IRS Policy Changes Impact R&D Credit IRS changes magnify the importance of methodology and documentation

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1 IRS changes magnify the importance of methodology and documentation The new IDR enforcement policy and the Appeals Judicial Approach and Culture project have been in effect for over a year. Both policies magnify the importance of implementing a process to substantiate R&D credits that will pass IRS scrutiny. This article summarizes both policies and presents guidelines for taxpayers filing claims for R&D tax credits. 1. New IDR Enforcement Through a series of three LB&I directives ( Directives ), the IRS has implemented a new set of procedures for issuing and enforcing IDRs. Two significant consequences of these procedures are to reduce IDR response times and implement a mandatory summons process under which the IRS can begin to seek an administrative summons in as little as 39 days.the process can be summarized as follows. IRS agents are now required to issue and discuss draft IDRs prior to the issuance of a final IDR. Both parties work collaboratively to determine a reasonable timeframe for the response. [1] The IRS then issues a final IDR with a specific due date. Under the Directives, the examiner may grant an extension of up to fifteen days from the due date on the final IDR. The Directives establish a three-step mandatory enforcement process when taxpayers fail to respond to an IDR. First, the IRS will issue a Delinquency Notice [2]. Second, the IRS will issue a Pre-Summons Letter. [3] Generally, both the Delinquency Notice and Pre-Summons Letter have ten-day response times. If no response is Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA 90028

2 received within fourteen days, the IRS may institute summons procedures pursuant to I.R.M. section The new IDR policy became effective in March The stated purposes of the process were to 1) improve the ability to gather information timely; 2) provide enhanced accountability; and 3) reduce the need for summons enforcement. 2. Appeals Judicial Culture and Approach ( AJAC ) AJAC was a project initiated by the IRS promote a quasi-judicial approach to the manner in which Appeals resolves tax controversies. In a series of two notices, the IRS instituted Phase 1 and Phase 2 of the AJAC. [4] The practical impact of these changes are: 1) Appeals will not raise new issues or open closed issues; and 2) Appeals will generally not return cases to Exam unless the protest is deficient or the taxpayer introduces new evidence or information; [5] 3. Impact on R&D Tax Credit Studies Both new policies have significant ramifications to taxpayers who file claims for R&D credits. The issue of substantiation of R&D tax credits has long been an area of contention that has been challenging for both the IRS to enforce and taxpayers to comply with. The IRS often contends that taxpayers rely on high-level estimates and fail to substantiate their R&D claims with contemporaneous documentation. Conversely, taxpayers often lack the internal resources necessary to gather the required information without significant assistance from external tax advisors.both IRS policies magnify the aforementioned challenges and shift the risk of an incomplete analysis or flawed methodology to the taxpayer. The new IDR enforcement policy shortens the time that taxpayers have to complete their R&D tax credit analysis. Exam will no longer allow taxpayers to perfect their studies during the exam process. Given Appeals mandate not to consider new evidence, the risk to the taxpayer of failing to have robust analysis more than ever shifts to the taxpayer. In light of the changed environment at Exam and Appeals, taxpayers who employ outside advisors to assist with their R&D credit analysis may wish to consider the Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA

3 following when designing a process that will pass IRS scrutiny. Firstly, does the tax provider s proposed documentation methodology result in a set of audit-ready deliverables that provides the IRS Exam team with an audit-roadmap, demonstrating the required nexus between the claimed expenses and the qualified research activities. Secondly, does the tax advisor bring a cross-functional team that includes IRS controversy expertise, R&D technical specialists, and industry specialists who not only understand the intricacies of I.R.C. section 41, but also can proactively implement a methodology that will address IRS concerns, while bringing industry expertise that builds credibility with both the company s engineers and the IRS. Footnotes 1. If no agreement is reached, the examiner/specialist sets a reasonable timeframe for response. 2. Letter Letter At this stage, notification is made to the taxpayer s IRS point of contact supervisor as well as the Territory Manger, IRS Counsel and the DFO. 4. AJAC is effective for all new receipts on or after September 2, The policy applies only to LB&I and SB/SE Field Exam cases. 5. IRM provides that alternative legal arguments are not considered new issues, but must rely on information already in the record. Appeals will provide LB&I with an opportunity to review and comment on the new argument within a specified period Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA

4 About Tax Credit Co: Tax Credit Co. provides tax incentive consulting, administration and technology for small business to Fortune 100 companies. Since 1996, Tax Credit Co. has been helping clients increase earnings by optimizing the process of obtaining a broad range of state and federal tax incentives. Tax Credit Co. provides complimentary assessments of credit value, and works closely with you and your team to maximize credits and deductions, with reduced audit risk. Team with Industry Experience. Our team is comprised of individuals with specialized technical expertise tax attorneys review third-party contracts, relevant industry experts conduct interviews, and CPAs with R&D credit specialization review each calculation and tax return. Innovative Solutions to High Value Problems. There is the easy way and the best way, which are not always the same. Tax Credit Co. works to ensure the best result for your business. This includes digging through boxes to find old records. But it can also include complex technical work such as obtaining a Pre Filing Agreement ( PFA ) with the IRS to have your methodology and credit amount pre-approved prior to filing your return. Aligned Interests. Whereas many firms charge for this phase, Tax Credit Co. provides a complimentary assessment (Phase I) to determine your estimated benefit and utilization. TCC also offers flexible fee arrangements that allow us to structure fees including audit defense services to better align interests. Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA

5 About the Author Peter Mehta, J.D., LLM is Managing Director of R&D Credits at Tax Credit Co. Peter has 20 years of experience with the Big 4, including 12 years with Deloitte in Tax Controversy where he worked in a national group of 5 attorneys supporting clients R&D audit defense needs. Peter has extensive R&D credit study and audit experience with IRS specialists at Exam and Appeals, as well as with MITRE on software audits. Peter has a B.S. in Biology with a specialization in Chemistry from UC Irvine. More information can be found at Tax Credit Co 6255 Sunset Blvd Suite 2200 Los Angeles, CA