IRS has made changes to its audit guidelines for the federal Research Credit, particularly for companies with assets over $10 million. This change now requires larger claimants to modify their GAAP-compliant financial statements to include all qualified research expenditures in their stated Research and Development account. The change reflects the requirement that all claimed expenses must first be eligible under Section 174 of the Internal Revenue Code (IRC), in addition to Section 41 which enables the credit itself. The IRS has stated that it will not consider the eligibility of any expenses that are not stated under the Research and Development account as set forth in ASC 730 as defined by the Federal Accounting Standards Board and reconciled in section M3 of the company tax return.
A link to the new guidance can be found at:
To understand this change, it is important to first understand the code sections involved. There are three of them: (Note: IRC sections are not usually related in numerical order.)
IRC Section 174 provides a rather broad definition of “Research and Development” expenses, and provides for the deductibility of them.
IRC Section 41 deals with a subset of that definition and defines “Qualified Research Expenditures”. These are the expenses that are included in the tax credit calculation.
IRC Section 162 allows for the deductibility of “ordinary, necessary and reasonable” expenses.
Often, companies incur expenses that are clearly eligible under Section 41 but that are not part of most formal R&D department systems. For example, efforts to improve process or equipment technology are often made by people who are not formally part of the R&D department. In a manufacturing environment, this could include personnel who are ordinarily included as part of the factory staff, like manufacturing engineers or sometimes even line-level employees who are actively trying to overcome technical uncertainty on one or more projects. These expenses are usually deducted under IRC Section 162 which has to do with the deductibility of expenses that are “ordinary, necessary and reasonable”.
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