In parts 1 & 2, we looked at the contract manufacturing qualifying activities (see How does contract manufacturing qualify for R&D tax credits (part 1)) as well as some of the potential IRS audit issues that could be a concern (see part 2).
Today we will look at some of the important components of documenting research and development activities for a contract manufacturing company taking a research tax credit.
Documenting people, processes and iterations
For most companies, the majority of R&D costs will be focused on people completing qualified R&D activities. As you can imagine, poor documentation as it relates to people, result in the largest degree of adjustments from IRS audits. Let’s look at some of the key areas where proper documentation will greatly improve your chances for sustaining your R&D tax credit:
Time is money
I can’t think of a better way to express just how important documenting time spent on qualified R&D than “time is money.” It’s actually a two-way street for business owners; time should be documented for qualified activities on a project-by-project basis and (in a perfect world) on a task-level basis. However, documenting takes time that does not add value to the finished product.
So, either an efficient documentation system should be developed and implemented or a reasonable level of detail should be agreed upon and documented recognizing the potential audit risks associated with the level of detail chosen.
Courts have been reasonable in terms of allowing estimates of qualified research time by employees. However, estimates must be based on reasonable assumptions and can still result in an adjustment if a tax auditor cannot be convinced that the estimates are reasonable.
There are a number of approaches that are efficient, inexpensive and provide strong support of time spent on qualified R&D projects. Some systems are more manually driven while others are online systems that guide the employee through the necessary information. Both can be developed to be efficient if support by management (one major key to adoption of any change).
Task Level Documentation versus Project Level
A quick review of the Audit Techniques Guide: Credit for Increasing Research Activities published by the IRS will convince you that the IRS prefers taxpayers track their efforts on a project-by-project basis. At the same time, each project must meet the four-part test defined in the tax code and regulations (for a brief summary see Navigating the R&D tax credit minefield (part 2)). One key area that taxpayers should document properly is the Process of Experimentation. This test requires that a taxpayer evaluate one or more alternatives or conduct a process of experimentation to alleviate the technical uncertainties identified at the onset of the project.
An approach to successfully meeting this test is to document the overall R&D process used for conducting research as well as on a project-level basis. Conceptually, it is important to operate in an efficient model that follows a defined approach, this allows a company to both document and evaluate/measure results and continuously improve their research process.
At the project level, documenting how people are spending their time provides the information to streamline processes. As a nice side benefit, it also demonstrates (if necessary under IRS audit) that the taxpayer is conducting a process of experimentation and meeting one of the tests necessary to qualify the project as qualified research.
In part 4 of Contract Manufacturing
In part 4, we will discuss the importance of contracts and specific language that should be considered by contract manufacturers to maximize the R&D tax credit.
What say you my friends?
Are you currently documenting your R&D process on a project basis?
Do you have a formalized R&D process that has specific tasks that can be measured?
Do you currently utilize a job cost system as part of your daily operations?
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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.