The IRS Large Business & International division (LB&I) released a directive to its examiners (LB&I-04-0917-005
) that effectively creates a new safe harbor method for large taxpayers to calculate certain qualifying research expenditures (QREs) based on financial statement information.
The guidance outlines a method for taxpayers to start with the research and development costs as calculated on their certified audited financial statements under ASC 730, make certain adjustments, and end with QREs for claiming the R&D credit under Section 41.
The directive cannot be used, cited, or relied upon as an official pronouncement, but LB&I examiners are instructed not to challenge QREs computed under this guidance. Thus the directive effectively creates a new safe harbor for LB&I taxpayers. LB&I covers taxpayers with assets equal to or greater than $10 million, and the safe harbor also requires that these taxpayers present ASC 730 R&D expenses in their Certified Audited Financial Statements as a separate line item on their income statement or a separately stated note.
Applying the directive
The directive provides a safe harbor only for certain specific costs. Due to the differences between the research as captured by ASC 730 and Section 41, there are several costs that will not fall within the safe harbor. The directive allows for these costs to be included in the computation as “additional costs,” and they are subject to traditional exam procedures. They may include:
- Research conducted for others under contract
- Prototype overhead costs
- Costs to improve existing products, production processes, manufacturing processes
- Full-scale pilot model costs
- Development of internal-use software
The safe harbor does include certain supply and wage costs charged to specific ASC 730 GL accounts, and provides methods to determine the amount of eligible wages for “qualified individual contributors,” “first level supervisor managers,” and “upper level managers.” Taxpayers are not required to use these methods to determine wages, but wage amounts that do not rely on the methods will be subject to traditional exam procedures.
The wage safe harbor methods allow the following amounts:
Qualified individual contributors: 95% of qualified individual contributor wage costs charged to specific ASC 730 GL accounts.
- First level supervisor managers: 95% of first level supervisor managers charged to specific ASC 730 GL accounts.
- Upper level managers: the lesser of 100% of upper level manager wages charged to ASC 730 cost centers, or 10% of the amount allowed under the qualified individual contributor and first level supervisor manager methods.
The directive applies to original returns filed on or after Sep. 11, 2017. Taxpayers currently claiming R&D credits should evaluate the approach outlined in this directive against their existing methodology before filing their next return. Taxpayers who may benefit, but do not currently disclose ASC 730 R&D costs in their financial statements, may wish to consider doing so in the future to implement this simplified approach.
Note that the approach described in this guidance is not as simple as using book R&D costs to compute a credit. Applying the directive may require taxpayers to modify accounting systems to generate necessary data. Taxpayers may also need to modify organizational structures to align qualified activities with ASC 730 accounts. The additional costs will require additional analysis and substantiation documentation.
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