A few months ago the IRS released an internal field advice memorandum (FAA 20214101F) that outlined the information that must be included in a valid Section 41 refund claim. The Field Advice added specific rules for these claims, including extensive documentation requirements that practitioners have noted will lead to significant costs. Failing to comply with the procedures risked the IRS treating the claim as deficient, with the IRS effectively deeming the claim as failing to satisfy the regulatory requirement that a claim “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.”
Practitioners have raised concerns with these special procedures, including that an IRS decision that a refund claim is deficient arguably can not be challenged in a traditional refund suit in federal district court or the Court of Federal Claims.
We have talked a great deal in this blog about credits, but mostly the kind that individuals can claim. Yet Section 41 provides a substantial benefit for businesses that engage in qualified research and development activities (For a brief article summarizing the R&D credit, see Karen Koch R&D tax credits: A valuable cash infusion for businesses, from the Tax Adviser).
The Field Advice addressing Section 41 refund claims generates some interesting procedural issues. The requirements for submitting a valid refund claim are based in statute, regulations and caselaw. For example, Section 6402 itself authorizes the IRS to credit an overpayment against any liability and if there is any overpayment that exceeds that liability (or other mandatory offsets) then refund the balance to the taxpayer.
There are extensive regulations under Section 6402 that flesh this out, including rules that specify how a taxpayer makes a refund claim, when the claim may be filed, what forms may be used, the location for filing, and signature requirements. In addition, Section 7422 requires that prior to bringing a refund suit, a taxpayer must have “duly filed” a claim according to “the provisions of law…and the regulations of the Secretary established in pursuance thereof.”
There is a vast body of caselaw that fills in the gaps, including cases analyzing 1) the context specific application of the regulatory requirement that the claim set forth in sufficient detail the grounds for the refund, 2) the informal claim doctrine which can act to revive deficient claims if the originally deficient claim was in writing, identifies the period, and provides the basis for the overpayment to allow the IRS to examine the claim, and 3) whether the IRS can waive some of the requirements associated with refund claims (for readers who want more on the nuances of these and other aspects of refund claims, I suggest Chapter 11 of Saltzman and Book IRS Practice & Procedure, where my colleague Marilyn Ames and I discuss these issues in detail).
The IRS’s additional requirements for Section 41 claims have generated backlash, with concern that about costly upfront burdens and a limited opportunity to challenge IRS claim sufficiency determinations. In addition, practitioners have noted the unusual approach of effectively modifying regulatory requirements with an internal nonbinding agency memo that skipped a formal notice and comment procedure that would have allowed for meaningful practitioner and taxpayer input (though there was an informal comment period following the Fall 2021 release of the Field Advice). See, for example, a legal alert from Eversheds Sutherland, An apparent 180 degree turn by the Service with research credit claims.
The IRS approach to essentially modifying regulatory requirements with a Field Advice and FAQs does seem unusual. Why did IRS add these special rules for a particular type of refund claim? This National Law Review article from last fall situates the IRS concern about shoddy R&D claims based merely on estimates rather than specific activities or components that constituted qualifying research:
These estimated claims arguably placed the IRS in a no-win situation. Without a meaningful factual statement of the claim, the IRS could not evaluate whether it should expend scarce resources to actively audit the claim or merely review and pay it. The IRS asserts that it receives thousands of such estimated claims.
A January 6, 2022 ABA Tax Section comment letter on the new Section 41 claim process recognized the Service’s interest in managing its resources but suggested that the best way to strike the balance between the agency and taxpayer rights would be to issue proposed regulations that would allow for a comment period and IRS formal engagement with taxpayer and practitioner concerns. The ABA Tax Section comment letter raises some interesting procedural questions, including 1) whether courts should give Auer deference to the memo’s interpretation of the 6402 regs’ specificity requirement and 2) how taxpayers can challenge an IRS determination that a claim was deficient. The comment notes that the new process’ failure to spell out how taxpayers can challenge the IRS’s decision that a return is deficient could “run afoul” of the taxpayer right “to raise objections and provide additional documentation in response to formal IRS actions or proposed actions, to expect that the IRS will consider their timely objections and documentation promptly and fairly, and to receive a response if the IRS does not agree with their position.”
Given the significance of this issue and many well-resourced claimants, I suspect that there will be litigation about the process. The National Law Review article from last fall notes that there is the potential avenue for a taxpayer to seek an injunction and in light of the Supreme Court’s CIC Services opinion that a challenge such a suit would likely survive the Anti-Injunction Act.
It seems likely that to head off some (but not all) procedural challenges, IRS should promulgate regulations. That, of course, could generate differing challenges, including questions of Chevron deference and whether the agency adequately responded to comments. It also would generate OIRA consideration of estimated costs and benefits and alternate solutions suggested in public comments, which, given the reaction to these rules, might lead to a better balance between the IRS’s concerns with resource issues and taxpayer concerns with excessive burdens.