The IRS lists the R&D tax credit as one of its Dirty Dozen, so is it still safe to claim it?
In July, the IRS closed its Dirty dozen list of scams, designed to warn taxpayers against abusive tax promotions. One practice mentioned is the abusive request for business credits, in particular the R&D tax credit. But does that mean that a taxpayer shouldn’t claim the research credit?
The credit for increased research activity was first established in 1981 to reverse declining research spending in the United States. This credit had been temporarily extended over the years before becoming permanent with the passage of the PATH Act in 2015. Projects qualify when they pass a four-part test set out in Section 41 of the Internal Revenue Code. . Eligible expenses in eligible projects include salaries, supplies, computer rental and contract research expenses incurred during the development of the project. Regulations published over the years have broadened the definition of qualified research and opened the door for more taxpayers to claim the R&D credit.
The reason R&D credit is on the Dirty Dozen list is not that taxpayers are clamoring for research credits in general. Rather, the problem is that some companies aggressively market the R&D credit to taxpayers who do not qualify in the first place. These companies use an extremely broad application of R&D credit criteria to persuade taxpayers that they are eligible for the credit and that they have a huge amount of eligible expenses. Dishonest companies spend little time learning about a client’s operations, but still assign high qualifying percentages to employees based on their titles and charge a high percentage of the calculated benefit as fees.
These companies are comfortable playing the “audit lottery” knowing that some taxpayers will be audited, but many will not and that any review that arises will take months, if not years, to resolve. . Taxpayers who are not audited mistakenly believe they have been certified by the IRS as eligible to claim the credit, so they refer industry peers to these companies for similar treatment. It is important to note that these taxpayers are not to blame – they relied only on these “experts” to advise them.
In recent years, unscrupulous tax professionals have lobbied dentists and orthodontists to claim the R&D credit. They tell these taxpayers that routine dental cleanings, adjustments and extractions – activities they perform on a daily basis – can qualify for R&D credits. These companies then include the salaries of all dentists and dental hygienists in the credit calculation, dramatically inflating the number of credits and the resulting fees.
However, these routine dental practices do not meet the tests of technical uncertainty and experimentation process outlined in the four-part test.
Does that mean orthodontists or dentists can never claim the credit? Of course not! If the firm develops a new or improved business component, defined as a product, process, technique, formula, invention or computer software, then it can potentially claim the R&D credit. For example, a dental surgeon could claim the R&D credit for a new procedure or a new dental appliance that he develops and patents. Qualified research activities included in the credit calculation would include the time of the surgeon as well as the time of other employees involved in the project. Eligible expenses may include supplies of prototypes used in development.
What can taxpayers do to ensure that they are truly eligible for R&D credit and are not the target of abusive tax promotion? It all starts with the sales process. If a business promises that a large portion of the business’s expenses qualify without first knowing the business, the taxpayer should be skeptical. A reputable R&D credit consulting firm will take time to get to know a business and understand the taxpayer’s development process before creating projections. A taxpayer should also consult a CPA or other R&D credit professional to obtain a second opinion on R&D credit eligibility.
Additionally, the taxpayer should have a clear understanding of the fee structure that the consultant will charge for an R&D study. Companies that charge a percentage of the calculated benefit have an incentive to overestimate the credits. In addition, an R&D credit company must be very transparent about how it calculated the R&D credit and conducted the overall study, including explaining the eligibility criteria, eligible expenses and exclusions. If specific projects have not been discussed and the numbers appear to come from a “black box”, worry that the expenses are not properly qualified or that the numbers are not based on actual research. Taking these small steps will help protect the taxpayer from an abusive tax scheme.
The R&D credit is a valuable incentive for eligible taxpayers that can help them recover some of the expenses they incurred for research. However, any taxpayer who claims or is considering claiming the R&D credit should carefully consider the consultants they might use. This can save them from aggressive tax promotions and unnecessary headaches down the line.