Missed this month's webinar from Acena Consulting (Acena)? Here’s what you need to know!

Federal and state-level R&D tax credits drive economic growth and job creation, which American businesses make possible by investing in innovation. However, substantiating these credits can be complex, and companies may face Internal Revenue Service (IRS) audits. 

Our recent presentation, "Cracking the (Tax) Code for R&D: Audit Defense," provided in-depth guidance on effectively navigating this process. Here were the key takeaways.

R&D Tax-Credit Fundamentals

We defined the federal R&D tax credit as an incentive to encourage R&D investment. Eligibility depends on conducting qualified research activities (QRAs), like developing new or improved products and processes. Qualified research expenses (QREs) include cloud-hosting costs for software development, contract research costs, supplies, and wages.

R&D Tax-Credit Calculation

The calculation involves defining the QRAs and identifying the QREs. QRAs must attempt to improve a business component, discover scientific unknowns using hard scientific principles, and conduct systematic experimentation. The credit amount is a percentage of QREs directly incurred during QRAs.

Audit 101

R&D tax-credit audits are conducted by IRS divisions such as the Small Business and Self-Employed (SBSE) and Large Business and International (LB&I) divisions.

Audits may be triggered by credits deviating from industry norms, claim inconsistencies, frequent or sizeable claims, random selection, or unusual credit-to-revenue or wage ratios. 

An audit starts with an IRS notification outlining the reason for selection, scope, initial data request, and timeline. SBSE audits typically last 12 to 18 months, while LB&I audits may extend from 18 to 30 months. Auditors often focus on contractor costs, the definition of business components, expense estimates, job titles and tasks, the process of experimentation (PoE), and reasonable compensation.

Audit Appeals

Taxpayers can appeal audit findings by filing a written protest with the IRS within a specific timeframe. The protest must include a copy of the IRS notification, supporting documentation, and detailed information, including the taxpayer’s contact details, tax years involved, and disputed issues.

The IRS reviews the protest. If its position is unchanged, then the case goes to the Independent Office of Appeals (Appeals) for an informal conference exploring potential resolutions. The appeal can lead to a settlement or a Notice of Determination, allowing the taxpayer to take the case to federal court.  

Audit and Appeal Tactics

Effective strategies include analyzing and responding to the IRS’ reasoning, communicating clearly and proactively, strengthening the supporting documentation, and writing a persuasive protest.

Seek expert guidance that is proactive, responsive, and impactful. Schedule a free consultation today to receive immediate assistance from Randy Eickhoff, CPA, Acena’s Founder & Head Coach.

Emerging Judicial Lessons

Recent court cases emphasize the importance of aligning contractual terms, properly documenting QRAs, and understanding eligibility criteria. 

Acena’s Project Manager and Head of R&D, Rae Fox-Smoltz, reviewed LITTLE SANDY COAL COMPANY, INC., v. COMMISSIONER (2023) and MEYER, BORGMAN & JOHNSON, INC. v. COMMISSIONER (2024). 

The 'Substantially All' Rule

This rule requires that at least 80 percent of the project time – or another reasonable measure – be part of the PoE for the associated costs to qualify for the credit. Accurate R&D credit calculations and compliance depend on applying this rule correctly to project analysis and business components’ development.

Dependence on Detailed Documentation

The key pillars of documentation are information, process, consistency, and accountability. 

Comprehensive documentation is integral to successful R&D tax-credit claims because it provides evidence of QRAs. Qualitative documentation may include correspondence, patents, project authorization requests (PARs), project lists, proposals, and technical documentation. Quantitative documentation may consist of cloud computing expenses, contract research expenses, estimates through testimony, taxable wages, time tracking systems, and qualified supply expenses.

Form 6765 Updates and Amended Return Requirements

For tax years starting after Dec. 31, 2024, Form 6765 will require reporting business components in Section G following the IRS’ 80%/Top 50 rule.

Read our explainer to dive deeper into Section G and understand reporting exemptions. Amended returns also require detailed documentation for all changes. 

Best Practices

Businesses claiming R&D tax credits should know the rules, document everything, maintain consistency, and track expenses carefully.

When facing an audit, respond promptly and professionally, understand the IRS’ focus, provide organized information, and remain truthful and cooperative. Consider representation.

During appeals, analyze the disallowance, strengthen the supporting documentation, craft a persuasive protest, communicate effectively, understand litigation risks, and document all interactions.

Stay Informed

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

• Register for our free monthly webinar, next on May 20: “Cracking the (Tax) Code for R&D."
  • This workshop provides one CPE credit for professionals who are keeping up with continuing education.

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

• Receive the next case study examining the agricultural industry directly in your inbox.

//

Edited by Laura Whittenburg, MSBME, Sr. Technical Writer at Acena Consulting.