Many businesses attempting to claim research tax credits find themselves navigating complex documentation requirements. No matter what documentation is provided, the IRS is not likely to accept it. The IRS will always ask for more.
But what happens when a taxpayer undergoes an extensive IRS audit of their research credit claim? Can the IRS later assert that the original filing was not detailed enough and prevent the taxpayer from having their day in court on the credits?
The recent case of Harper v. United States, 847 Fed.Appx. 408 (9th Cir. 2021), addresses this question by examining whether the IRS waived the specificity requirement for taxpayers claiming research credits after conducting a four-year audit of their claim.
Facts & Procedural History
The Harpers are individual taxpayers who filed amended tax returns claiming research tax credits under Section 41 for tax years 2008 and 2010. The Harpers submitted Form 6765 (Credit for Increasing Research Activities) along with their amended returns to request refunds based on qualified research activities.
The IRS pulled the Harpers’ returns for audit and conducted an extensive four-year investigation. During this process, the IRS requested specific information about the taxpayers’ research activities, including their project accounting methods, calculation of qualified research expenses, and allocation of employee time to research projects. The taxpayers responded by providing over 100,000 pages of documentation to support their claim.
After completing its review, the IRS denied the refund claim, stating the taxpayers had “not shown you are entitled to the claimed refund” and informing them they could challenge the determination by filing suit in district court. The Harpers subsequently filed their lawsuit in the United States District Court for the Southern District of California.
On request of the IRS, the district court dismissed the case, ruling that the taxpayers had failed to satisfy the specificity requirement in Treasury Regulation § 301.6402-2(b)(1). The court also denied their motion for reconsideration. The taxpayers appealed to the Ninth Circuit Court of Appeals.
Understanding Section 41 Research Credits
Section 41 of the tax code sets out the rules for the research tax credit. This credit rewards taxpayers for increasing their investment in qualified research expenses in the United States. In a way, it is a U.S.-jobs credit. It is intended to save the highly-paid technical design jobs that would otherwise be offshored.
To qualify for the research credit, activities must meet several criteria. Congress set out a number of rules for this. So too has the IRS.
The cryptic but short version is that there must be research activities undertaken to discover information that is technological in nature, and the application of that information must be intended to develop new or improved business components. The research must also involve a process of experimentation to eliminate uncertainty.
If the prior paragraph does not make sense, don’t fret. These are terms of art and vocabulary that is unique to the research tax credit. One can basically replace them all with the concept that the taxpayer has to design something and it has to involve the hard sciences, such as engineering, chemistry, computer science, etc.
What Is the Specificity Requirement?
This brings us to the specificity requirement. Before a taxpayer can file a lawsuit seeking a tax refund, they must first file an administrative claim with the IRS. The claim has to meet certain requirements.
This is set out in Treasury Regulation § 301.6402-2(b)(1) which states that “”the claim must 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.”
This requirement serves several important purposes. It ensures the IRS has adequate notice of each claim and its underlying facts, allows the agency to conduct an effective administrative investigation, and prevents surprise in subsequent litigation.
As the Ninth Circuit explained in Boyd v. United States, the specificity requirement exists “to prevent surprise, and to give the IRS adequate notice of the claim and its underlying facts so that it can make an administrative investigation and determination regarding the claim.”
The requirement comes up when taxpayers, like the ones in this case, file suit to recover a tax refund. The IRS can ask that the litigation be dismissed because the specificity requirement was not met.
How Can the IRS Waive the Specificity Requirement?
While filing an administrative claim is a jurisdictional prerequisite under I.R.C. § 7422, the courts have recognized that the IRS can waive enforcement of the specificity requirement in certain circumstances.
In the landmark case Angelus Milling Co. v. Commissioner, the Supreme Court said that the Commissioner may choose “not to stand on his own formal or detailed requirements” by substantively examining a taxpayer’s claims. However, for a waiver to be effective, there must be an “unmistakable” showing “that the Commissioner has in fact seen fit to dispense with his formal requirements and to examine the merits of the claim.”
What does this mean? And what constitutes an “unmistakable” showing? Courts have looked at whether the IRS actually investigated the specific factual and legal basis of the claim being asserted, rather than dismissing it on procedural grounds. So if the IRS actually does an audit and investigates the claim, it cannot come back and say that the original refund claim submitted does not meet the specificity requirement. The result is that the court does not dismiss the taxpyaer’s refund suit.
The Ninth Circuit’s Analysis in Harper v. United States
This gets us to the Harper case. In Harper, the Ninth Circuit had to determine whether the IRS’s extensive audit constituted a waiver of the specificity requirement. The court found several factors that supported finding a waiver.
First, over the course of the four-year audit, the IRS targeted its questioning and document requests specifically on determining the taxpayers’ eligibility for research credits. The investigation covered their project accounting practices, the methods used to identify qualified research expenses, the breakdown of business components, compliance with the “substantially all” rule, and the allocation of employee salaries.
Second, the IRS received and reviewed multiple responses and extensive documentation from the taxpayers, including over 100,000 pages of supporting materials. This demonstrated that the IRS had a clear understanding of the basis for the taxpayers’ claim.
Third, the IRS ultimately made a determination on the merits of the claim rather than rejecting it for procedural deficiencies. The agency’s communication informed the taxpayers of the availability of recourse by filing suit in district court, which the court viewed as “a strong indication of the IRS’s understanding that it was making a substantive determination.”
Based on these factors, the Ninth Circuit concluded that the IRS’s actions demonstrated an “unmistakable” waiver of the specificity requirement. The court explained that the IRS’s targeted investigation and final determination showed that it understood the taxpayers’ claims and “the exact basis thereof,” had “adequate notice of the claim and its underlying facts,” and had chosen “not to stand on its own formal or detailed requirements.”
The Takeaway
The Harper case is significant. It confirms that when the IRS undertakes a substantive examination of a claim’s merits, it may waive formal specificity requirements through its conduct. This means that even if a taxpayer’s initial refund claim lacks some technical details, the IRS’s decision to investigate the claim thoroughly may prevent it from being dismissed later on procedural grounds. This provides taxpayers with a potential path forward when facing technical challenges to refund claims that have undergone substantial IRS review.
