How can you substantiate an R&D tax credits claim under audit?

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Posted by Randy Eickhoff on Jun 12, 2012 2:00:00 AM

Acena-can-help-lower-your-risk-in-an-auditThe first thing that happens when a company receives “that letter” from the IRS announcing the audit of their tax return is typically sheer panic.

What caused this?

What do we do now?

Is there anything in the tax return we should be concerned about?

While the IRS may audit any item of revenue, expense or credit, the process could be a random selection or an item on your tax return that does not match other information they have in their system. It could also be that a tax credit you have taken looks too large for your company’s industry and size.

R&D Tax Credit Audit Support

Our focus in today’s blog is some things to consider having in place BEFORE you get audited for your research and development tax credit.

This is part one of a three-part series.

Let’s take a look:

Qualitative Information – Do your development projects qualify?

Each development effort your company spends time and resources on may qualify for R&D tax credits. However, each individual development effort must be able to pass the 4-part test detailed in the Tax Regulations under Section 41 (see Navigating the R&D tax credit minefield (part 2)).

Some consultants advocate application of the 4-part test to a subset of projects (or development efforts) as proof that the company does conduct qualified research and development.

While sampling projects can be successful under audit, the sampling methodology must be a true statistical sample and not simply a judgment sample.

Our recommendation (and typically what will be requested under audit) is to apply the 4-part test to all projects that may qualify and use the applicable costs and expense for only those projects that qualify.

Contemporaneous Documentation – Timely, Project-based, consistent

design-projects-can-qualify-for-R&D-tax-creditsAnother area, where many taxpayers struggle in terms of proper documentation, is the proper TYPE of documentation.

As an example, if part of your technical uncertainty relates to, not knowing the appropriate design of a new product, proper documentation would include several iterations of your designs showing the changes necessary for success AND that you did not know the appropriate design at the onset of the project.

Another example might be a notebook kept by the development team showing dates for a project moving from design to prototype AND reasons the first and/or second prototypes failed.

While interviews with key R&D personnel are important as support, documentation created when the project was in the process is a stronger defense and should be kept during a project’s development cycle.

In our next blog, we will look at how to document the hours and tasks of employees working on R&D projects.

What say you my friends? 

What system do you use to evaluate your development projects for the R&D tax credit?

Does your company’s development process include documentation to support your research tax credits?

Related Articles

R&D Tax Credits: 5 Critical Items to Document (part 1)

8 Things that won’t pass an R&D tax credit audit (part 1)

10 Reasons not to take an R&D tax credit (part 1)

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.

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Randy Eickhoff

Randy Eickhoff

Acena Consulting Founder and Partner. Randy is a licensed CPA and has worked with over 200 companies on various tax credits and other government incentives including multinational technology firms as well as small privately held manufacturing, sports, and technology companies.