical companies are under the umbrella of the IRS’s Large Business & International (LB&I) division, which serves corporations, S-corporations and partnerships with greater than $10 million in assets.

As recent as December 2012, the LB&I issued guidance to its examiners that would provide them greater flexibility when auditing pharmaceutical companies’ tax returns with R&D tax credit claims attached.

For several years, the LB&I has been working with companies in an effort to eliminate some of the controversy between the IRS and taxpayers regarding the R&D tax credit, especially for activities considered “core research,” such as those incurred by pharmaceutical companies.

This new directive states that examiners should not challenge the amount of a taxpayer’s qualified research expenditures (QRE) if the following two factors occur:

  • Expenses are incurred during Stage 1 and Stage 2 of new drug development
  • The taxpayer provides, under IRS examination, a signed certification statement of their research expenditures 

While the directive is not an official pronouncement of law and cannot be used, cited or completely relied on, it provides an accurate explanation of the IRS’s examination position on pharmaceutical R&D claims.

This directive allows taxpayers to qualify their expenses incurred in the discovery, preclinical and clinical stages of development with less IRS scrutiny. The directive also outlines the general pharmaceutical drug discovery and development process as including the following four stages:

  1. Discovery and preclinical stage
  2. Clinical trial stage 
  3. Regulatory review stage
  4. Post-approval stage

The directive instructs that examining agents should not challenge QRE incurred in Stages 1 and 2 as long as the requirements of IRC Section 41 are otherwise met and the certification statement is submitted.

The certification statement requires taxpayers to segregate the amount of QRE incurred in Stages 1 and 2 of development, and requires taxpayers to agree to retain and readily provide underlying documentation upon request of the IRS. If the certification statement is submitted, examiners must receive approval from the IRS’s territory manager before requesting the underlying documentation.

A Word Of Caution

While the IRS’s pharmaceutical directive may not challenge qualified expenditures in drug development Stages 1 and 2, taxpayers need to be aware that the IRS may look into other areas of the R&D tax credit calculation to disallow expenses and credits.

For example, the IRS will still review and examine key audit areas, such as undocumented base periods as well as improper review and qualification of development agreements with clinical research organizations and other consultants performing research on behalf of the taxpayer.

Pharmaceutical companies need to do due diligence when evaluating and analyzing all of their R&D activities that may be eligible for both federal and state R&D tax credits.

Ready to learn more about capturing R&D tax credits for your qualifying pharmaceutical manufacturing expenses?

Capturing Pharma R&D Tax Credits To Fund New Drug Discovery & Development  Discover what R&D activities will qualify your pharmaceutical company for tax  incentives. Download Guide

Topics: R&D Tax Credit

Taz Singh, CPA

Written by Taz Singh, CPA

Taz has 20 years of experience in tax and business incentives. Prior to establishing CTI, Taz served as a corporate tax auditor for the California Franchise Tax Board. During his tenure, Taz specialized in auditing tax credits, including manufacturers’ investment credits, research & development credits and credit limitations (IRC 382 Limitation) due to ownership changes.