By: Christopher D. Cook, CPA
The Inflation Reduction Act (IRA) allocated $45.6 billion to the IRS specifically for tax enforcement activities that would include hiring more enforcement agents, providing legal support and investing in “investigative technology.” That is an enforcement funding increase of 69% relative to prior projections, according to the Congressional Research Service.
While it will take some time for the IRS to hire and train more enforcement agents, tax credits claimed now could be retroactively audited in the future. A careful analysis of processes and recordkeeping for the complex but valuable R&D tax credit should be prioritized within organizations.
Inadequate Recordkeeping Increases Tax Credit Claims Risk
In an ideal world for tax practitioners, all employees on a project team care about the R&D tax credit and become experts to help the company qualify for it. In reality, the team’s actual research and development comes first. They can be trained and retrained to report their time and expenses in certain ways, but it’s not an exact science.
And yet, documentation is critical to qualify — and show proof — for this valuable credit.
Under the four-part test to determine qualifying activities for the R&D tax credit, most companies can prove that their activities are (1) “technological in nature” with regard to science or engineering. However, they also need to document aspects of (2) the business component/purpose of the R&D, the (3) elimination of technical uncertainty as well as (4) the company’s process of experimentation.
How should government contractors and other business owners document their research and development activities? Based on our experience with calculating the R&D tax credit for clients (and maintaining proof for the IRS), here are several examples of what to document and save in your tax records.
Business Purpose Documentation
To qualify for the R&D tax credit, research and development activities must relate to a new or improved business component’s function, performance, reliability, quality or composition. As the team presents their hypothesis or goal to the company, they should save any slide decks of presentations, whitepapers or email correspondence.
Why? The company must connect the dots between the expenses incurred during R&D activities and its benefit to business products or processes. Therefore, as the project team discusses innovative ideas and progress with stakeholders, someone needs to maintain a record of those communications that demonstrate how their work will improve the business component.
Technical Uncertainty/Process of Experimentation
Within the four-part test, companies must also show that their qualifying activities involve technical uncertainty and have a process of experimentation: “simulation, evaluation of alternatives, confirmation of hypotheses through trial and error; testing and/or modeling; or refining and discarding hypotheses.”
Documentation can include minutes of early planning meetings or concepting meetings that document how the team will tackle and overcome uncertainty. The team can also save email threads in which various team members brainstorm uncertainties and possible solutions prior to pursuing their experimentation.
Technical drawings can show iterations of solving technical uncertainties or experimenting with different solutions. This is valuable proof to pass the four-part test.
Qualifying Expense Reporting
In order to calculate the expenses that will eventually lead to the R&D tax credit on your tax return, your advisor needs to review all of the materials previously mentioned as well as time and payroll records and expense reports.
While it is helpful to track time and expenses by project name, specific R&D qualifying expenses within that project require investigation. For example, out of a team of 15 people on an R&D project, maybe only five people worked on R&D activities 100 percent of the time while some only worked on them 40 percent of the time and still others had no role in R&D at all.
There may be projects that extend from 18 months to several years. In the first tax year, most R&D activities could meet the four-part test, but by year two or three there may be less technological uncertainty or experimentation involved. Upon further investigation, qualifying activities and expenses to calculate the tax credit could decrease or increase in subsequent years.
Tax Credit Proof
A good rule of thumb is to track and save R&D records for up to seven previous tax years in case of an IRS audit. If the IRS takes issue with a recent tax credit claim, it’s possible that auditors will look back several years for any additional discrepancies.
Historically, new tax court rulings sharpened our understanding of how the IRS interprets the four-part test and applies it to tax returns. But in recent years, court rulings are running counter to previous rulings, depending on the court hearing the case. A precedent-setting case in the Southeast may run counter to a ruling in the Midwest, for example.
All of this is to say that documentation is critical to support R&D tax credit claims year after year. Documentation as you perform the activities is also much easier than trying to go back and build documentation in the event of an audit.
Federal (and state) R&D tax credits save companies thousands of dollars in taxes each year as a reward for their experimentation and innovation. They can reinvest this extra cash into their team, resources and future research.
Christopher D. Cook, CPA, is with Anglin Reichmann Armstrong CPAs and Business Advisors, with offices in Huntsville, Ala., and Pensacola, Fla. Cook has a special focus on government contractors and the R&D Tax Credit. firstname.lastname@example.org
Published by R&D World here.