Taxpayer-Friendly Developments on R&E Credit Refund Claims
There has been a flurry of recent developments for taxpayers considering claiming a refund for additional Research and Experimentation (R&E) credit. Twice in the last week, the IRS made two taxpayer-favorable updates to its published guidance on its new documentation requirements for a valid R&E credit refund claim. In addition, in Cromwell Architects Engineers, Inc. v. United States, a federal district court rejected the IRS's attempt to incorporate those same requirements into the standard for filing a valid refund suit in court.
On October 15, 2021, the IRS announced its view of the requirements for valid R&E credit refund claims and simultaneously issued a Chief Counsel Memorandum (the R&E Memo) setting out its legal case for the requirements. The R&E Memo takes the position that a valid R&E credit refund claim must include the following requirements:
- All business components in connection with which the taxpayer is claiming the R&E credit
- For each business component:
- All research activities performed
- All individuals who performed each research activity
- All the information each individual sought to discover
- Total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses
The R&E Memo states that the IRS would begin to apply these new requirements in processing refund claims as of January 10, 2022. The IRS also announced a one-year transition period, during which the IRS will notify a taxpayer if it concludes that a claim is deficient and allow the taxpayer 45 days to perfect its claim before they are rejected. The transition period as originally set forth was scheduled to expire on January 10, 2023. On September 30, the IRS announced that it is extending the transition period for an additional year until January 10, 2024.
On October 4, the IRS updated its frequently asked questions (FAQs) on the R&E Memo. Previously, the FAQs stated that a taxpayer whose refund claim "includes the Research Credit and other items" must satisfy the documentation requirements or the IRS would reject the entire refund claim. The October 4 update clarifies that a taxpayer need only satisfy the documentation requirements if its refund claim "relates to the Research Credit." An amended return that does not include a refund claim or one that does not request an adjustment to the R&E credit does not need to meet the documentation requirements.
In a September 26 order, the U.S. District Court for the Eastern District of Arkansas rejected the government's attempt to impose the requirements similar to those articulated in the R&E Memo in the context of a well-pleaded complaint under the Federal Rules of Civil Procedure. Cromwell Architects Engineers, Inc. v. United States, No. 4:21-cv-00829-KGB (E.D. Ark. Sept. 26, 2022). In Cromwell, the taxpayer, an architecture firm, filed a claim for refund for tax years 2009 and 2010 seeking additional R&E credit and a deduction for energy efficient commercial building activities under section 179D. After a multi-year audit, the IRS denied Cromwell's refund claim and Cromwell filed a refund suit. In its complaint, Cromwell claimed, in relevant part, that the IRS erred in denying its R&E credit refund claim for four reasons:
- The government erred in failing to recognize Cromwell incurred substantial qualified research expenses for the tax years ending December 31, 2009 and December 31, 2010, for which the law provided a tax credit.
- The government erred in its interpretation and application of the Internal Revenue Code requirements for the taxpayer to properly claim the research and experimentation tax credit.
- The government erred in completely disallowing Cromwell's research and experimentation tax credit for tax years ending December 31, 2009 and December 31, 2010.
- The government erred in improperly calculating the R&E tax credit for tax years ending December 31, 2009 and December 31, 2010.
On February 4, 2022, the government filed a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) for failure to state a claim. The government argued that Cromwell's complaint was deficient because it fails to include any specific qualified research expenses (QRE), how those QREs satisfy the four-part test in section 41, or how Cromwell calculated the additional R&E credit it claims. Rather, the government argued that contains only conclusory statements that Cromwell satisfies the elements of section 41 and, therefore, failed to state a claim.
The district court denied the government's motion and held that the government's motion misstated the standard for surviving a motion to dismiss. Rather than provide the information requested by the government, the court held that Cromwell's complaint need only contain factual allegations sufficient to state a claim that not speculative but "is plausible on its face." The court found that the Cromwell's complaint met this standard.
While neither the updates to rules relating to the R&E Memo or the district court's order in Cromwell remove any barriers to making R&E credit refund claims, both are positive developments. Extending the period during which taxpayers can cure their administrative R&E credit refund claims acknowledges the new burdens imposed on taxpayers by the R&E Memo requirements and clarifying that only taxpayers who claim an adjustment to their R&E credits must comply with the requirements is welcome. The Cromwell order prevented the government from heightening the standard for surviving a Rule 12(b)(6) motion in R&E credit refund suits.
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