The realization of research and development (R&D) tax credit benefits by software-industry Chief Financial Officers (CFOs) can be swiftly overshadowed by the receipt of an audit notification. Inadequate documentation can transform a six-figure asset overnight into a significant financial liability when scrutinized by the Internal Revenue Service (IRS) or state-level tax authorities.

But it doesn’t have to be that way.

Robust documentation can serve as your most potent defense, facilitating the recovery or retention of credits under audit.

Reversal of State Audit Denial Through Strategic Appeal

One of Acena Consulting’s software partners faced an unexpected, state-level audit of its fully documented R&D tax credit claim, prepared by Acena. 

Following a yearlong period involving the completion of multiple Information Document Requests (IDRs), the state finally issued a complete credit denial, citing the ineligibility of qualified projects – projects were denied based on the auditor’s positions on data that were never requested – and disputed fixed-base percentage calculations, which were accurate.

Our client heeded our advice to appeal the denial.

During the appellate process, our team provided comprehensive support, including:

• Reapplication of the four-part test to each project.
• Delivery of detailed legal and technical analyses of all business components.
• Reinforcement of the original fixed-base calculation through precedent and logical argumentation.

The appeal was a resounding success, resulting in the approval of all but one project, the reinstatement of the credit, and the enhanced financial acumen of the CFO.

Key Considerations: Federal and State-Level Audit Requirements

Whether you’re facing an IRS or state-level audit, here’s what matters most.

• Project-level documentation:
  • Capitulation of the addressed technical uncertainties.
  • Description of the experimental process and the multiple alternatives evaluated.
  • Identification of activities and expenses that directly supported qualified R&D.
  • Tip: Payroll records alone are insufficient. Comprehensive narratives, iterations, and evidence of problem-solving are essential.
• Time-tracking substantiation:
  • Records of personnel involvement during specific activities and projects.
  • Categorization of project phases and corresponding time allocations.
  • Tip: Solutions like Jira, timesheets, and time-study methodologies can help insofar as they are linked to qualified projects, phases, and activities.
• Defensible fixed-base calculation:
  • Robust historical data capable of withstanding rigorous scrutiny.
  • Tip: If the auditor doesn't understand your base years, then your entire claim can collapse.

During our client’s appeal, the auditor’s misapplication of the statute and attempted alteration of the base calculation – to one that would eliminate the credit – were successfully countered during detailed statutory interpretation and presentation. After exhaustive discussion, the auditor acquiesced and applied our originally submitted fixed-base percentage. 

Proactive Audit Preparedness

To mitigate audit risks, CFOs should implement the following preemptive measures:

• Incorporate documentation improvement into annual R&D studies.
  • Assess your current documentation practices and implement updates to align with contemporary standards.
• Align engineering and finance teams.
  • Ensure your technical leads understand the documentation requirements and their rationale.
  • Provide streamlined tracking processes and systems coupled with accountability measures.
• Develop a defensive file now.
  • Don’t wait for an audit to scramble. Document contemporaneously. Organize intentionally.
  • Schedule a free consultation today to receive immediate assistance from Randy Eickhoff, CPA, Founder & Head Coach at Acena.

Bottom Line

The R&D tax credit is among software development companies' most powerful tools. However, its realization hinges on the ability to substantiate claims through defensible calculations and meticulous documentation.

Stay Informed

Want to learn more about qualifying and documenting activities for R&D tax credits?

• Register for our free, monthly webinar next scheduled on April 22 @ 10:04 a.m. Pacific: “Cracking the (Tax) Code for R&D: Audit Defense.”
  • This workshop provides one CPE credit for professionals who are keeping up with continuing education.
    
  • We’ll break down:
    • Auditor expectations.
    • Common pitfalls.
    • Real-world victories.
    • Strategies to strengthen your R&D documentation.

  • Read our blog, "The Business’ Guide to Decoding the R&D Tax-Credit Audit."

Visit our Acena Events page to sign up for our newsletter and stay abreast of all upcoming events.

• Send our next case study from the manufacturing industry directly to your inbox.

//

Edited by Laura Whittenburg, MSBME, Sr. Technical Writer at Acena Consulting. Photo courtesy of Milosz1 on Flickr.