UNDERSTANDING AUDIT RISKS AND IMPORTANCE OF PROPER RECORD KEEPING IS CRITICAL TO DEFENDING R&D TAX CREDITS ON AUDIT, APPEALS AND LITIGATION
IRS Attacks Research and Development Tax Credit Cases Aggressively
Understanding the Risks and the Importance of Proper Recordkeeping is Critical to Defending R&D Tax Credits on Audit, Appeal and Litigation
When exploring the world of tax incentives, research and development (R&D) tax credits emerge as a vital opportunity for businesses focused on innovation and development. The R&D tax credit offers a financial reward to businesses investing in innovation. Under IRC §41, eligible taxpayers can claim a tax credit for specific expenses linked to qualified research activities. Familiarity with what constitutes qualified research is essential since it can invite scrutiny from the IRS.
Taxpayers are responsible for keeping detailed documentation to prove their projects and expenses qualify. This includes maintaining records of wages for employees, supply costs, and costs to third-party contractors.
The prospect of the IRS challenging the allowance of this tax credit poses a risk that the financial incentives may be lost unless all the requirements of the tax credit are provable through proper recordkeeping.
The IRS has set clear guidelines for evaluating R&D tax credit claims and businesses that understand these guidelines can minimize their audit risk. To withstand IRS scrutiny, businesses must maintain thorough documentation corresponding to their research activities. This includes:
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- Project documentation: Detailed records of R&D projects, including descriptions, objectives, and results. For example, if a startup is testing a new product prototype, it should document the testing process, feedback received, and how the product was improved based on these insights.
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- Financial records: Detailed documentation of R&D-related expenditures. This means maintaining precise payroll records, invoices, and receipts. Statistics show that 70% of R&D claims are denied due to inadequate documentation.
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- Employee records: Clear classifications of employees involved in R&D, including documentation of their roles and the percentage of time they dedicated to research activities.
The IRS uses 4 criteria to determine if activities qualify as research expenses under §41:
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- 1. Permitted Purpose: Research should aim to develop or enhance a product, process, software, or technique.
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- 2. Elimination of Uncertainty: Research must seek to uncover information that removes uncertainty regarding capability or method.
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- 3. Process of Experimentation: Research should involve experimentation to evaluate options, enhance products, or create new products.
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- 4. Technological in Nature: Research should rely on principles of physical or biological sciences, engineering, or computer science.
Navigating the IRS audit practices for R&D tax credits under IRC §41 can be challenging. Understanding documentation requirements and eligibility criteria are crucial. Create and follow best practices, maintain accurate records, and seek professional guidance.
Mario Fazio is a Partner in the Business & Corporate Department and Section Lead of the Firm’s Tax Group. He can be reached at 216-831-0042 or mfaziom@meyersroman.com.
Disclaimer: Please note that this Legal Update and the information contained herein do not, and are not intended to, constitute legal advice or legal representation or create (and is not a solicitation to create) an attorney-client relationship; instead, all of the information, content, and materials contained in this publication are for general informational purposes only and may not reflect current legal developments. You should not act upon any such information, content or materials contained in this publication without first seeking qualified legal counsel.
