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Improper Documentation Can Jeopardise Your Research Credit
Research credit continues to be an area of intense scrutiny during IRS examinations despite strong support from the President and Congress. One of the most common reasons for IRS disallowance of reported research credits is lack of substantiation, but preparing and organising required research credit documentation is a time-consuming activity that can potentially overwhelm your tax department resources. Taxand US focuses on the methodologies that can be used when qualitatively documenting research credit activities and highlights common forms of documentation.
The 1998 proposed regulations required taxpayers to record the results of their research to satisfy the process of experimentation requirement. The 2001 final regulations eliminated the specific recordkeeping requirement, but created even more controversy by requiring taxpayers to prepare documentation at the outset of their research projects describing how they were seeking to exceed or refine the common knowledge of skilled professionals in their field. Both of these requirements were eliminated from the final regulations because commentators expressed concern about incorporating specific documentation requirements in the regulations due to significant variations in documentation standards among taxpayers and industries. The final regulations and the legislative history further explain that the focus should be on the nature of the taxpayer's activities, not on the specific types of records that are kept, so long as the records are usable enough to form a reasonable basis for calculating the research credit.
There is no requirement that a taxpayer must have a specific type of record or document. However, a review of the statutory, regulatory and administrative guidance for the research credit points to 4 key areas that documentation should address:
- Permitted purpose test: The research must intend to be useful in the development of a new or improved business component.
- Technological in nature test: The research be technological in nature.
- Technical uncertainty test: The research must intend to eliminate uncertainty concerning the development or improvement of the business component.
- Process of experimentation test: The research must substantially involve a process of experimentation.
In addition to focusing on documentation that supports the four-part test, it is also helpful to review areas that are likely to be of interest during an IRS examination. Recent experience shows that the following areas are likely to be subject to challenge: direct support, direct supervision, supply costs, base period support and the process of experimentation component of the four-part test.
The federal research credit is an important incentive, but has little value if taxpayers cannot sustain a significant portion of their credit amount. Documentation is critical to sustaining the research credit. And remember, the burden of proof in sustaining the credit falls on the taxpayer. When documenting your research credit, you must first understand the types of documentation and costing information in place at your company. Then you should match the available support to the required documentation. Although it is extremely helpful to prepare specific documentation for the research credit, the IRS tends to be more accepting of technical documentation that a taxpayer prepares for non-tax business or regulatory purposes. Thus, existing technical documentation should be the starting point for substantiating your research credit. Any documentation gaps can be filled in with credit-specific documentation. A brief summary of your qualifying activities is also generally helpful. This summary should address both how the activity satisfies the four-part and reference the supporting documentation (including the source or location of the documentation) or the technical experts interviewed.
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