California Follows IRS Guidance for LB&I Taxpayers with Section 41 Research Credit Expenses

February 2018

Summary

On September 11, 2017, the IRS issued a Directive to Large Business & International (LB&I) Division examiners providing guidance for Internal Revenue Code (IRC) Section 41 examinations (LB&I-04-0917-005). The purpose of the Directive was to provide an efficient manner of determining qualified research expenses (QREs) for LB&I taxpayers that meet the Directive’s eligibility requirements and to more efficiently manage LB&I’s audit resources. On February 1, 2018, the Franchise Tax Board (FTB) announced that California will follow the IRS Directive.
 

Details

IRS Directive
The Directive applies only to taxpayers (1) whose assets equal or are greater than $10,000,000, (2) who follow U.S. GAAP to prepare their Certified Audited Financial Statements, and (3) who show the amount of their currently expensed ASC 730 R&D costs as a separate line item on their income statement or separately stated in a note. If such taxpayers comply with the Directive’s certification requirements, LB&I examiners will not challenge the QREs which are the Adjusted ASC 730 R&D costs.

For more information on this “safe harbor,” check out our R&D Tax Alert from October 2017 .  

FTB’s Position
For LB&I taxpayers that meet the IRS Directive’s requirements and file a California tax return, the FTB will use GAAP expenditures for the calculation of the California Research Tax Credit (CRTC).

During a CRTC audit, LB&I taxpayers following the IRS Directive must provide a copy of the completed and signed Certification Statement filed with the IRS and disclose all ASC 730 in-house R&D expenses performed outside of California. In addition, LB&I taxpayers must make an adjustment to the federal “safe harbor” when computing the CRTC by subtracting all in-house and contract expenses performed outside of California from the calculation of Adjusted ASC 730 R&D costs.

The FTB may also request other relevant documentation to support the credit, such as documentation for any expenses included in the credit in excess of the “safe harbor” and information necessary for the calculation of the credit.
 

BDO Insights

LB&I taxpayers have already begun implementing the IRS Directive for 2017 at the federal level and are seeing the benefits from streamlining QRE identification, improving financial statement benefits, and managing audit risk. Therefore, LB&I taxpayers who file a California tax return should:
  • Assess whether the Directive approach to determining QREs would be beneficial compared to their current approach both at the federal and California state levels starting with the 2017 tax year;
  • Consider whether they can efficiently comply with the Directive requirements given their current operations and processes surrounding the necessary accounting and HR records required, and if not, whether they should invest the resources to do so; and
  • Ensure they are still maximizing the identification and documentation of the additional QREs allowed outside of the Directive as a part of their credit claims.
 

For more information, please contact one of the following regional practice leaders: 
 
Chris Bard
National Leader
Los Angeles
 
  Jonathan Forman
Principal
New York
 

 
Jim Feeser
Managing Director
Philadelphia
 
  Chad Paul
Partner
Milwaukee
 

 
Patrick Wallace
Managing Director
Atlanta
 
  David Wong
Partner
Los Angeles
 

 
Laura Morris
Managing Director
San Francisco
 
  Brad Poris
Managing Director
Long Island
 

 
Joe Furey
Managing Director
Chicago
 
  Sanjiv Gaitonde
Senior Manager
Houston
 

   
Gabe Rubio
Managing Director
Los Angeles