Clarification on new Regulations, Increased IRS Scrutiny, and a Rate Increase to the ASC
After a year of monumental taxpayer favorable changes to the IRC Section 41 Research and Development Tax Credit, it’s time to turn our focus on the future and question whether the taxpayer victories of 2016 will continue. While the change at the White House will make prognostication much more difficult this year, I am willing to put my powers of prophesy to the test, as I believe the credit will continue to be considered a primary tool for helping U.S. businesses stay competitive against global competition, and therefore favorable changes will continue.
Alas, here are my 3 R&D tax credit predictions for 2017:
1. An Increase in IRS Scrutiny (a carryover of a 2016 prediction)
On Dec. 18, 2015, as part of the PATH Act of 2015, the president signed into law a permanent R&D credit that also allows for a credit offset of Alternative Minimum Tax (AMT) and Payroll taxes. And on October 4, 2016, Treasury and the IRS published final regulations relating to Internal Use Software (IUS) and the credit qualification of software development activity in general. While taxpayers and tax practitioners alike have celebrated these decisions, we must now be mindful of how these new laws and regulations will be interpreted by the IRS.
While it’s too early to determine if the credit will once again come under a form of “Tier 1” scrutiny, (as it has in years past), there is no doubt that the IRS will be highly interested in verifying taxpayer compliance with these new provisions.
Specific areas the IRS will surely be auditing:
- Compliance with the definitions of an “eligible small business” and a “qualified small business” (especially in the case of partners and S corporation shareholders);
- Compliance with limitation and aggregation rules by taxpayers claiming the new payroll tax credit.
- Taxpayer’s interpretation of the new definition of IUS and non-IUS software;
In light of the increase in IRS audits and the potential for penalties, taxpayers must be diligent about following the rules and procedures relating to these areas. Considering that the R&D Tax Credit is one of the most complex areas of the tax code, consulting with an expert in this area is highly advisable.
2. The 14% ASC Credit rate will Increase Substantially
While in the past there had been much speculation around the elimination of the General Method of credit calculation and an increased 20% Alternative Simplified Credit rate (ASC), until now that change was unlikely. With a new administration in office, and as part of a larger tax reform initiative, this scenario could now become a reality. The IRS has been pushing for the elimination of the general method in order to ease administration burden, and Congress generally is sympathetic to their burden. On the other side of the coin, if taxpayers are made whole by a corresponding ASC rate increase, there should not be much argument against the general method elimination. I would expect that an increased ASC rate will find its way into the credit statute in 2017, with a possible linked provision eliminating the General Method of credit calculation.
3. Informal guidance will clarify the two new credit provisions added by the PATH Act of 2015
Although effective for tax years ending after December 31, 2015, the AMT offset and Payroll Tax offset provision of the PATH Act of 2015, many tax practitioners are uncertain of if or how the provisions apply to their clients. The applicable statute provisions contain significant uncertainty and ambiguity, which will need to be clarified – AND SOON.
As time grows short before tax returns are due, I anticipate the issuance of informal guidance in the form of notices, FAQs, and form instruction, as opposed to the formal regulatory guidance.
Areas I would expect the IRS to clarify include:
- Use of carryover credits within the application of both provisions;
- Impact of related entities (application of controlled group rules);
- Process of utilizing the new payroll tax offset provision.
So there you have my 3 R&D Tax Credit predictions for 2017. If and when these predictions come true, you can be sure that we’ll provide you with updated information right here on the R&D blog.