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It is projected that we are about to enter an era of enforcement marked by more stringent enforcement of tax policy, which will raise the bar for small businesses seeking to claim the R&D tax credit. On today’s show, Michael Garofalo sits down with Brad Poris. Brad leads the northeast region of BDO’s Business Incentives Group, with a specialization in the research and development tax credit. He discusses lessons learned from the Little Sandy Coal Company case from February 2021, in which the IRS narrowly required the taxpayer to prove a “process of experimentation,” but fell shy of meeting the threshold. They also discuss the Chief Counsel Memorandum, released on October 15, 2021, and how it could impact businesses.

The R&D credit can be a major tax-saving tool for the right business, but it takes a professional to understand the reporting requirements. With membership in the BDO Alliance, JGS, CPA is equipped to handle these kinds of tax situations and many more.

Listen to the podcast here:

New IRS Policies And Rules For R&D Tax Credit With Brad Poris

We have a special BDO guest. We have Brad Poris, the Managing Director of the Business Incentives Group with BDO. He specializes in R&D tax credits and leading the other Northeast division. How are you, Brad?

I’m doing well. How are you doing, Mike?

I’m doing fine. This is your second show. You previously did a BDO retail show.

I did. It’s exciting as a purveyor and listener of podcasts, I always enjoy listening to other people’s hot takes on things. This is a little bit different but I’m excited to give my thoughts and views on all things R&D.

We are glad to have you. We have two main topics but why don’t you kick us off by telling the readers a little bit about what you do because JGS is a part of the BDO Alliance so there is an opportunity for a reader to maybe read this episode and say, “There’s an opportunity for me to connect with Brad and benefit from what he does.”

TAP S2 5 | R&D Tax Credit

R&D Tax Credit: It’s a really nuanced space where you have to know what your customers and clients are doing to know if there’s eligibility and point them in the right direction where that eligibility lies.

 

I started my career at a not-for-profit. When I moved over to BDO way back in 2007, I was part of a growing group that focused on the research and development tax credit. I spent years going through that practice, learning a ton, experiencing a lot of different things, working with all sorts of companies in varying industries. It has been a cool and exciting industry to follow.

You work with high technology companies, life sciences companies, manufacturing companies and financial services. My background was in finance. I went to the University of Florida and studied Finance but somehow, I found that my love of accounting one overall and got me into the specialized tax services world of BDO’s big group. That’s a little bit of my background.

Someone might casually be reading and say, to specialize in the R&D, that’s a narrow, nuanced aspect or task but this isn’t a line item on 1040 where you can say, “I’ve got this deduction covered. I’ve got that one.” This is a nuanced topic that takes many hours for businesses to make sure that they are properly applying for this credit. There have been some pretty serious cases in the court that have tested the details involved with the rules here.

The R&D tax credit has two code sections. I like to joke with my court tax brother in that I only have to know two code sections but if you really dig deeper, those two code sections reference a ton of other outside sections. There have been many court cases like one that I know has been pressing on a lot of taxpayers’ minds that we will talk about. I’m sure a Little Sandy Coal but more so, an R&D tax credit is where there’s an art and science to figuring out and understanding what a company is developing from the standpoint of products, processes, and software.

Not just the numbers associated with it but how a company is going through their process of experimentation and what it is that they are trying to design and develop. It’s a nuanced space where you have to know what your customers and clients are doing to know if there’s eligibility and point them in the right direction where that eligibility lies.

It spans so many different industries, and you are right. We are going to talk about Little Sandy Coal. They are making sea vessels in a dry dock and those Maritime products. You also mentioned software and other manufacturers. Can you speak to what it’s like to take this aspect of tax and apply it to 2, 3, or 4 totally different kinds of businesses?

That’s the most fun part of my team’s day. It’s something where we could pivot from a company that’s developing software to enable vehicles to drive autonomously. The next day, we are talking to a retailer who’s developing an eCommerce platform to help them sell their goods online and expand their market presence or companies that are physically making products like wireless speakers. It does encompass a lot of areas of the US economy. At its basic form, it’s a US-based incentive meant to spur innovation, jobs, and activity in the US. It does cross along a lot of different industries and spaces. It’s cool getting to learn all the things that are out there and coming out there from companies we speak with.

It’s always great to learn things that could help your business processes. Click To Tweet

When we talk about Little Sandy Coal, one of the reasons that things became so contentious is because there was a gray area. It’s hard to narrow down exactly what the IRS wants for something to qualify. Two terms that stick out from the main article. This was a BDO article entitled R&D Tax Credit Denied Where Taxpayer Failed to Demonstrate and Document a “Process of Experimentation.” That was our first keyword. The next key phrase was the substantially all requirements. Can you touch on those two?

The big thing and what we are witnessing in the audit environment is keying in on that process of experimentation. The easiest way that I will describe it is at the outset of your development efforts, you are coming up with what your design requirements might be. What is it you are trying to design? That’s known as the permitted purpose test. Process of experimentation is the process that our technical contacts will undertake to try to determine what it is and how they are going to design and develop their products, software or manufacturing process improvements.

That POE or Process Of Experimentation is one where you go through multiple iterations. As you are going through those iterations at the outset of your development efforts, you are uncertain about something. You are uncertain as to how you are going to do your development efforts or what the most appropriate design is going to be, or what the best method of doing so might be as well.

To figure out that uncertainty, you go through a process of experimentation to create models, prototypes, computer simulations to evaluate those requirements. You test it. Based on those test results, you make changes. It fails miserably. You have to go back to the drawing board. That’s where this case keyed in on that POE or Process Of Experimentation and showed substantially all that key phrase that you had mentioned.

That 80% or more of the development efforts related to something newer improved and research constituting a process of experimentation. That’s where Little Sandy Coal fell a little bit short and the IRS challenged their case. We could talk a little bit more about it. Some other thoughts come to mind, but that’s where they struggled in displaying to the IRS how they were undertaking a process of experimentation.

It wasn’t just that. For instance, the new dry dock was a little bit better or improved and the previous one is narrowed down to the process by which they did the research. Is that right?

It is. What stood out the most is the IRS, even in their commentary, made comments such as, “We do not doubt that the taxpayer undertook qualifying activities but due to the lack of documentation that existed and how they were able to demonstrate what the process of experimentation was, was where they fell short.” That was the most jarring thing to see that although it seemed obvious and just because it’s obvious it’s not the standard. It’s something we are having to demonstrate and having documentation that speaks to how you are meeting the process of experimentation is what’s key here. That was the thing that caught the most issues and made it where the IRS challenged it and felt strong enough in court.

The entire claim was thrown out. The other topic that I will hit here is how their business components were categorized. Business components are either a product, process, software invention technique or formula. The business components were very broad in how they were identified. It’s something where they looked way too macro at it and could not shrink back and say where their sub-components under it that we know were qualified. Since that shrink-back didn’t exist, it was an all-or-nothing type of argument that was being made, and they didn’t satisfy the test at that macro level.

I’m stewing on that a little bit because it sounds like if you were advising a client, you would probably direct them to take precise records in terms of the subcategories. That might even be a little bit of a boundary to entry. If you are asking someone now to take this task and make it even more challenging, cost more work hours, more money for them, and everything like that, you have raised the bar.

Using more layman’s terms, I will give you a good example where the dry dock and apex tanker were the two business components that were thrown out there using a company and a product that we all know. Ford Explorer is a vehicle that’s out there. The Ford Explorer could be a business component. That’s some of the ways that we would advise our client. A little bit different is if you think of some of the core systems and sub-components that exist rather than just the overall Ford Explorer, there are a lot of pieces that year-over-year roll forward certain aspects of the vehicle. There are not any changes that happen.

However, if you look at some of the sub-components, let’s say the navigation system, the engine-assisted driving systems on a year-by-year basis, you could look at a more granular level of what the development efforts centered on in that given year. That’s a way where if the IRS challenges some of the development efforts related to an Explorer versus others. You would have some things that would hold up and it’s clear, “There were development efforts related to this. We are not qualifying things that maybe don’t change year over year in terms of the body, the frame and the transmission.” Hopefully, that resonates and makes some sense.

That’s a good example that a lot of people can relate to. That helps it become a little bit more understandable. If small business owners are reading this, it might even make them a little bit wary that if the IRS is being this nuanced about a case like that, maybe that’s the direction they are headed, and maybe taking the R&D credit isn’t the right choice for their business. We are doing this in November of 2021. We are looking at a memorandum that came out on October 15th of 2021. I would love for you to touch on that and what business owners didn’t know about that.

TAP S2 5 | R&D Tax Credit

R&D Tax Credit: The IRS isn’t looking to disallow all sorts of claims and make it where small businesses can’t claim the credit. However, this is a good opportunity to differentiate your own claim and increase the amount of work you’re doing upfront so that it adheres to the ultimate standards.

 

This case continues a trend from the IRS and their stance on the R&D tax credit. I have been doing this for many years. What I’m saying is the pendulum seems to be shifting for the IRS, the courts, and how they are interpreting some of the rules. We went off of a long string of almost a decade where there were very taxpayer-friendly cases that opened the door to some of the claims that are being put out there.

For the most part, Little Sandy Coal, the taxpayer was relying on Trinity, which was a taxpayer-friendly case similar to industry. What’s shifting now is we just went from a time where the IRS was undermanned and underfunded. What I’m telling my clients is, what we are seeing is we are about to enter into an era of enforcement.

If you look at what’s being put out there in the infrastructure packages that are being talked about again, it’s November of 2021, nothing has been passed. The largest funding source of these packages is IRS enforcement and beefing up the IRS. Hundreds of billions of dollars are going to be put into upping the enforcement level. I know you are excited to know the statistics.

The average number of C corporations that had their claims examined was probably somewhere in the 7% to 10% range for LB&I over $10 million in assets taxpayers for pass-through businesses historically. These are at record lows. Pastors were under 1%. For S-Corps and partnerships, in particular, it was 0.25% of claims were being examined by the IRS. Those numbers are going to go up. There’s going to be additional scrutiny. That’s what leads us to this Chief Counsel Memorandum that was put out curiously on October 15th, 2021.

It was critical before but you could also look at it the other way and say, “This will help reduce fraud and abuse.”

Trying to play devil’s advocate and think both ways, you understand why the IRS is doing this. The level of enforcement was very low. There are a lot of questionable claims that have been put in. The finding is they were a little bit overwhelmed with the number of claims and had no real ability to police and enforce the actual rules. This was a Chief Counsel Memorandum that was put out on October 15th, 2021. The intent was to up the level of information that’s submitted at the time of an amended claim for a refund.

To be clear about a few important things, this does not contain and have the same legal standing as, let’s say, code or regulations. Not to say that it doesn’t need to be followed but it’s not the same as this being hard-coded into the law. However, it can’t be disregarded until it is modified or withdrawn. That’s why there are a lot of controversies around this now. It’s something where the IRS is saying, “Here’s the standard.” The standards are somewhat reasonable for what they are asking for but from a practical perspective, that can add some challenges to a lot of taxpayers.

This is only tangentially related. It wasn’t that long ago when we saw the worst-case scenario, the Ferrari situation. If you remember that with PPP. The business owner puts in for PPP, completely misuses it, and is caught driving around in a Ferrari. People hear that story. Even though it’s a headline and an attention grabber, it’s probably not representative of a large segment, unfortunately, the population. If you hear a story like that, it makes you a little more sensitive to the fact that people are getting away with some pretty shady things out there. That would make someone more amicable to an IRS that’s going to be enforcing stricter codes.

What we are telling our clients is the IRS isn’t looking to disallow all sorts of claims and make it where small businesses can’t claim the credit. However, this is a good opportunity to differentiate your own claim that you are putting in and increase the amount of work you are doing upfront so that it does adhere to what the ultimate standards are almost nothing of what is being requested in the CCM, Chief Counsel Memorandums. There’s almost nothing in there that was new to what is required ultimately upon exam.

It’s more of the matter in which upfront, when submitting a claim for refund. This is an amended claim for a refund. This is where they are asking for certain additional criteria, which is somewhat new to the US and the US standards. For the readers’ knowledge, in the US credit, there’s a Form 6765 on it. There are some numbers and that’s all that gets submitted.

What are your qualified research expenses? What are your three prior year qualified research expenses? What’s your fixed-base percentage if you are using a different method? That’s it. It’s just the numbers. Any of the documentation or description of what development efforts were being done or anything else that is still required upon a further look from the IRS has not been requested upfront, now they are starting to move in that direction a little bit.

We spoke a little bit about this before we started. You said that some other nations have a similar perspective on this. Can you expand on that a little bit?

I’m thinking of some of our friendly neighbors like Canada and the UK. There are increased standards of what they look for upfront as you are filing for the credit. Not to say that the US is looking to directly mirror either of those two countries but the higher bar that they request upfront mirrors more of an application basis. What this does is for taxpayers on amended returns, where they are requesting a refund. This opens the door for the IRS to say, “If we don’t see these types of things upfront, we have the right to withhold paying a refund.”

There is the possibility that due to the nature of when some of these refund claims go in there, they are right up against that statute of limitations, which is a three-year statute of time, the statute could run out on a taxpayer where the IRS reaches out, says, “We didn’t see this information. The statute of limitations has run. There’s no time for a taxpayer to correct their claim. Therefore, they might miss out on a full year of credits that they would. Otherwise, had they done all the work upfront and be entitled to this?”

To clarify also to readers, this is so much different than you contact JGS and say, “I’m sorry, but I’m going to return it. I missed the following line items. Can you file a quick amended return?” This is many hour-long projects. Let’s say we will take a small business and I know the range will be very large. How many work hours are you typically putting in to do for one successful business to apply for R&D?

It could vary. What I always love and joke about is on Form 6765, if you look at any of the IRS’s forms, they will layout, “Here are the average number of hours it should take to complete this form.” For the R&D tax credit, they lay out about 12 to 16 hours. I’m going to say it’s more than that, especially if you are looking to meet these standards. I’m curious to see if they update that one after this thing comes out there. To lay out what types of activities happen and are being requested here, the request at this point is that at the time of refund and claim is filed, you need to identify all the business components to which a research claim relates for that year.

Again, products, processes, software, invention, techniques or formulas. For each business component, you need to identify all research activities that were performed and the names of the individuals who performed each research activity as well as the information each individual sought to discover. I’m quoting exactly what’s written here. That one becomes a little scary for those that have been in this profession. The word discovery sets off some red flags there but I will go on.

The last big point is providing the total qualified research expenses. That’s total qualified supply expenses, wage expenses, contract research expenses for that claim year. That’s something we usually do on Form 6765. That’s laying out what they are requesting and requiring. It’s instructing taxpayers to detail out what the facts are sufficient to claim this credit. That’s the basis of it.

It’s detailed in the sense that you have an employee who’s working on a new project that then you classify as research and then it doesn’t even go as far into depth as to say, of that person’s 40-hour workweek, how much of their time were they spending on research? We have jobs that can be varied. Maybe they were on the computer doing answering emails. That’s not really researching or answering a phone call. It’s got to be pretty detailed, even down to the employee.

The pendulum right now seems to be shifting for the IRS and the courts and how they're interpreting some of the rules. Click To Tweet

One thing that I will still layout there is time-tracking or project-tracking, still to this day, is not the standard. It’s somewhere where you could breathe easy if you are a small project because very few taxpayers have detailed project tracking systems in place where you need to track it down to the hour. If you do have it, it’s a great thing to utilize or leverage because it’s contemporaneous in nature. It shows what activities were performed daily and weekly. It’s something that usually plays nicely. However, when you are thinking of those overall business components, I’m going to use maybe another example. Let’s say it’s a life sciences company that’s developing five different formulations or drugs.

The formulation is what that business component is. For a scientist who maybe works on certain aspects of those drugs in the pipeline, there might be only 2 of those 5 drugs that they are actively working on research efforts related to them in a year. It could be allocating their time spent on credit-eligible activities to each of those two business climates.

This could be done utilizing some factors and information that the company might already have. It’s not something that we do need to go back and say, “This employee spent 90.4 hours spending research activities on formulation A.” There’s a bit of a way to get there but that’s giving you some perspective on the level of detail. Obviously, the more, the better.

I overshot a little bit there. It’s nice to have that information but it doesn’t go quite that extreme now.

The one thing which I wanted to point out as well is, again, although this Chief Counsel Memorandum refers to Amended Claims For Refund, the way we are approaching it as this is what they view the standard is being. We think that this is how they are going to, over time, move the needle and swing that pendulum towards timely filed claims. What’s the difference between an amended claim for a refund on a timely filed claim? They are going to request this information upfront. It gives you some insight into what they are thinking.

Although this still has not been enacted, they gave a window of time as to January of 2021, in which then that level of enforcement goes into effect for any claims after that time. Any claims that you are doing at the moment are going to fall under the CCM. If you are thinking about claiming the research credit, it’s getting it up to that standard, allocating and understanding your business components, understanding the activities each of the individuals, consultants, and supply expenses related to. That’s the standard that you want to think of.

Do you think most of the clients you work with are already equipped with the necessary software and personnel to do that to meet the standards?

TAP S2 5 | R&D Tax Credit

R&D Tax Credit: Expect the idea that your claim’s going to be examined. Raise the standard of how you’re looking at your own claims, and gather documentation and keep documentation.

 

Yes. It exists at every company. If you dig deep enough, I’m not saying that you have to dig 1,000 meters from the center of the Earth to get there. It’s something where if you are talking with your technical contacts. That’s the biggest thing that we do when we are doing an R&D tax credit study. We are not just talking to financial contacts.

We are talking to the people that develop the products and the software and do the process improvements. They are the ones that are familiar with the activities they are performing. If you talk to someone and ask them to tell you about what they do for a living and what they did over a few months or a year, they are usually able to speak to it.

Asking the right questions is what brings out all of these credit eligible activities and lays out what that process of experimentation is. We are talking about smart people in each of these industries that are familiar with the activities they are performing. It’s organizing that information in a manner that speaks to all of the various tests. That process of experimentation that’s being keyed in on both Little Sandy Coal court cases and the Chief Counsel Memorandum.

Thank you, Brad. I appreciate your time. We’ve got a pretty good picture of CCM now. Do you have any closing remarks that you would want to leave business owners with? We know things are going to change and new information will come out. What’s your main takeaway at this point?

We're about to enter into an era of enforcement. There's going to be additional scrutiny. Click To Tweet

The main takeaway is giving each year’s credit and independent look and almost scrutinizing what you are gathering to the same level that you would expect. Expect the worse than being happy with the best. Expect the idea that your claim’s going to be examined. Raise the standard of how you are looking at your own claims, gather documentation, keep documentation. Please don’t throw out anything that you ever have related to the development efforts that you work on.

For the year, gather that documentation related to your products and efforts. The biggest thing is if you ever have questions, know that you have people that you could reach out to ask questions. Mike, I hope you share my contact info with some of JGS’ clients and others. Please, feel free to always reach out, even if it’s just a simple question. We are happy to help you in this journey, figure out this process and make it as stress-free as possible.

We always try to support the BDO Alliance the best we can. We love being a member because it helps us. We are about 30 staff strong but it allows us to compete with larger firms for this reason. We open ourselves up to and avail ourselves to resources like yours that help us be competitive and help our clients. That’s what it’s all about. Thank you for your time.

Thank you so much.

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About Brad Poris

I am a Managing Director at BDO USA, LLP who leads the Northeast Region’s Business Incentives and Tax Credits Practice. I am based in the New York Metro area and have been at BDO since 2007.

My professional experience has been primarily focused on R&D Tax Services where I have assisted a wide range of small privately held start-up companies to billion-dollar publicly traded companies.

I have served companies in a broad range of industries, including: Biotechnology, Financial Services, Consumer Products, Food & Beverage, Manufacturing, Online Retail, Construction and Engineering, Professional Services and Software.

BDO USA, LLP is a US professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through 60+ offices and more than 500 independent alliance firm locations nationwide. As an independent member firm of BDO International Limited, BDO serves multinational clients through a global network of more than 1,400 offices in 158 countries.