I think it appropriate that this week’s article is part 3 of the series, and we are discussing the Process of Experimentation.
Why?
Because the documentation of this test involves three parts; namely, the uncertainties, alternatives and process related to the development of a new or improved business component.
If you missed the article from last week, we reviewed documentation problems and solutions for technical uncertainty (see Problems & Solutions Documenting Technical Uncertainty). While this is one component of our discussion today, the IRS and Treasury believe taxpayers must document more than uncertainties to qualify for R&D tax credits.
Because this area has been a highly contested topic, we will be breaking it into two articles. Today, we will discuss documenting alternatives and will discuss documenting the process in a later post.
Let’s take a look:
Defining Experimentation is more than just trial and error
The third test in the four-prong test for qualifying development activities for R&D tax credits is the Process of Experimentation. Under Internal Revenue Code Regulation 1.41-4(a) (5), the process of experimentation is defined as
“…a process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.”
Under this definition, it is critical to the documentation process to identify not only the uncertainties but the alternatives and process the development activity followed in order to alleviate those uncertainties identified at the beginning of the R&D process.
Problems and solutions documenting alternatives
Depending upon the industry, company, number of projects and structure, documenting each alternative on every project can be not only cumbersome but could outweigh the benefit of the R&D tax credit. Many times, small businesses are moving too quickly to stop and track each and every approach evaluated and do not have an efficient way to capture the information. Other companies simply have too many projects to track and so, choose not to track this critical information. I could give you many reasons (or excuses) for not tracking the correct information that my clients have given me but let’s focus on only a few and discuss the solutions to each.
It takes too long to document the alternatives.
Many engineers keep a project notebook so they can retrace their steps or alternatives when working on a project. These notebooks are a tremendous help when looking back at a project to identify alternatives or failures.
At the same time, companies will hold standard weekly or monthly engineering meetings to discuss projects, status and problems that are holding up completion. A form that can be circulated during the meeting to track both hours and a few notes on current alternatives can minimize the time it takes to document each project.
Software development companies often have a large number of development projects in progress, and many perform ongoing releases of new functions or features. A documentation system that provides quick access and easy input can provide good information on the specific functional improvement worked on for the day or week. Under audit, additional information contained in issue reports, software development logs, etc. can provide additional back up if necessary.
We don’t know how to document this information
Engineers and scientists (not to mention programmers) like to design and build cool products. Right? They didn’t become engineers because of their love for “paperwork” or “administrative stuff”. However, these employees are the key to your development efforts and have the knowledge needed to document the alternatives and process for the research tax credit. In many cases, creating an efficient process and training them properly is all that is needed to gather the information. Whether the process ultimately is paper-oriented or through an online system (which we recommend for a multitude of reasons), the knowledge on how to track critical information is less technical than the work they are doing daily.
We have too many projects to track this information
A common problem we encounter with many of our clients is they have a large number of development projects and documenting each in detail would be difficult or cost prohibitive. This challenge often happens with software development companies as they develop and release updates or enhancements on a continual basis. As noted above, much of the information needed is already captured in the various tools used as part of their development methodology.
One key to proper documentation is tracking which enhancement a developer is working on and making sure the documentation system logs that information. If audited, additional support can be pulled to review with the auditor and qualify the time and effort.
In our next article on Problems and Solutions
We will continue our discussion of the Process of Experimentation with an article on documenting the process used during your R&D efforts.
What say you, my friends?
Do you have a system that currently tracks your alternatives evaluated during R&D?
What are the biggest challenges your company faces when trying to track your R&D efforts?
What would you like to see from your CPA in terms of assistance in this area?
Other Noteworthy Articles
R&D Tax Credits – 5 Critical Items to Document (part 5)
Are all R&D tax credit firms the same?
Shrinking Back – An Important R&D Credit Concept for Small Businesses
Free Resources
Free R&D Credit Documentation Assessment
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Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.
