The Internal Revenue Service today warned taxpayers to avoid improperly claiming various business tax credits, a common scam used by unscrupulous tax preparers.

Two credits often targeted for abuse by shady tax return preparers are the Research Credit and the Fuel Tax Credit. Each of these credits has specific eligibility criteria.

Each year, the IRS publishes its “Dirty Dozen” list of common scams that taxpayers may encounter any time. These can peak during the tax filing season as people prepare their tax returns or hire others to help with their taxes.

To combat these scams, the IRS warns people to watch out for suggestions to make improper claims on their tax return. Selecting a reputable tax professional can also help. The IRS reminds taxpayers that they are responsible for the information on their tax return no matter who prepares it.

Research Credit scams

Section 41 of the Internal Revenue Code provides a credit for increasing research activities, commonly known as the Research Credit. Congress enacted the credit in 1981 to provide an incentive for American private industry to invest in research and experimentation.

Improper claims for this credit generally involve a failure to participate in or substantiate qualified research activities and/or a failure to satisfy the requirements related to qualified research expenses.

To get the credit, a taxpayer’s research activities must, among other things, involve a process of experimentation using science with a goal of improving a product or process the taxpayer uses in their business or holds for sale, lease, or license. Activities specifically excluded from qualifying for the credit include research after commercial production, adaptation of an existing business product or process, foreign research and research funded by the customer. Qualified research activities also do not include activities where there is no uncertainty about the taxpayer’s method or capability to achieve a desired result.

The IRS often sees expenses for nonqualified activities included in claims for the Research Credit. In addition, qualified research expenses include only in-house wages and supply expenses and a portion, typically 65 percent, of payments to contractors. Qualified research expenses do not include expenses without a proven nexus between the claimed expenses and the qualified research activity.

Steps to properly claim the Research Credit

Eligible taxpayers may claim up to 20 percent of qualified expenses above a base amount by completing and attaching Form 6765, Credit for Increasing Research Activities, to their tax return. For tax years beginning in 2016, eligible small businesses may use the Research Credit to offset the alternative minimum tax. Also, qualified small businesses may elect to use a portion of the Research Credit as a payroll tax credit against the employer’s portion of the Social Security tax. They make this election on Form 6765 and must complete and attach Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, to their Form 941, Employer’s Quarterly Federal Tax Return.

To claim the Research Credit, taxpayers must evaluate and document their research activities contemporaneously (that is, over the period of time in which the research occurs) to establish the amount of qualified research expenses paid for each qualified research activity. While some expenses may be estimated, taxpayers must have a factual basis for the assumptions used to create the estimates.

Unsupported claims for the Research Credit may subject taxpayers to penalties. Taxpayers should carefully review any reports or studies prepared by third parties to ensure they accurately reflect their activities. Third parties who are involved in the preparation of improper claims or research credit studies also may be subject to penalties

Fuel Tax Credit scams

The Fuel Tax Credit is generally limited to off-highway business use or use in farming. For that reason, it is not available to most taxpayers. Still, the IRS routinely finds unscrupulous tax return preparers who have enticed sizable groups of taxpayers to inflate their refunds by erroneously claiming the credit.

Improper claims for the fuel tax credit generally come in two forms. First, an individual or business may make an erroneous claim on their otherwise legitimate tax return. Second, identity thieves file bogus claims, often as part of a broader fraudulent scheme.

The IRS has stepped up efforts to improve Fuel Tax Credit compliance. IRS processing systems, including new identity theft screening filters, are now stopping a significant number of questionable Fuel Tax Credit refund claims.

Fraud involving the Fuel Tax Credit is considered a frivolous tax claim and can result in a penalty of $5,000.

Additionally, illegal scams can lead to significant penalties and interest and possible criminal prosecution. IRS Criminal Investigation works closely with the Department of Justice to shutdown scams and prosecute the criminals behind them.

Properly claiming the Fuel Tax Credit

The federal government taxes gasoline, diesel fuel, kerosene, alternative fuels and certain other types of fuel. Certain commercial uses of these fuels are nontaxable. Taxes paid for fuel to power vehicles and equipment used off-road may qualify for the credit and may include farm equipment, certain boats, trains and airplanes. Individuals and businesses that purchase fuel for one of those purposes can claim the credit by filing Form 4136, Credit for Federal Tax Paid on Fuels.