Final IUS Regulations, Increased IRS Scrutiny and a No-Change to the ASC
As the 2015 year comes to an end with the surprise of a permanent R&D Credit and other favorable legislation, the question arises: What does the future hold for the credit?
While we know that it will be tough to beat the 2015 year for the amount and significance of legislation, regulation, and judicial decisions issued impacting the credit, we can certainly assume that some important changes are yet to come.
Alas, here are 3 R&D tax credit predictions for 2016:
1. The issuance of Final Treasury Regulations for Internal Use Software
On January 20, 2015, under 41(d)(4)(E), proposed regulations around Internal Use Software were issued. Since then, the issuance of final regulations has been listed on the Treasury Departments Priority Guidance Plan for 2015-2016. All indications point to these regulations going final in 2016.
What can we expect to see in these final regulations:
- The treatment of “connectivity” software being addressed;
- Further guidance on the treatment of “dual function” software, and utilization of the related safe harbor rules, which were included in the proposed regulations;
- Definition of the Significant Economic Risk prong of the High Threshold of Innovation Test. (Let’s hope the regulation drafters heard our outcry about “design uncertainty” being eliminated in the proposed regulations as a means to meet the “substantial uncertainty” component of “economic risk”!)
2. An Increase in IRS Scrutiny
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 AMT and Payroll taxes. While taxpayers and tax practitioners alike have celebrated this decision, we must now be mindful of how these new regulations will be looked at 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.
3. The 14% ASC Credit rate will Remain the Same
While there has been much speculation around the elimination of the General Method of credit calculation and an increased 20% Alternative Simplified Credit rate (ASC), it’s unlikely this change will happen in 2016. (Remember it’s an election year.)
Rather, you should look for this to happen in 2017 as part of a larger tax reform initiative. The IRS has been pushing for the elimination of the general method for a while, in order to ease administration 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.