6 R&D Tax Credit Trends to watch: Sweeping changes, millions in investment
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1. More IRS scrutiny around nexus
To claim the R&D credit, you’re supposed to establish the “nexus” (connection) between the activities people worked on and the “business components” (products, processes, tools, etc.) they were for. In the past, plenty of firms didn’t establish this nexus in their R&D credit studies, and just made separate lists of business components and activities, often with general activities deduced from job titles (it’s easy to guess a “Software Engineer” did “Software Engineering”). But in recent years, IRS auditors have been cracking down on this. And Chief Counsel Memo 20214101F (October 2021) goes a big step further, saying that if you submit an amended return with a Research Credit, the IRS won’t even consider your credit unless the amended return includes a report of which personnel worked on which activities on which business components, and the technical uncertainties they were trying to resolve.
2. Companies have tons of data for R&D analysis
Workers are using more and more cloud software to coordinate their activities with colleagues, and this trend has accelerated with remote work. Nearly all software engineers in the U.S. use the same tool (called Git) to record their code changes every day. And companies in all industries now commonly use task-tracking software like Asana, Trello, Monday.com, Rally, etc. Jira is the most common of these, and it’s used by 4 out of 5 Fortune 500 companies. Mining this task data can produce an accurate and detailed R&D study (and establish nexus- see Trend #1) with much less work than traditional interviews.
3. AI for claiming R&D credits
A handful of firms are now claiming to use artificial intelligence for R&D studies. Although like anything algorithmic, AI is only as accurate as its input data. If a firm runs AI on job titles, that’s not sufficient for a study- see Trend #1. But using AI to classify each task into qualified vs. non-qualified activities can yield much stronger substantiation to back up the credit.
4. Massive investment in R&D software
In 2021 alone, investors poured over $300 million of debt and equity financing into R&D specialist firms and tax/finance firms selling R&D credit services. And many of the Top 100 accounting firms we’ve spoken to are considering investing in R&D software platforms to improve efficiency and reduce burden on their clients. Much of this investment craze is being driven by the 2015 PATH Act, which expanded the R&D services market by allowing small, unprofitable companies to use the Research Credit to offset their FICA taxes.
5. Cash advances for the credit
In the last two years, some R&D specialist firms have adopted the neat marketing gimmick of paying the credit amount (minus their fees) to clients as soon as they complete the study, and letting the client repay the full credit amount once they receive it from the IRS or state agencies. If your firm doesn’t do this (most firms don’t) but you’re competing against firms who do, explain to your clients that it’s really just a high-interest loan: if they pay 20% of the credit for a cursory R&D study and get the cash up front instead of receiving the money next quarter via a payroll tax offset, it’s effectively a three-month loan at 80% APR.
6. Tougher IRS enforcement
The IRS has repeatedly highlighted the Research Credit as an area ripe for increased scrutiny. It’s been on the Dirty Dozen list of tax scams in 5 of the last 6 years. And the October 2021 Chief Counsel Memo is the start of a crackdown on Research Credits on amended returns. But heavier enforcement requires more audit staff, so we’ll have to wait and see what becomes of the Biden administration’s plan to ramp up funding for the IRS.
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