The Federal Research Credit: Is It Worth All the Trouble?

Victoria Sherlock, Special Counsel,Tax Controversy and Litigation Practice, Chamberlain Hrdlicka

Initially enacted in 1981 as part of the Economic Recovery Tax Act,¹ the Federal Research Credit (Section 41 of the Internal Revenue Code²) has been both an important tax savings provision and an audit challenge for the Internal Revenue Service (IRS) Examinations division. Certainly, its history has been far from smooth sailing. Since 1981, the credit has been allowed to expire and has been extended and modified multiple times. Efforts to make it permanent were unsuccessful until 2015. The regulations underlying Section 41 have a similar history, with regulations being proposed, then withdrawn, and long delayed.

Nevertheless, there is no question that the research credit provides significant tax savings and should be considered by pharmaceutical companies and other taxpayers that engage in substantial research activities. The regular credit equals 20% of the excess of the taxpayer’s qualified research expenses (QREs) over a historical base amount. Alternatively, taxpayers can elect the alternative simplified credit, which equals 14% of the amount by which the taxpayer’s QREs for the taxable year exceed 50% of the taxpayer’s average QREs in the prior three years. Because the research credit was designed to encourage taxpayers to increase their domestic research activities, under either method taxpayers measure current research expenditures against historical amounts.

Qualifying expenses include wages, supplies, and contract labor costs, but only if the research in question meets certain tests outlined in the statute and regulations, often referred to as the four-part test. These tests include the “Section 174 test,” the technological information test, the business component test, and the process of experimentation test. Internal-use software development costs must meet three additional tests.

For at least the past 15 years, the IRS has treated the research credit as an area of high concern, believing that taxpayers were claiming credits they were not entitled to.³ This high level of scrutiny, along with questionable “rules” issued by the Office of Chief Counsel in 2021 concerning research credit refund claims, recently proposed changes to the IRS form for applying for the credit,⁴ and a significant legislative change to the scope and current deductibility of research expenses raises the question once again: Is taking the credit worth it?

In October 2021, the IRS issued a Chief Counsel Memorandum (CCM)⁵ that outlined specific information taxpayers were required to include in a valid research credit refund claim before it would even be substantively reviewed by the IRS:

• A list of all business components, and for each, all research activities performed.
• All individuals who performed each research activity.
• All the information each individual sought to discover.

For taxpayers, there is often a large number of business components in their research credit amounts. Providing this information as an attachment to a claim for refund can be challenging. However, pharmaceutical companies may actually find this easier than other taxpayers since they are used to documenting for the FDA.

It should be noted that neither Section 41 nor its underlying regulations contain any specific recordkeeping requirement. Moreover, regulations concerning what must be included in a valid claim for refund seemingly require only basic information.⁶ Thus, whether these new rules will ultimately be upheld remains an open question, and at least one federal district court case implies that the IRS went too far.⁷

Recognizing that the “requirements” in the CCM were new, the IRS stated that during a trial period (now extended for research credit claims filed on or before Jan. 10, 2025), taxpayers whose research claims the IRS found to be deficient were allowed to refile them and supply any missing information. In response to a veritable outcry from taxpayers and their representatives that the requested information was too onerous and went beyond what is technically required, the IRS subsequently announced that for refund claims filed on or after June 18, 2024, taxpayers will no longer be required to provide the names of individuals who performed each research activity and the information each individual sought to discover. This does not mean, however, that information concerning individuals’ specific efforts will not be requested during an examination of the taxpayer’s credit.

In September 2023 and June 2024, the IRS released new draft Forms 6765. Initially, the agency included a new section for reporting both quantitative and qualitative information for each business component. However, in response to feedback from concerned taxpayers, the IRS reduced the number of business components that must be reported and made Section G optional for certain qualified small business taxpayers and those with total qualified research expenditures of less than $1.5 million and equal to or less than $50 million of gross receipts. New Section G will be mandatory for tax year 2025 and will require taxpayers who are required to file to provide information with respect to 80% of all business components included in the determination of QREs, but no more than 50.

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), R&D expenditures were eligible to be both deducted and eligible for research and credit (assuming taxpayers also met other criteria). The TCJA eliminated the availability of a current deduction, and for tax years beginning after Dec. 31, 2021, taxpayers are required to amortize their qualified research expenditures, including software development costs, over a five-year period (15 years for expenditures related to foreign research). Immediately after this provision was enacted, efforts to eliminate it began in earnest, and for at least the first few years, taxpayers seemed confident that the amortization requirement would not actually take effect. Unfortunately, efforts to change what is now the mandatory capitalization of R&D expenditures have failed, and currently there is little hope for any retroactive relief.

Although capitalization under Section 174 is mandatory regardless of whether the taxpayer claims the research credit, commentators have suggested that the change to Section 174 may act as a deterrent to taxpayers seeking to claim the credit. Presumably, any chilling effect the change may have on the research credit arises because pharmaceutical companies and other taxpayers will have to identify and properly capitalize research and expenditures upfront and will not be able to wait until years later to identify expenditures that meet the Section 174 test embedded in Section 41.

In recent years, it has been common for the IRS to challenge claimed research credits on the basis that they do not meet the Section 174 test or the process of experimentation test.

For pharma companies and other taxpayers who have had their claimed research credits audited by the IRS, the experience often leaves them wondering if claiming the credit is actually worth the trouble and expense of responding to an audit inquiry. Such audits often include numerous requests for documents and interviews with taxpayer employees, and frequently take years to finish. Nevertheless, the answer to the “is it worth it” question is still “yes”—so long as companies are prepared to fully document why their research activities qualify for the credit and are ready to vigorously defend why they are entitled to the claimed credits.

Victoria Sherlock, is Special Counsel, Tax Controversy and Litigation Practice, at Chamberlain Hrdlicka

References

1. H.R.4242 - Economic Recovery Tax Act of 1981. Congress.Gov. https://www.congress.gov/bill/97th-congress/house-bill/4242/text

2. Sec. 41. Credit for Increasing Research Activities. IRS. https://www.irs.gov/pub/irs-regs/research_credit_basic_sec41.pdf

3. Research Credit Claims Audit Techniques Guide (RCCATG): Credit for Increasing Research Activities Section 41. IRS. May 2008. https://www.irs.gov/businesses/research-credit-claims-audit-techniques-guide-rccatg-credit-for-increasing-research-activities-section-41

4. IRS Sets Forth Required Information for a Valid Research Credit Claim for Refund. IRS. November 25, 2024. https://www.irs.gov/newsroom/irs-sets-forth-required-information-for-a-valid-research-credit-claim-for-refund

5. Office of Chief Counsel Internal Revenue Service Memorandum. IRS. September 17, 2021. https://www.irs.gov/pub/irs-lafa/20214101f.pdf

6. Internal Revenue Service, Treasury. govinfo.gov. https://www.govinfo.gov/content/pkg/CFR-2005-title26-vol18/pdf/CFR-2005-title26-vol18-sec301-6402-2.pdf

7. Premier Tech, Inc. v. United States. Casetext (Thomson Reuters). July 15, 2021. https://casetext.com/case/premier-tech-inc-v-united-states