On August 16th, President Biden signed the Inflation Reduction Act (IRA) into law, and although there were many provisions, there are a few that stand out for business owners. One of which being that there are additional funds for the Internal Revenue Service (IRS). We will explain what this means to taxpayers, specifically ones claiming business tax credits and what they can do to protect themselves from IRS examinations.
The time to reverse the changes made by the 2017 Tax Cuts and Jobs Act (TCJA) is quickly running out. These changes force companies to begin amortizing research and development expenses over a period of 5 years rather than deduct them entirely in the year in which it was claimed. A measure to help offset the revenue lost from cutting the corporate tax rate from 35% to 21%, the change to I.R.C. section 174 removes the option of a current year deduction in full.
A new court opinion issued by the U.S. Tax Court emphasizes the importance of contract review for the analysis and substantiation of an R&D tax credit claim. The opinion alludes to additional requirements to demonstrate a taxpayer's economic risk when conducting research. Moreover, the court points to precedence to emphasize that terms and conditions within any contract agreement are most important, and no implications or assumptions should be needed or considered to substantiate a credit claim.
There’s still hope that the Tax Cuts and Jobs Act’s (TCJA) changes to Section 174, requiring amortization for research and experimental (R&E) expenses, could be delayed or repealed. Under the TCJA, as of January 1, 2022, domestic R&E expenditures are required to be amortized over 5 years and foreign R&E expenditures over 15 years. Prior to January 1, 2022 taxpayers had been able to write-off 100% of R&E costs.
The new definition of R&E expenditures under Section 174 also includes software development costs. Previously, under Revenue Procedure 2000-50, taxpayers had the option to immediately expense or amortize software development costs over a period of 36 or 60 months. With the TCJA change, these options are no longer available. Domestic software development costs must be amortized over 5 years and foreign software development must be amortized over 15 years.
For most tax return preparers, the end of the day on October 15th marks a joyous occasion—the end of a frequently grueling tax filing season and a much-needed reprieve before the cycle begins again in January. Unfortunately, the Service cut the party short in the world of R&D tax credits with its issuance of a new memorandum. This memorandum, published by the Internal Revenue Service Office of Chief Counsel on October 15th, issued new guidance regarding what required information a taxpayer must now include in its claim for an R&D tax credit.
On February 11, 2021, the tax court issued a new memorandum opinion in Little Sandy Coal Company v. Commissioner. In this case, the taxpayer—a shipbuilding subsidiary—was denied its claimed R&D credit based on the development of 11 vessels by the IRS. After receiving its notice of deficiency, the taxpayer brought suit in the tax court seeking a redetermination. For the sake of expediency, the parties agreed to limit review to just 4 of the 11 projects at issue; the court’s opinion addressed only two of these—the Apex Tanker and Dry Dock Projects.
On January 11, 2021, the tax court issued a new opinion concerning the application of the Federal Credit For Increasing Research Activities. In Tangel v. Commissioner, the taxpayer—a designer and manufacturer of integrated controls and switchgears utilized in power generation—was denied its claimed R&D credit by the IRS. After receiving its notice of deficiency, the taxpayer brought suit in the tax court seeking a redetermination. For procedural reasons, the court limited its opinion and ruling to a single project performed under contract by the taxpayer. The Service argued that the research performed by the taxpayer under this third-party contract was “funded” as defined under section 41 of the code. Specifically, the government contended that under the contract, the taxpayer retained no substantial rights in the results of the research.
Signed into law on December 27, 2020, the Covid-19 relief bill contains a favorable update to the Employee Retention Credit (“ERC”). The Employee Retention Credit was one of the more successful components of the CARES Act, but there are several significant updates to the credit that are even more favorable for qualified businesses. Several updates can be seen below, along with a comparison to the credit terms under the CARES Act. Unless stated otherwise, the effective date of the provisions covered by the new law will be January 1, 2021.
Updated Dec 28, 2020
Officially signed into law on December 27th, the recent omnibus Covid-19 relief bill H.R. 133 reversed the Service’s previous stance regarding the deductibility of PPP-related expenditures. Among the bill’s voluminous provisions, section 276 (beginning on page 2004) makes clear that no deduction shall be denied as a result of a PPP loan’s forgiveness. Consequently, a taxpayer’s potential federal research credit will be unaffected as a result of the taxpayer’s utilization of a PPP loan and subsequent loan forgiveness. This protection is extended both to loans under the original Paycheck Protection Program as well as future loans to be granted under the bill’s expanded program.
Populous Holdings, Inc. v. Commissioner marks a highly favorable case decision for taxpayers claiming the research and development tax credit in general, and for the architecture industry in particular. In Populous Holdings, the court granted summary judgment in favor of the architectural design services taxpayer, holding that all five representative contracts at issue in the case were unfunded and therefore eligible for inclusion in calculating the tax credit.
