The Large Business & International (“LB&I”) Division of the IRS recently issued Directive IR 2017-158 to provide LB&I examiners guidance regarding the examination of the Credit for Increasing Research Activities under §41 (“R&D Credit”). It is applicable for taxpayers with assets equal to or greater than $10 million and who follow U.S. GAAP to prepare their Certified Audited Financial Statements. The Directive utilizes the ASC 730 definition of R&D expenses as a starting point and provides a series of calculations and adjustments to get to the “Adjusted ASC 730 Financial Statement R&D”, which LB&I examiners are directed to accept as Qualified Research Expenses (“QREs”) for the year provided certain requirements are met. QREs in excess of the directive guidelines can still be claimed on Form 6765 but will be subject to regular examination.
While this Directive appears to simplify the calculation and lessen the burden of qualifying and calculating QREs, it is important to note that there are certain expenses that are not eligible. For example, contract research, which is one of the three main expenses for the R&D credit, is not eligible for safe harbor inclusion. Furthermore, any projects that are completed by a taxpayer under a third-party agreement where research is necessary to complete the project cannot be included. This provision limits the application of the Directive to QREs linked to the taxpayer’s own internal research efforts. In addition, there are further limits to the number of wages that can be included for upper-level managers and officers who perform qualified research.
The most likely beneficiaries from the Directive will be large companies who spend a large number of resources on internally developed products that are released for sale to the general market. These larger organizations typically invest substantial funds in accounting and auditing services to claim the R&D Credit and obtain a certified audit. This Directive will allow them to simplify the R&D calculation process and ensure that a large number of their QREs will be accepted under an IRS audit without a lengthy examination. While some companies may benefit from this Directive, the majority of smaller taxpayers will likely see more benefit from a traditional R&D study. Taxpayers conducting a traditional R&D study will be able to include expenses that the Directive excludes, such as wages for upper-level managers who are integrally involved in the development process, QREs pertaining to customer-driven projects, and contract research.