Getting notified that the Internal Revenue Service is going to audit your research and development (R&D) tax credit claim, can be an unsettling experience. Even if your team worked hard to follow the many rules and regulations, it is possible that something was missed. Additionally, it can be hard to decide exactly which documents the IRS needs to accept the amount computed. Because these audits can produce such uncertainty and stress, tax and finance leaders will be in a significantly better position if well prepared before the IRS auditors get in touch.
#1: Determine the Methodology You Will Use to Secure the R&D Credit
Remember — no one knows more about what you do than you. With that thought in mind, the first step is to determine which projects and activities would qualify for the credit and what records you have to prove it. The agent may or may not understand your industry and will seldom ever have knowledge of your precise business. Try to look at your business through their eyes, remembering that they’re an outsider to the company. Imagining yourself in their shoes will help you develop a more specific methodology for how to organize yourself and document operations. Determine what information and type of documentation is necessary to prove what you’re doing, then create a reliable ongoing system to gather, update and maintain that data.
#2: Prepare a Brief Company and R&D Function Overview
An auditor will likely appreciate a brief overview of your business and how you conduct qualifying research. The first thing an agent needs to understand and believe is, yes, it is reasonable to believe this taxpayer would conduct research. This can include a more detailed presentation on how you put your R&D study together. If this step is thorough and logically explains the steps taken to calculate the credit, there is more chance the IRS will audit the study as prepared as opposed to imposing its own audit plan.
#3: Prepare a List of R&D Projects with Qualifying Tasks
Once the auditor understands your company, they will want to review documentation on a project-by-project basis to identify the activities that qualify for the tax credit. Include projects that qualify and projects that don’t qualify on your list. This effort will show you didn’t arbitrarily include every project as qualifying for the credit.
Finally, identify the subset of qualified activities in which employees perform, directly supervise, or directly assist in research. This subset of activities represents the only activities you can include in the R&D tax credit calculation. Other tasks, such as administrative support, budgeting, training, and attending conferences are not eligible because they don’t involve performing, supervising, or assisting with research tasks.
#4: Use Your Product Development Process to Organize Documentation
One of the best ways to organize the information that auditors need and present it in a consistent format for each project is to use your formal product development process as the framework. Each step of the process — from idea generation to commercial production — should contain the notes, diagrams and other documentation that help determine qualifying activities.
Once you have a list of potentially qualifying projects and activities, it’s time to start quantifying your credit by associating expenses accordingly. Examples of expenses that you can quantify include the following:
- Employee wages
- Supplies directly related to the research
- Third-party research that meets certain criteria
#5: Map Employees’ Time to Projects and Activities
In an ideal world, you will have a timekeeping system in place similar to what you might find in an accounting, consulting, or law firm. Employees code their time to projects and within projects to codes that enable you to separate qualifying and non-qualifying activities. If you don’t have such a system, then you need a method for allocating specific employees’ time to qualified activities. Remember the “best” time to do this is throughout the year as research is being conducted or at least soon after year-end. Even after the fact, you can develop and conduct surveys to capture qualifying time spent. Besides using this information for calculating qualifying wages, this supplements your hard documentation created and saved during the research process.
#6: Show the Wages for Qualified Activities for Each Project
Linking qualified activities to individual employee time makes calculating qualifying employee wages simple. For each person, add the time spent on qualifying activities and divide that by their total working time to get an allocation percentage. Then multiply the allocation percentage by their gross federal taxable wages (W-2, Box 1) to get each person’s contribution amount. The sum of the contribution amounts is the total wage qualified research expense.
#7: Gather Expenses for Supplies
The only supplies you can include are ones your team directly uses in the research activities. These expenses might be associated with individual projects or could potentially be aggregated across all R&D projects. The total expense is typically a small portion of the overall claim.
#8: Collect Third-Party Research Contracts and Agreements
If you pay a third party to conduct research, then you can expect an auditor to review the contracts and agreements you have in place with these organizations. Auditors need to ascertain that
- Expenses are for qualified research activities,
- Third parties get paid, whether the research succeeds or fails,
- The taxpayer retains sufficient rights to the research,
- All research is performed in the United States, and
- Only 65 percent of the contract research expenses are claimed for the tax credit.
Benefits of Being Prepared
There are many advantages to being prepared for an R&D audit with the IRS. You’ll make a strong first impression with the audit team, be in a position to discuss potential audit approaches the IRS can easily use and ensure you have sufficient documentation to substantiate your claimed amount. Perhaps most important, excellent preparation will ensure the IRS sustains your research credit, which will ultimately turn uncertainty into confidence for future audits.
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.