Look no further than the COVID-19 pandemic to appreciate the magnitude of the impact that research and development by private-sector companies can have on our economy and our society. To encourage private-sector organizations to continue to invest in R&D, Congress created the Credit for Increasing Research Activities, commonly known as the R&D tax credit.
If you’ve been involved in calculating the R&D tax credit, you’re probably very familiar with the four-part test Congress established to determine which R&D activities qualify. What you might be less familiar with are some of the reasons the IRS has given to disallow R&D credits during an audit.
Here’s a summary of 5 of the most common objections the IRS raises when auditing companies.
1. Process of Experimentation
The failure to meet this requirement is a common reason for disallowing R&D credits. Two recent cases, Siemer Milling Company v. Commissioner and Suder v. Commissioner (the former a win for the Service, the latter taxpayer favorable), provide valuable insight into the process of experimentation testing. While a comprehensive analysis is beyond this article’s scope, the key takeaway is that a process of experimentation requires “systematic trial and error;” a process involving “simple trial and error” is generally not sufficient.
So, what is the difference? Systematic trial and error is an organized product development process characterized by the formation of a hypothesis before experimentation and testing. By contrast, simple trial and error requires no hypothesis, focusing on finding a solution to a problem by trying many possible solutions based on “hunches” or “guesses” and learning from mistakes until a viable solution is found.
For example, taxpayers who claim research for manufacturing and process improvement activities (e.g., continuous improvement, Kaizen, etc.) often do their research “on-the-fly” and/or in the manufacturing environment. This type of research frequently does not necessarily follow a structured process and, as a result, will have a tougher, but not necessarily impossible, substantiation hurdle.
Properly documenting the steps of your product development process is therefore very important for establishing a process of experimentation. If you can substantiate a formal development process, the IRS then shifts its inquiry to whether you undertook the experimentation to resolve a technical uncertainty that existed at the beginning of the project.
2. Exclusion for Research after Commercial Production
Activities conducted after commercial production of a business component has begun are not qualified research. Applying this exclusion is often challenging since there is no bright-line test for when a product is ready for commercial production or when a manufacturing process is no longer being improved.
For example, a typical fact pattern involves activities related to improving the functionality or performance of existing products. Because the products are commercially available in the marketplace, IRS auditors will often conclude that the exclusion applies.
To overcome the exclusion, you must at a minimum be prepared to show that the activities performed were undertaken to significantly improve the function and performance of an existing business component.
3. Adaptation of an Existing Business Component
Activities relating to adapting an existing business component to a particular customer’s requirement or need are not qualified research. Many taxpayers invest in developing products for an initial customer which they intend to add to a general product line. While the regulations clarify that the exclusion does not apply simply because a business component is being built for a specific customer, the key inquiry is whether a new or improved functionality, performance, reliability, or quality is being developed or if the activity is merely configuring an existing product for a subsequent customer.
4. Significant Economic Risk Test for Internal Use Software
Besides meeting the traditional four-part test for R&D, work related to developing internal use software must meet three additional requirements (collectively known as the “high threshold of innovation test”). The significant economic risk test is one of those additional requirements and involves, as the name suggests, demonstrating that software development activities involved significant economic risk. For example, you committed substantial resources to development and, due to technical risk, there is considerable uncertainty that those resources will be recovered within a reasonable period.
What makes this test challenging is the degree of technical risk required. Unlike the technical uncertainty requirement under the four-part test, demonstrating design uncertainty will rarely — if ever — be sufficient to meet the technical risk requirement under the significant economic risk test. Technical risk requires the taxpayer to demonstrate either methodology or capability uncertainty.
Although the bar is high, the following four factors may assist you in meeting this requirement: 1) the size and complexity of the project; 2) whether the software provides functionality not offered in other software; 3) whether your company attempted to employ existing technology in a new and dynamic way; and 4) whether you considered and accounted for the technical risk in funding and monitoring the progress of the software system development activities.
5. Substantiation and Recordkeeping
The R&D Audit Techniques Guide explains that a taxpayer must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit (see I.R.C. § 6001; Treas. Reg. § 1.6001-1). Failure to maintain records under these rules is a basis for disallowing the credit. Given the lack of any specific recordkeeping requirements, the issue of substantiation is one that is difficult for both taxpayers to comply with and for IRS auditors to enforce.
Case law clarifies that the use of testimony and reasonable estimates are both permissible. However, the issue often boils down to a matter of degree. As a general rule to meet the substantiation requirement, you must have some combination of documentation and testimony to demonstrate both qualified research activities and estimate qualified costs. Reliance solely on testimony without any supporting contemporaneous documentation will generally not be sufficient. As an IRS auditor once told me, “You can use testimony to fill-in the potholes but not to pave the entire road!”
Obtaining an R&D credit can mean that the cost of innovating and staying competitive stays more reasonable for your company. Be proactive about passing the four-part test and commit to strategies that reduce the odds that you’ll fall prey to the most common objections. Do this well and you’ll likely feel much more confident — not just about the audit process, but about reaching bold short- and long-term goals, too.
Peter Mehta, J.D., LL.M, is TCC’s Managing Director and National Service Leader for our R&D Tax Credit practice. With over 20 years of tax experience with the Big 4 and a law firm, Peter has significant expertise with R&D tax credit matters and federal and state practice and procedure issues.