Field attorney advice 2021410F
On 15 October 2021, the IRS Office of Chief Counsel (OCC) issued field attorney advice (FAA) 2021410F (17 September 2021), setting forth substantial new information requirements for section 41 refund claims. The ostensive purpose of the requirements is to enable the IRS to determine whether taxpayers' section 41 refund claims are valid or require further examination based entirely on the face of the claims. Accordingly, "for the refund claim to be valid," OCC requires taxpayers to, in effect, report every technical element of their qualifying research activities under section 41. For refund claims filed after 9 January 2022 (deadline established in a contemporaneously issued IRS news release (IR-2021-203) ("IRS News Release")), taxpayers must now include:
- All business components relevant to the section 41 refund claims;
- For each business component:
- all research activities performed;
- all individuals who performed each research activity; and
- all the information each individual sought to discover; and
- The total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (this may be done using Form 6765, Credit for Increasing Research Activities).
OCC noted that this information ("Foundational Information") should be conveyed in a written statement rather than through document productions. However, if a taxpayer provides documents, including a credit study, the "taxpayer must specify the exact page(s) that supports a specific fact. A mere volume of documents will not suffice to meet a taxpayer's obligation."
The IRS News Release indicates that after 9 January 2022, there will be a one- year "transition period" (10 January 2022 through 9 January 2023) during which taxpayers will have 30 days to perfect (i.e., rehabilitate) a purportedly deficient section 41 refund claim prior to the IRS's final determination.
On 3 January 2022, the IRS Large Business and International (LB&I) Division issued guidance (LB&I-04-0122-0001) for applying the FAA and set forth procedures "that must be followed to determine if [a section 41] claim is valid" ("LB&I Memorandum"). The LB&I Memorandum provides further insight into the IRS's refund claim review procedures and the claim perfection process (which LB&I extends from 30 days to 45 days) during the one-year transition period.
The LB&I Memorandum limits the section 41 refund claim perfection process to taxpayer claims timely filed during the transition period. Any claim filed in that period that includes a claim for section 41 credits, but with insufficient Foundational Information, triggers the perfection process. LB&I will issue to taxpayers with deficient section 41 refund claims a Letter 6428 (or Letter 6426C), Claim for Credit for Increasing Research Credit Activities - Additional Information Required, commencing the 45-day perfection period. If taxpayers thereafter fail to provide to the IRS sufficient Foundational Information-a determination requiring both LB&I management (i.e. a Territory Manager) and OCC concurrence-LB&I will issue a Letter 6430, No Consideration, Section 41 Claim to the taxpayer, informing the taxpayer that the claim will not be processed. LB&I does not consider a Letter 6430 to be a claim disallowance.
IRS webpage - FAQs
On 5 January 2022 (supplemented 8 February 2022), the IRS posted a Frequently Asked Questions (FAQ) page on its website with responses to several questions related to the FAA.
The FAQs offer guidance on the process for submitting the Foundational Information (including for pass-through entities) and address other "special circumstances" involving section 41 refund claims, providing that:
- In lieu of specific names, a taxpayer may identify the individuals who performed each research activity by listing their titles or positions. However, taxpayers may be asked to provide specific names upon the IRS's substantive review of their claims;
- If a group of individuals performed research activities and sought to discover the same information for a business component, the taxpayer may list all employees by name or title/position for that one business component and describe the information they aggregately sought to discover;
- If taxpayers use a statistical sample to compute their section 41 refund claim, the documentation for all units in the sample must contain all Foundational Information;
- The IRS will review each section 41 refund claim to determine whether taxpayers have included all Foundational Information;
- If the IRS does not receive all Foundational Information, the IRS will reject the entire claim for refund, notwithstanding that the refund claim may include other items;
- The IRS can only accept Foundational Information provided on paper or submitted through facsimile (i.e., the IRS cannot accept information provided through other forms, such as portable electronic storage devices);
- The IRS Independent Office of Appeals' resolution process is not available for section 41 refund claims rejected for inadequate Foundational Information;
- The IRS's goal is to make determinations on section 41 refund claims within six months of receipt; and
- The IRS will continue to review taxpayer feedback and will modify processes if necessary. Taxpayers can submit comments to email@example.com.
The IRS's guidance represents a significant (and potentially improperly promulgated) shift in administrative procedures. Taxpayers will now have to direct substantially more resources to preparing their section 41 refund claims, which, for many, will be cost prohibitive. Large corporate taxpayers, in particular, with numerous employees conducting qualifying activities for multiple business components must perform complicated and comprehensive contemporaneous or retrospective fact finding to satisfy the Foundational Information requirements.
The practical challenges are patent. Under a cost-benefit analysis, some taxpayers may simply choose to forego credits for their otherwise qualifying activities. The IRS's guidance, therefore, manufactures administrative obstacles that subtly undermine the section 41 credit regime.
The IRS's guidance will also inevitably lead to more refund litigation, shifting the IRS's administrative burdens to the DOJ, who litigate those cases on behalf of the IRS. Taxpayers, whose claims may not satisfy the Foundational Information requirements but otherwise "set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof," Treas. Reg. § 301.6402-2(b)(1), will justifiably test the IRS's position in court. Indeed, recent case law conflicts with the IRS's stated position in the FAA. In Premier Tech., Inc. v. United States, 2021 U.S. Dist. LEXIS 132700 (D. Utah 2021), which the FAA conspicuously relegates to a footnote ("The Service and Counsel are currently evaluating the opinion"), the United States District Court for the District of Utah rejected the IRS's argument that section 41 refund claims must include sufficient information to establish every section 41 element for every business component, stating:
the United States argues that the amended return is not sufficient because Premier did not attach additional documents addressing every single element in 26 U.S.C. § 41, such as describing the research conducted, explaining how that research worked to develop a business component, detailing on whose wages and what supplies the money was spent, and proving the amount spent on research in the prior three tax years. But the United States offers no authority for imposing such a requirement. Form 6765 does not ask taxpayers to provide any of these details. If the IRS wants more information about the research tax credits, the IRS could require that information on Form 6765. It does not, and the IRS cannot now say its own forms are not sufficient to constitute claims for refunds.
Premier highlights the fundamental inconsistency of the IRS's position. As of 10 January 2022, what is sufficient for claiming section 41 credits on a timely filed income tax return is, under the new guidance, insufficient for purposes of a refund claim. The IRS, therefore, incentivizes taxpayers to claim section 41 credits on their timely filed tax returns, rather than in refund claims, notwithstanding that the refund claims are often supported by better information and benefit from additional time and closer taxpayer review.
Taxpayers may also avoid the Foundational Information requirements by making section 41 overpayment claims in United States Tax Court proceedings. The Tax Court has jurisdiction to determine that taxpayers have overpaid tax in the taxable year under review. Section 6512(b)(1). Taxpayers who have received statutory notices of deficiency for other issues can, therefore, separately raise their section 41 claims in Tax Court petitions, which need only provide "fair notice of the matters in controversy and the basis" for the relevant positions. Rule 31 of the Tax Court Rules of Practice and Procedure. Accordingly, taxpayers in deficiency postures should reconsider their entitlement to section 41 credits and, if merited, plead their claims in their petitions without the onerous requirements of the FAA.
Going forward, taxpayers should, to the extent possible, make section 41 claims part of their timely filed income tax returns. If taxpayers must make section 41 refund claims, they should attempt to adhere to the IRS's Foundational Information requirements to avoid administrative headaches. Those taxpayers in deficiency proceedings should also re-evaluate whether they have valid section 41 claims that were not reported on their original income tax returns.
Nonetheless, the IRS's position and Foundational Information requirements have dubious legal foundation, and will either be amended or finally tested in court.