2023 May be a Mix of Favorable and Unfavorable Changes
This article has been reposted with permission from The Ohio Society of CPAs. The article originally appeared in the January/February 2023 Edition of “CPA Voice” Magazine. You can access the original article here: R&D tax credit predictions for the new year
For nearly 40 years, I have worked with the Federal Research and Development (R&D) Tax credit—first as an auditor scrutinizing taxpayers who claimed it, and later as an adviser helping taxpayers navigate the claims process. Throughout this time, I have witnessed firsthand the highs and lows of this valuable, yet often misunderstood, tax credit.
When first enacted in 1981, the R&D tax credit served as a huge win for U.S. taxpayers, as it was regarded as a valuable tool created to help domestic companies fight back against strong foreign competition. But by the mid 2000s, this much regarded credit began to receive so much scrutiny that it hit the Internal Revenue Services “Tier 1” audit list. Despite its fall from grace, the reputation of the R&D credit has been restored and has grown in esteem. In recent years, the credit has received widespread bipartisan support, paving the pathway for much new and improved legislation, which has significantly expanded and bolstered the opportunity for a new generation of taxpayers.
Unfortunately, despite these modern-day wins, signs are once again pointing to a pendulum swing, and it’s possible that the credit will face a bumpy road of ups and downs this next year. With that in mind, here are my top three predictions for 2023:
#1 – Good News is on the Horizon for Startups
Just a few months ago, the Inflation Reduction Act (IRA) of 2022 was signed into law, effectively doubling the amount of R&D tax credit that startups¹ can use to offset their payroll taxes. Prior to this, early-stage companies were limited to offsetting $250,000 of credit against the 6.2% employer portion of FICA, for up to five years. Now, under the new act, they can use an additional $250,000 of credit against the 1.45% employer portion of the Medicare tax for the same five-year time period. In theory, this allows a firsttime startup who never claimed the credit to offset up to $2.5 million in tax liability.
Beyond this new act, there are at least four additional bills sitting in Congress, all of which propose further improvements to the R&D tax credit for the benefit of startup companies. Most notably, the Fostering Innovation and Research to Strengthen Tomorrow (FIRST) Act and the Furthering Our Recovery with American Research & Development (FORWARD) Act.
Under the FIRST Act, legislation proposes doubling the payroll tax credit offset for startup companies from $250K to $500K against Social Security taxes. Given the new IRA Act, if the FIRST Act moves forward, it’s possible that a startup company would have an opportunity to offset up to $750K of annual payroll tax. Further, this act also proposes increasing the current gross receipts cap from $5 million up to $25 million (U.S. Code § 448(c)(1), which would significantly open the opportunity up to more businesses.
Like the FIRST Act, the FORWARD Act also aims to improve credit access to startups, by enhancing the definition of a Qualified Small Businesses (QSB) from those with less than $5 million in gross receipt for five years to those with less than $20 million for eight years. It also proposes an allowance of up to $25K minimum gross receipts before the taxable-year period begins.
#2 – Software Developers Will Seek Refuge in the Credit
Perhaps one of the greatest tax challenges facing CPAs and taxpayers alike in 2023 is how to treat R&D expenditures under IRC Section 174. This stems from legislative changes that were baked into the Tax Cuts and Jobs Act (TCJA) Act of 2017 which go into effect this year. Rather than being able to deduct R&D expenses in the year they were incurred, taxpayers are now required to capitalize and amortize them overtime (five years for domestic expenditures and 15 for foreign expenditures).
Overall, these changes are bad news. However, there may be a silver lining for taxpayers who are developing software. Because the new changes mandate software development to be treated as R&D – making them subject to IRC Sec. 174 treatment – these same expenses should now be eligible for the R&D tax credit.
This should open the credit for more software developers, giving them an additional tool to combat their increased tax liability under the larger amortization changes to IRC Sec. 174. Of course, there is no guarantee these new credit claims won’t come under federal audit, but it will prove difficult for the IRS to argue against software development activities as R&D, considering Congress has now explicitly called out software development as R&D.
#3 – Audits Will Be on the Rise
The IRA Act may have increased the amount of R&D tax credit that startups could claim, but it also increased the amount of funding for the IRS, approximately $80 billion over the next 10 years. Using a portion of these funds, the IRS will now hire 87,000 new agents, many of whom will be focused on tax enforcement. This news will likely lead to an uptick in the overall number of R&D audits.
Beyond IRS staffing increases, the agency also sent additional warning signals in October 2021, in the form of a memorandum outlining new information taxpayers will be required to provide to amend past tax returns to claim the R&D credit. In addition to their Form 6765, taxpayers are now also required to provide a signed statement compiling five items of additional documentation regarding the grounds for the claim.
Thus far, taxpayers who have attempted to claim credits under this new rule have found it incredibly challenging and overly burdensome. The purported goal of this mandate is to allow the IRS to better determine upfront if an R&D tax credit claim should be paid immediately or undergo further examination. The mandate is already deterring taxpayers from claiming retroactive claims altogether, while simultaneously giving the IRS a powerful tool to deny claims before they ever make it to audit.
This mandate only applies to amended returns, however, there is speculation the IRS may try to issue similar rules for credits claimed on originally filed returns.
Another telltale sign audits will be on the rise comes from recent litigation. In the 2021 U.S. Tax Court Case, “Little Sandy Coal Company Inc. vs. Commissioner” the court disallowed all taxpayer R&D claims citing the company’s failure to document that “Substantially All” of its research cost and activities (80% or more) were elements of a process of experimentation.
While this ruling only serves as a tax court memorandum, the IRS will likely see it as precedent for disallowing credits using a similar argument in the future. The taxpayer has appealed the case to the United States Court of Appeals for the Seventh Circuit, but for now we can expect the Process of Experimentation test to become more burdensome. Since most taxpayers do not time track their specific activities, we are already advising clients to provide more detailed documentation and explanation of their activities whenever they are dealing with the substantially all thresholds.