December 6, 2024

Recent administrative guidance hints at tax accounting priorities heading into 2025

Anna Hargett Awad, Kristen Martin, Ellen McElroy, Michael Resnick

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Eversheds Sutherland (US) LLP

IRS LB&I has updated several pieces of administrative guidance, including a notice regarding the transition period for complying with increased substantiation requirements for research credit refund claims and two practice units covering (1) use of the completed contract method of accounting (CCM) for land developers and subcontractors (the CCM practice unit) and (2) section 263A for producers (the 263A practice unit). These updates may signal certain LB&I priorities heading into the new year.

Grace period extended to perfect R&D credit refund claims

In October 2021, the IRS issued a chief counsel memorandum (the FAA)¹ which set forth five specific and extensive documentation requirements that must be satisfied in order for a research credit refund claim to be considered valid, in part motivated by a growing IRS concern that taxpayers may be filing research credit claims lacking adequate support. Earlier this year, on June 18, 2024, the IRS reduced the requirements under the FAA to three items.² Under the modified documentation requirements, taxpayers must (1) identify all business components, (2) identify research activities performed for each business component, and (3) provide total qualified employee wage expenses, total qualified supply expenses, and total qualified research expenses for the refund claim year on Form 6765, Credit for Increasing Research Activities. The IRS initially granted a one-year transition period during which taxpayers would have 45 days to perfect a research credit refund claim to comply with the documentation requirements before the IRS issues a final determination on the claim.

On November 25, 2024, the IRS announced that it is extending the research credit claim transition period. This is the third time the IRS has extended the transition period, which was originally set to expire on January 10, 2023, and is now set to expire on January 10, 2026.

Eversheds Sutherland observation: The extended grace period grants taxpayers additional time to acclimate to the IRS’s increased reporting requirements, while also providing the IRS more time to make the requisite updates to its form and instructions. The substantiation requirements under the FAA and the IRS FAQs far surpass the substantiation required under the IRS’s current regulations, which have been in place for more than 20 years. Accordingly, the current Form 6765 neither requires, nor provides space for, the extensive documentation now being required by the IRS. Consequently, the IRS has been working on updating its Form 6765 and instructions to comport to its current position regarding the substantiation required with respect to research credit claims.

Eversheds Sutherland observation: While the revised Form 6765 is expected by year-end, the IRS has not yet released draft instructions to accompany the updated form. The IRS had released an earlier draft Form 6765 in September 2023 to address the heightened requirements of the FAA. However, after receiving significant taxpayer feedback, the IRS released an updated draft this past June that reflects the modified documentation requirements. Draft instructions did not accompany the release of either draft form. Rather, they are expected to be released, along with a request for feedback, in 2025. Final instructions are expected in January 2026, when the transition period is now set to end. See our previous alert for more details on the project to update Form 6765.

Eversheds Sutherland observation: Over the past few years, commenters and stakeholders alike have requested the IRS issue proposed regulations regarding the substantiation requirements rather than implementing its policy shift through sub-regulatory guidance, such as FAQs, a revised Form 6765 and accompanying instructions. The hope is that the required notice and comment period could generate meaningful discussion between the IRS and stakeholders.

Updated practice units could signal forthcoming examination activity for construction industry and manufacturers
On November 19 and 22, 2024, respectively, the IRS LB&I division released updated practice units on: (1) use of the Completed Contract Method (CCM) under section 460 for land developers and subcontractors; and (2) section 263A for producers. Practice units are job aids and training materials developed collaboratively by IRS staff and used to guide IRS examination teams on particular topics. For example, practice units may provide explanations of general tax concepts or information about specific types of transactions.

Eversheds Sutherland observation: According to the IRS, practice units evolve as the compliance environment changes and new insights and experiences are contributed.³ While practice units may not be relied upon as authoritative tax law, they can provide helpful insight into how the IRS might view a particular issue and positions that could be taken on examination. An updated practice unit often signals that increased examination activity can be expected.

The CCM practice unit

The updated CCM practice unit corrects cites to section 460 to comport to the Tax Cuts and Jobs Act’s modifications to paragraph (e). In the practice unit, the IRS doubles down on its long-held position that the CCM is not available with respect to land developers’ long-term contracts. Specifically, the unit distinguishes activities performed under home construction contracts, which are eligible to use the more favorable CCM, from activities performed by land developers and the subcontractors they hire to construct common improvements, which generally must use the less favorable percentage of completion method.

Because the CCM generally allows for the deferral of income recognition, land developers and subcontractors working on common improvements often attempt to apply the CCM when developments or common improvements relate to homes that are being constructed. However, the practice unit reinforces the IRS position, which has been upheld by both the Tax Court⁴ and the Fifth Circuit,⁵ that the CCM is not available to land developers and subcontractors that do not actually construct homes.

The 263A practice unit

To round out the trifecta of updated administrative guidance, the 263A practice unit no longer references pre-1986 (i.e., pre-section 263A) law related to identifying section 471 costs. Curiously, the updated practice unit fails to address the final section 263A regulations released in November 2018.

Eversheds Sutherland observation: The updated practice units may indicate the IRS is increasing enforcement efforts in these areas. Alternatively, the updated practice units may signal that IRS examination teams have encountered specific issues in the field impacting these areas. Of course, the updates also could simply be part of a pro forma review to update citations and remove old law.

Eversheds Sutherland observation: The 263A practice unit update would have been more valuable and provided greater insight into issues important to producers if it had been updated to address the final regulations issued in November 2018, generally addressing the definition of section 471 costs and the new modified simplified production method, rather than merely deleting old law. It is possible the IRS removed reference to pre-section 263A law to distance the determination of section 471 costs under section 263A from the case law and regulations relied upon before section 263A was enacted, which generally granted more flexibility in determining inventoriable costs.

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¹ FAA 20214101F (Oct. 15, 2021).
2 See FAQs, Q&A 21, available at https://www.irs.gov/businesses/corporations/research-credit-claims-section-41-on-amended-returns-frequently-asked-questions (last accessed 10/29/2024).
3 INTERNAL REVENUE SERVICE, Practice Units (Dec. 2, 2024), available at https://www.irs.gov/businesses/corporations/practice-units.
4 Howard Hughes Company, LLC v. Comm’r, 142 T.C. 355 (2014).
5 Howard Hughes Company, LLC v. Comm’r, 805 F.3d 175 (5th Cir. 2015).

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