In our last blog, we looked at a few of the qualitative components of the R&D tax credit that should be documented as well as the timing for documentation (See How can you substantiate an R&D Credit claim under audit (part 1)?).
Today we will turn our attention to the most important aspect of the calculation, the hours spent by employees on qualified R&D projects. Because the wage expense associated with an R&D tax credit claim is typically the largest single expense item, an audit will focus attention here to determine if proper documentation exists to verify the hours and people included in the research tax credit calculation.
This is part 2 of a three part series.
Let’s take a look:
Employee Hours – Linking people to projects
Under the latest Audit Techniques Guide for the R&D tax credit (you can download a copy from a link on our blog post, R&D Credit Documentation Standards – The Moving Target), IRS agents are directed to review each individual project and identify the employees that completed qualified research on each. In the event a taxpayer does not provide a road map that links employees to the projects they worked on, there is little chance the research tax credit claim can be sustained.
Simply, if a taxpayer cannot provide documentation that shows how a project qualify and who worked on it, the IRS agent would have difficulty verifying the amount of credits claimed for the project.
Companies with a job cost system can (assuming they are using their systems properly) track hours by employee on individual projects as part of their normal course of business. Other companies, typically small businesses that do not use a job cost or other project base costing system would not have the detail needed.
Senior Executives not tracked through job costing
Some companies that may have a job cost system might not track senior executives within the system that claim some R&D hours for concept development or supervisory time (see Research Tax Credits – Estimates not accepted in Shami Court Case).
As these individuals are typically among the highest paid employees in the company, their hours are valuable in terms of overall tax credits. It is critical senior executives track their hours contemporaneously to projects if they expect to include their time in the R&D tax credit calculation.
Task Level Documentation – Proving out the Process of Experimentation
Even companies that use a job cost system may be at risk in an R&D tax credit audit. While tracking hours by employee by project is critical, it does not provide the road map to show HOW an employee spent their time.
The next level of detail necessary to properly document employee hours to qualified research projects should include the tasks or milestones within the development cycle.
Examples of milestones for a product-based company would most likely include Concept Development, Design, Prototyping, Testing, Manufacturing Process Design, etc.
It is important to point out that any system that is developed to track R&D projects should blend into the overall development cycle rather than hinder it.
A common complaint we hear from new clients is the additional time and expense needed to develop all the documentation necessary to sustain an R&D tax credit. Depending on the system develop, they may be correct.
Taking the extra time to make the process efficient and forms or format streamlined is imperative to both adoption by the company employees and overall success.
In our next blog, we will review supply and contract research expense documentation on R&D projects.
What say you my friends?
How are you currently tracking hours of your employees to projects?
How do your senior executives track their hours to development projects?
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.