IRS lists R&D tax credit among its Dirty Dozen, so is it still safe to claim?
In July, the IRS wrapped up its annual Dirty Dozen scams list, designed to warn taxpayers against abusive tax promotions. One practice mentioned is the improper claiming of business credits, specifically the R&D tax credit. But does this mean a taxpayer should not be claiming the research credit?
The credit for increasing research activities was first established in 1981 to reverse the decline in U.S. research spending. This credit had been temporarily extended through the years before becoming permanent with the passage of the PATH Act in 2015. Projects are qualified when they pass a four-part test defined in Section 41 of the Internal Revenue Code. Eligible expenses within qualified projects include wages, supplies, computer leasing and contract research expenses incurred during project development. Regulations released over the years have expanded the definition of qualified research and opened the door for more taxpayers to claim the R&D credit.
The reason for the R&D credit appearing on the Dirty Dozen list is not that taxpayers are claiming the research credits in general. Rather, the issue is that certain firms are aggressively marketing the R&D credit to taxpayers who don’t qualify in the first place. These firms use an extremely broad application of the R&D credit criteria to persuade taxpayers they qualify for the credit and have an enormous amount of expenses that are eligible. Rogue firms spend little time getting to know a client’s operations but nonetheless assign high qualified percentages to employees based on their titles and charge a high percentage of the calculated benefit in fees.
These firms are comfortable playing the “audit lottery,” knowing some taxpayers will be audited but many will not and any exams that do come up will take months, if not years, to resolve. The taxpayers who do not get audited erroneously believe they have been certified by the IRS as eligible to claim the credit, so they refer industry peers to these firms for similar treatment. It is important to note that these taxpayers are not to blame — they were only relying on these “experts” to advise them.
In recent years, unscrupulous tax practitioners have mounted a push to get dentists and orthodontists to claim the R&D credit. They tell these taxpayers that routine dental cleanings, fittings and extractions — activities they perform daily — can qualify for R&D credits. These firms then include the wages of all dentists and dental hygienists in the credit calculation, greatly inflating the credit numbers and the resulting fees.
However, these routine dental practices do not meet the technical uncertainty and process of experimentation tests outlined in the four-part test.
Does this mean orthodontists or dentists can never claim the credit? Of course not! If the practice is developing 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 dental procedure or device they are developing and patenting. Qualified research activities included in the credit calculation would include the surgeon’s time as well as the time of other employees involved in the project. Qualified expenses might include prototype supplies used in development.
What can taxpayers do to ensure they truly qualify for the R&D credit and are not the target of an abusive tax promotion? It all starts with the sales process. If a firm promises that a large amount of the company’s expenses qualify without getting to know the company first, the taxpayer should be skeptical. A reputable R&D credit consulting firm will take time to get to know a company and understand the taxpayer’s development process before creating projections. A taxpayer also should consult with a CPA or another R&D credit professional to get a second opinion on R&D credit eligibility.
Additionally, the taxpayer must have a clear understanding of the fee structure that the consultant will charge for an R&D study. Firms that charge a percentage of the calculated benefit have an incentive to overstate the credits. Moreover, an R&D credit firm should be very transparent about how it calculated the R&D credit and conducted the overall study, including explaining the eligibility criteria, qualifying expenses and exclusions. If specific projects were not discussed and numbers appear to come from a “black box,” be concerned the expenses may not be properly qualified or 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 recoup some of the expenses they incurred for research. However, any taxpayers who claim or are considering claiming the R&D credit should carefully vet any consultants they may utilize. Doing so can save them from abusive tax promotions and unnecessary headaches down the line.
