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There’s been a disturbing change in precedent as practiced by the IRS: IRS audits of research and development (R&D) tax credit claims by service providers, such as architecture and engineering (AE) companies, have become inconsistent over the last couple of years. In fact, IRS audit actions appear to be reversing the long-standing precedent for the type of activities that qualify for the credit. Up to now, service providers have qualified for the R&D credit as long as they satisfied a four-part criterion (outlined below).
First off, what is the R&D tax credit? It was established by law in 1981 to act as an incentive to spur U.S. research and economic competitiveness and made permanent in 2015. It remains critical to the growth of U.S. innovation. To qualify, research must entail activities that satisfy a broad four-part test. The activity must include the elimination of uncertainty, the process of experimentation, be technological in nature, and have a qualified purpose (the business component test).
Historically, two main groups benefit from the credit: manufacturers and service providers. Nearly half of taxpayers who claim the credit are manufacturers, while nearly one-third of taxpayers who claim the credit are service providers–most of which are small businesses in the fields of architecture, engineering, construction, and computer software design.
Despite this longstanding precedent, recent audit denials for architecture and engineering research claims are reflecting a very different position by the IRS, which now argues that “services” do not qualify for the R&D tax credit. This dramatic break in precedent has an outsized impact on small businesses that lack the resources to fight IRS denials. While the IRS’s stated reason for disallowances has varied from case to case, a consistent theme from IRS examiners in the Small Business/Self-Employed division argues that services provided by architecture and engineering firms cannot meet the “qualified purpose” portion of the four-part test because their research lacks an identifiable “business component.”
This new position is concerning, given that the IRS Code clearly defines the term “business component” as a product, process, computer software, technique, formula, or invention. In the past, the IRS has allowed design drawings to qualify as the business component, since the term “technique” is synonymous with the term “blueprint” or “design drawing.”
However, in many recent cases, the IRS has ignored the terms “technique” and “formula” in R&D claims for service providers altogether. While no court cases have addressed this issue directly, there have been cases involving service firms that took the R&D credit where neither the IRS nor the courts questioned whether service providers can qualify for the credit; this shows service providers aren’t inherently disqualified from taking the credit.
The architecture and engineering industry in the U.S. employs millions of Americans conducting essential research and development activities that are vital to achieving U.S. advancements and innovations in clean energy, safe and modernized infrastructure, and health-conscious building design and construction in a post-pandemic world.
This is exactly the type of innovation and R&D expertise that political leaders on both sides of the aisle want to continue to foster here in the U.S., and it’s clear that IRS guidance that’s consistent with the longstanding Congressional intent for the type of U.S.-based innovation this credit was designed to promote is needed to ensure this industry can achieve our next generation of safe, reliable, and sustainable infrastructure goals.
If the IRS is allowed to unilaterally change the R&D credit’s applicability to the AE service industry, it stands to set a dangerous precedent that will damage U.S. innovation, as well employment and wages in this critical sector, and it could potentially prove inflationary to the construction industry.
It’s for this reason that I’ve teamed up with tax professionals to formally request the IRS include clarifying guidance for computing and substantiating the qualifying research activities performed by service firms, such as architecture and engineering firms, under I.R.C. § 41 in its Priority Guidance Plan for 2021-2022.
Specifically, we’re asking for the IRS to provide formal guidance in the form of a Revenue Procedure or Ruling modeled after the 2012 IRS Guidance for Computing and Substantiating the Credit for Increasing Research Activities Under Section 41 of the IRS Code for Activities in Developing New Pharmaceutical Drugs and Therapeutic Biologics.
Under this proposal, guidance could be developed that creates a “checklist” of activities conducted by taxpayers in the AE field that qualify for the research credit and that are subsequently certified to appropriately compute the credit. As in the pharmaceutical industry’s guidance model, if a taxpayer meets the criteria and makes the appropriate certification with their tax returns, an audit would be unnecessary.
This approach would ensure the research tax credit is consistently and fairly applied to a critical industry and, importantly, would alleviate the considerable amount of time and resources the IRS SB/SE exam function is currently spending auditing research tax credits for these small businesses, freeing up valuable IRS audit personnel to address other important Administration tax priorities.
This type of approach is in the best interest of the U.S. government and taxpayer, and we’re encouraged that the groundswell of bipartisan support to protect and improve this critical research tax incentive will lead to fair and clear IRS guidance that allows these important small businesses to continue to deliver the R&D innovations our country is relying upon.