November 11, 2021
IRS Chief Counsel provides legal advice on information that IRS may require for a research credit claim to be considered valid
A new Chief Counsel memorandum (20214101F) announced by the IRS in a News Release (IR-2021-203) on October 15, 2021, identifies the information necessary to meet the specificity required to make a valid IRC Section 41 research credit claim for refund. The IRS advised examiners that the additional information will help determine at the initial stages if the refund claim should be paid immediately or further reviewed.
IRC Section 41 allows taxpayers a credit against income taxes for a portion of the increased expenses incurred and attributable to qualified research activities. The specificity requirements of Treas. Reg. Section 301.6402-2 require taxpayers to set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the IRS of the exact basis for the refund, in the context of research credit refund claims under IRC Section 41. Generally, the IRS may reject claims that do not satisfy the specificity requirements of IRC Section 6402 as deficient and refuse to consider them on their merits.
The IRS said in the News Release that taxpayers must provide the additional information identified in the memorandum beginning on January 10, 2022. There will then be a one-year transition period during which taxpayers will have 30 days to perfect refund claims before the IRS makes a final determination. The IRS said further details will be forthcoming. In response to an inquiry by EY, the IRS stated that the 30-day period to perfect refund claims begins when the IRS issues a letter requesting additional information after reviewing a claim. The IRS also told EY that it plans to issue frequently asked questions (FAQs) to assist in the implementation of the new guidance.
Information sought under the memorandum
The memorandum contains specific instructions on what information a taxpayer must submit as part of the refund claim to avoid the IRS finding it deficient. Under the memorandum, a valid refund claim must:
1. Identify the following items:
2. Submit a written declaration verifying the facts signed under the penalties of perjury (in most cases Forms 1040X or 1120X will suffice)
3. Submit the refund claim within the correct time period (within the later of three years of the date the Form 1040 or 1120 was filed or two years from when the tax was paid)
The memorandum states that a written statement is preferred over document production; if documents are supplied, then the taxpayer must specify the exact page that supports a specific fact.
The memorandum discusses applicable statute of limitations rules, limitations of the amount of refund that can be claimed and how a taxpayer may satisfy the refund limitations period even if the taxpayer filed a deficient claim. The memorandum also discusses the waiver doctrine, which allows a taxpayer to be treated as having made a valid, formal claim, even if the claim is deficient, if the IRS demonstrates that it knew of the claim and unmistakably took action on the claim without requiring the taxpayer to perfect the claim (thereby waiving its administrative requirements).
The memorandum advises its examiners that "[r]ejecting a deficient refund claim before initiating an audit (or otherwise actively considering the refund claim on its merits) is recommended and should eliminate the likelihood that a court will find the Service waived the specificity requirement under [Treas. Reg. Section] 301-6402-2(b)(1). Rejecting a deficient refund claim may preclude a taxpayer from amending or perfecting [its] refund claim if the refund claim failed to follow procedural requirements and the statute of limitations to file a new refund claim has expired" (emphasis in the original).
The IRS points to two cases as support for its interpretation of the specificity requirement: United States v. McFerrin, 492 F.Supp.2d 695 (S.D. Tex. 2007) and the district court decision in Harper (No. 3:18-cv-02110-DMS-LL (S.D. Cal. Apr. 25, 2019)).
In McFerrin, the US District Court for the Southern District of Texas found that the taxpayer's refund claims (which were based on credits claimed by pass-through entities) satisfied the specificity requirement because the taxpayer submitted (1) a Form 1040X explaining the reason for amending the claim, (2) a Form 6765 reporting the amount of the pass-through research credit, and (3) Schedule K-1s for the pass-through entities stating that the credits were for increasing research activities. The district court stated that the "amendment makes it plain that the basis for the credit is increasing research activities and calculates a specific amount. The IRS was on notice of the 'nature of the claim,' the entities claiming the credit, and the legal theory upon which the claim was founded." The court further stated that the "specificity requirement is met 'if the basic issue is evident from the record, and the IRS is aware of the nature of the claim.'"
In Harper, the Ninth Circuit found in favor of the taxpayer, reversing a district court's dismissal of a suit to recover a research credit refund through an amended return. The district court found that it lacked jurisdiction to hear the suit because the taxpayer failed to satisfy the specificity requirements in Treas. Reg. Section 301.6402-2(b)(1). The Ninth Circuit reversed the district court, finding that the IRS waived enforcement of the specificity requirement because it had conducted a four-year audit that was "specifically directed to determining [the taxpayers'] eligibility for an increased research activities credit" (see Tax Alert 2021-0510).
The memorandum distinguishes the taxpayer-favorable decision in McFerrin based on the government's posture in the case (plaintiff), the type of motion (summary judgment) and the burden of proof (on the government), pointing out that, "crucially, [the district court] noted that the government 'provided no indication of what additional information [the taxpayer] needed to satisfy the requirements of Treas. Reg. [Section] 301.6402-2(b)(1)" (internal edits omitted).
The memorandum mentions two additional recent cases in footnotes. Similar to Harper, in Intermountain Electronics, Inc. v. United States, No. 2:20-cv-00501 (D. Utah July 16, 2021) the US District Court for the District of Utah found that the government waived the formal claim requirements by examining the taxpayer's claim. The government argued that the taxpayer failed to satisfy the specificity requirement in Treas. Reg. Section 301.6402-2(b)(1), even though the IRS had examined the taxpayer's refund claims for several years. In and Premier Tech, Inc. v. United States, No. 2:20-cv-00890 (D. Utah July 15, 2021, decided the day before Intermountain, the US District Court for the District of Utah also decided in the taxpayer's favor, denying the government's motion to dismiss the taxpayer's suit for IRC Section 41 research credit refund claims. In contrast to Harper and Intermountain Electronics, the court in Premier evaluated the taxpayer's amended return (the question of the government's waiver of the specificity requirement was not addressed), and found that Premier's amended return was sufficiently specific, in that it stated that the tax credits claimed were for increasing research activities. Additionally, it noted, the Form 6765 (1) specified the qualified research expenses claimed for wages, supplies and base amounts, (2) showed the increase in qualified expenses, and (3) calculated the credit amounts.
Chief Counsel advice is a written determination that may not be used or cited as precedent (see IRC Section 6110(b)(1)(A) and (k)(3)). The memorandum's recommendation, however, to reject claims that do not conform to its requirements (but otherwise meet the standards articulated in Treas. Reg. Section 301-6402-2(b)(1)) potentially places taxpayers in a difficult situation: spend time and resources compiling detailed information to comply with a non-precedential memorandum, or possibly spend time and resources later filing suit in court.
The memorandum's recommendation to reject a deficient refund claim before initiating an audit (or otherwise actively considering the refund claim on its merits) could lead to more controversy, as taxpayers seek redress in district courts or the US Court of Federal Claims (refund courts). If the IRS does not examine a refund claim because it does not contain all the information sought by the memorandum, but instead rejects it as an invalid claim, taxpayers must choose between submitting another claim with the designated information or litigate the validity of the refund claim in a refund court. If the taxpayer litigates the validity of the claim in court, the court will essentially be asked to perform the examination function that the IRS did not pursue if the court agrees that the claim meets the specificity requirements of Treas. Reg. Section 301-6402-2(b)(1).
Once the statute of limitations for claiming a refund has passed, a deficient claim may not be amended or perfected after the IRS rejects it on procedural grounds. Subsequently, the IRS's recommendation to reject claims that do not meet the requirements suggested in the memorandum may prevent a taxpayer from satisfying informal claim requirements. Thus taxpayers that file an amended claim may want to consider filing a refund suit at the earliest opportunity to preserve the ability to cure (before the expiration of the statute of limitations for perfecting the claim) any formal claim deficiencies that the government raises. Accordingly, taxpayers need to be cautious if they file a refund claim close to the expiration of the three-year statute of limitations and the IRS is not examining the merits of the claim.
In a footnote, the memorandum stays that it "applies only in part to taxpayers claiming an I.R.C. Section 41 research credit for the development of internal use software. The memorandum does not discuss which parts apply to these taxpayers, and whether additional guidance will be forthcoming is unclear.
Additional guidance would be useful to understand the interplay between the use of statistical sampling, as authorized under Revenue Procedure 2011-42, to identify qualified projects, or determine the level of qualified activities performed by an individual. For taxpayers that hire contractors to conduct research on their behalf, the detailed information requested in the memorandum may also be unavailable, as the identity of each of the contractor's personnel, details of the specific activities conducted by the contractor's personnel, and the specific information sought by each of the contractor's personnel are not likely to be within the taxpayer's knowledge
Taxpayers that have filed research credit refund claims that have not yet been rejected or acted upon should carefully consider what additional information, if any, they could provide to comply with the memorandum. If a claim is currently under examination, taxpayers may want to assess the likelihood that the examination team would stop their audit activities to prevent the taxpayer from satisfying informal claim requirements or to reduce the potential for the taxpayer to establish that the IRS waived its specificity requirement. Taxpayers that had not yet filed, but are planning to file, amended refund claims may want to consider including more information than they otherwise would to avoid potential IRS arguments that the claim did not satisfy the specificity requirements of Treas. Reg. 301.6402-2(b)(1). Taxpayers should also assess how quickly they can respond to the IRS's requests for additional information. Finally, taxpayers should be especially vigilant in evaluating their refund claims if the three-year statute of limitations to claim the refund is close to expiring to avoid a finding that they missed the time to perfect a claim within that time period. Consultation with a tax advisor to evaluate refund claims already filed and refund claims being considered is recommended.