As a CPA specializing in tax incentives, this question comes up in virtually of meeting with companies and CPA firms.
“If I (or my client) take an R&D tax credit, doesn’t that mean an automatic IRS audit?”
No, it does not. Wouldn’t it be great if I could stop there and move on to other questions specific to a company’s activities to assess whether or not they will qualify? Yeah, it would, but clearly, a major concern from the business owner’s (and CPA’s) perspective is the risk (as it should be).
No one wants to go through an IRS audit.
What are the chances of an IRS Audit?
As much as I would like to give you an estimate of the chances you will get audited as a result of taking an R&D Credit, a truth is ….. it depends on. It depends on the size of the credit you take both about your industry and size as well as absolute based purely on the credit you take (assuming it is a large credit).
If I get audited, will the credit be denied?
It depends (see a common theme here?) on a number of factors, the largest of which is really the documentation you have to substantiate the credit as well as the activities for which you are taking the credit.
Do you have a time keeping system in place where your employees log hours to individual jobs or activities?
If so, your chances for a successful result to an IRS (or state) audit increase dramatically.
If you don’t have a system for tracking time, estimates have been used successfully but those estimates must be based on reasonable factors and should be completed as soon after year-end as possible. The more time between the estimates, the more assumptions made, the farther from the actual activities giving rise to the R&D credit, the more difficult it will be to sustain those numbers in an audit.
Does it matter if I take the R&D Credit on an amended tax return?
Yes, the R&D Tax Credit became a Tier 1 issue in 2007 which means it is an area where the IRS would like to have a consistent approach (many believe Tier 1 means automatic denial) nationally and where there is a perception of taxpayer abuse. Only amended tax returns filed with an R&D credit go through the Tier 1 process. If you file for your R&D credit on an originally filed tax return, it goes through the normal processing and may have a lower risk of audit.
Is it safe to take an R&D Credit?
Yes, assuming your activities meet the definitions of qualified R&D, and you have adequate documentation. What is adequate documentation? Well, that is a great question. There are differences between what the IRS considered adequate and the way the courts have ruled. Your best bet may be to review your documentation with your CPA or a specialist in R&D tax credits.
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.