On Friday, October 15, 2021, the Internal Revenue Service (IRS) Office of Chief Counsel published a memorandum (the Memorandum) purporting to answer the question of what a taxpayer must include in a claim for refund relating to the I.R.C. § 41 Credit for Increasing Research Activities. The conclusions of the Memorandum, if followed, would represent a sea change in the IRS's approach both to research credit refund claims and to the research credit more broadly.

First, the Memorandum concludes that for a research credit refund claim to be valid, the claim itself must "identify all the business components to which the I.R.C. § 41 research credit claim relates for that year." Memorandum at 21. Then the Memorandum asserts that, for each identified business component, the claim must "identify all research activities performed; identify all individuals who performed each research activity; and identify all the information each individual sought to discover." Id. Finally, the Memorandum indicates that the claim must "provide 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)." Id.

The last purported requirement should come as no surprise, as it directs taxpayers to provide the information required on Form 6765, the form on which a credit is claimed in the first place. However, the other requirements go far beyond what courts mandate and demand a level of detail that conceivably could stretch into the thousands of pages. The Memorandum cites no authority for the other requirements, and mandating the provision of more information than what Form 6765 calls for could "lead to absurd and patently unfair results for taxpayers." Premier Tech, Inc. v. United States, No. 2:20-CV-890-TS-CMR, 2021 WL 2982064 (D. Utah July 15, 2021). In Premier Tech, a federal district court recently rejected the government's assertion that a taxpayer must include in every Section 41 refund claim "additional documents addressing every single element in [Section 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." Premier Tech, 2021 WL 2982064 at 4. The court observed that Form 6765 does not ask for any of those details, and "if the IRS wants more information about the research tax credits, the IRS could require that information on Form 6765." Id. The Memorandum acknowledges the existence of this authority and says that the IRS is "currently evaluating the opinion." Memorandum at 11, fn. 27.

The Memorandum also does not address what a taxpayer who used a valid statistical sample under Rev. Proc. 2011-42 must produce. By definition, one who uses sampling only has the supposedly necessary information for units in the sample and then extrapolates from that to the rest of the population.

Second, the Memorandum notes that the IRS may waive its right to treat a claim as deficient if it proceeds to examine the merits of the claim. Thus, it encourages agents not to begin the process of auditing a Section 41 claim and to reject it as deficient unless the claim, as filed, contains the information described above. See Memorandum at 21 ("Rejecting a deficient refund claim before initiating an audit (or otherwise actively considering the refund claim on its merits) is recommended and should eliminate the likelihood that a court will find the Service waived the specificity requirement under Treas. Reg. § 301.6402–2(b)(1).").

Finally, in discussing the application of the four-part test that activities must satisfy to be eligible for the Section 41 credit, the Memorandum adopts the language of the Tax Court's recent Little Sandy Coal decision. Little Sandy Coal v. Commissioner, T.C. Memo. 2021-15 (2021). There, the Tax Court determined that a taxpayer must be able to demonstrate quantitatively that 80% or more of its research activities with respect to a business component constitute a process of experimentation (the fourth part of the four-part test) and that work performed by those directly supervising or directly supporting research may not be included in the numerator of the fraction used to compute the 80%, even though such activities may qualify for the credit if the test is met. Predictably, the Memorandum adopts the extremely commissioner-friendly view in that Tax Court Memorandum decision, but we believe the court's analysis of the treatment of support and supervision activities is incorrect based on a careful reading of the regulatory language. However, until that erroneous conclusion is challenged successfully in court, taxpayers should expect the IRS to follow it in research credit examinations.

The Memorandum appears to augur a new level of aggressiveness by the IRS in challenging research credit refund claims. An accompanying IRS Release indicated that the "IRS will provide a grace period (until January 10, 2022) before requiring the inclusion of this information with timely filed Section 41 research credit claims for refund." IR-2021-203 (Oct. 15, 2021). Taxpayers who are unable to submit claims prior to that date will have to consider carefully whether they will go to the time and expense of preparing Section 41 refund claims with the extensive information purportedly required so that their exam teams will review their claims, or whether they are willing to have their claims rejected for supposed procedural deficiencies and to address the issue with IRS Appeals (which may be reluctant to consider the merits of the claim if the Exam Team relied on the Memorandum and did not develop the underlying facts) or in court.

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