The Sec. 41 research and development (R&D) credit is a valuable tax savings opportunity that many eligible businesses miss out on. Some of these businesses are aware of the benefit but opt out in part due to fears about getting hauled in for an IRS audit. But you can cut your risk of running afoul of the IRS if you understand the types of information they’re likely to seek in an audit and prepare in advance.
What is the R&D credit?
In 1981 The Economic Recovery Tax Act (ERTA) was passed by Congress creating the “Credit for Increasing Research Activities.” As the name implies, Congress wanted to incentivize companies to innovate in the United States. The credit generally allows a business to reduce tax liability by a percentage of “qualifying research expenses.” This is a dollar-for-dollar offset of bottom line federal corporate tax liability (whether regular income tax or, for eligible small businesses, the alternative minimum tax). The PATH Act even adds a provision for Qualified Small Businesses to offset payroll tax liability.
Qualifying research expenses[BN2] (QREs) include:
- Taxable wages for employees involved with the research,
- Supplies to conduct the research (for example, supplies used for prototypes),
- Amounts paid to rent or lease computers to conduct the research (including cloud services), and
- A portion of the amounts paid or incurred for contractors to work in the United States on the research (usually 65 percent).
There’s no limit on how large of a credit you can claim each year to offset income tax liability, although limits apply to how much you can use. But unused credits can be carried forward for 20 years or back one year to offset tax liability.
Which research activities qualify for the credit?
The IRS has a four-part test for what it calls “qualifying research activities” (QRAs):
1. The research is performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions,
2. The research is undertaken to discover information that’s technological in nature (that is, it relies on physical, biological, engineering, or computer science principles),
3. The research is intended for use in developing a new or improved business product or process, and
4. Substantially all of the research activities—generally, at least 80 percent—are elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.
What is an R&D credit audit?
In an R&D credit audit, IRS examiners generally will scrutinize your claim to determine whether:
- The claimed expenses are QREs,
- The claimed research activities are QRAs under the four-part test,
- You complied with the consistency requirement (see below),
- Your credit calculations are accurate, and
- You satisfy the substantiation and recordkeeping requirements.
An audit begins with a notice from the IRS. The initial notice includes reasoning for the selection of your return and information you need to make available to an IRS agent. Each audit is different, and the scope can change based on findings. The IRS may focus on any one of the following topics during their audit:
- Filing Information
- Controlled Groups
- Domestic Qualified Research Expenses
- Technological in Nature
- Rights & Risks
- Business Component
- Technological Uncertainty
- Process of Experimentation
- State Credits
- Special Rules
- Tax Preparer
- Wages
- Contract Expenses
- Supplies
- Tax Returns
- Supporting Documentation
You should expect to receive multiple Information Document Requests (IDRs) that require extensive written responses and documentation collection. You may, for example, receive an IDR before the initial meeting, addressing potential subjects for discussion and documents you should produce. Audits may also include interviews.
What documentation do I need to establish wages?
You’ll be in the best position if you have a reliable, detailed time-tracking system that ties employee hours to specific activities. If you don’t, you may need to allocate each employee’s time between QRAs and non-QRAs.
The wage component is typically documented with:
- Forms W-2,
- Payroll registers,
- Interviews, and/or
- Work schedules.
Can I estimate the time spent on QRAs if I don’t have a time-tracking system?
You can estimate time allocations, but the IRS will take note of exactly who makes the estimates. It may not give much credence to estimates that come from higher-level staff (for example, the CEO or CFO) who haven’t consulted with individuals closer to understanding the day-to-day activities. The farther the person making the estimates is from the actual QRAs being performed, the more likely the IRS will question the allocations.
What documentation do I need to establish qualified supplies?
To document qualified supplies, you generally can rely on your:
- General ledger,
- Chart of accounts,
- Purchase orders, and
- Invoices.
You must be able to link the expenses to QRAs.
What documentation do I need to establish qualified computer rental or leasing expenses?
According to the IRS, this is one of the most straightforward parts of the R&D audit. Your examiner will probably request a list of all contracts, along with the dollar amount of the claimed contract research expense (by contract). From this list, they’ll select the contracts to be requested and reviewed. If you have only a few significant contracts, the examiner may request all of them.
What documentation do I need to establish my costs for contractors?
You can substantiate these costs with:
- General ledger,
- Chart of accounts,
- Contracts,
- Purchase orders,
- Invoices, and
- Forms 1099.
And don’t forget that only contractor services performed in the United States are QREs. So you’ll need evidence of where your contractors did their research work for you.
What if I don’t have documentation for some of my QREs?
You can rely on oral testimony or employee surveys (for example, about how they allocated their time) to determine your QREs, but you should be prepared to provide:
- The total dollar amount of such QREs,
- A list of the employees, with their job titles, who you interviewed or surveyed, with the QRE wages associated with each employee,
- Copies of all original records from each employee interview or survey, and
- The number of months between the claim year and the time the testimony or survey occurred.
You also can rely on estimates or extrapolations to determine QREs if:
- You can establish that you engaged in QRAs (see below), and
- Your failure to maintain a proper system to capture relevant information wasn’t “an inexactitude of [your] own making.” (That is, it was your own fault).
You can use estimation only when the sole issue is the exact amount paid or incurred in the QRA. Be prepared to describe the dollar amount of the QREs that were estimated or extrapolated, the methodologies you employed, and the factual support for every assumption underlying your estimate or extrapolation.
Note: Large businesses (those with assets of $10 million or more) may be allowed to establish their QREs based on their adjusted ASC 730 financial statement R&D for the credit year. The intent is to reduce the work required of IRS staff by letting them rely on the work of financial statement auditors. Extensive documentation is required, as well as proof that the business has internal controls in place designed to reduce the risk of fraudulent misrepresentation of expenses on financial statements.[BN3]
How do I show my QRAs comply with tax regulations?
The information you can glean from your accounting and financial systems generally won’t cut it when you need to show that your research satisfies the four-part test. Instead, the IRS will want information such as:
- Design plans,
- Specifications,
- Prototypes and models,
- Photos and reports showing progress,
- Patents or patent applications,
- Lab notes and reports,
- Meeting minutes and notes,
- Correspondence on R&D,
- Test results,
- Brochures, press releases, and similar documents explaining research activities,
- Project authorizations, budgets, or work orders that initiate a research project.
Can I use oral testimony or estimations instead of written documentation to show my research satisfies the four-part test?
Yes, but the IRS won’t just accept such evidence on its face. It will, for example, consider whether oral testimony comes from employees who actually performed the research and the amount of time that elapsed between the research and the testimony.
Remember, that the IRS doesn’t have to accept estimates or extrapolations because taxpayers are legally required to keep records supporting their tax credits.
Will the IRS check the math on my credit?
The IRS considers the review of the computation of the R&D credit an “essential step” in the audit process—one that should be performed in all audits.
The regular R&D credit generally[BN4] equals 20 percent of the smaller of the:
- Current-year qualified research expenses (QRE) that exceed a base amount, or
- 50 percent of the current-year QREs.
The base amount is determined by applying a fixed-based percentage (FBP) to the average gross receipts for the four most recent years (less returns and allowances).
The IRS will want to see your detailed calculation of the FBP and the base amount, as well as the gross receipts. This will help examiners weed out strategies such as understating the base amount by understating 1) the FBP, or 2) the gross receipts in the prior four years.
For each product or process included in the credit claim, expect the IRS to request:
- The QRE wages by employee,
- The QRE supplies, and
- The contract QREs by contract.
These should reconcile to the total QREs you used to compute your FBP.
Note: Instead of the regular credit calculation, you can opt for the “alternative simplified credit”[BN5] (ASC). The ASC generally equals 14 percent of the excess of current-year QREs over a base amount. The base amount is 50 percent of the average QREs for the three previous tax years. If you had no QREs for those years, the ASC rate is 6 percent of the current-year QREs.[BN6]
What is the consistency rule?
While the Sec. 41 credit generally is referred to as the R&D credit, its formal name is the “credit for increasing research activities.” It’s an incremental credit based on conducting more research activities in the credit year than you did during a base period. The increase can be accurately measured only if you include the same type of expenses for both the base years and the credit year.
Under the consistency rule, the QREs and gross receipts you took into account when computing the FBP must be determined on a basis consistent with how you determined the QREs for the credit year. Specifically, you must show consistency between:
- The QREs in the credit year and the QREs in the base years, and
- Gross receipts in the base years and the previous four years’ average.
So, if an expense wasn’t a QRE in the credit year, you must remove it from your base year expenses (regardless of the law in effect in those earlier years).
How long do I have to worry about an audit?
Generally, the IRS audits tax returns from the previous three years. It may add additional years if it finds a substantial error but usually doesn’t go back more than the last six years. The IRS says most audits are of returns filed within the last two years.
What’s the most important step I can take if I plan on claiming the R&D credit going forward?
Wherever you can, it’s a best practice to document your research activities and expenses contemporaneously. That includes collecting information that addresses each prong of the four-part test for QRAs and clearly connects the expenses to the QRAs (for example, tracking employee hours to specific research projects).
