Posted by Andrea Stone on 06.22.17
Research and development (R&D) tax credits represent an outstanding opportunity for businesses in a wide range of industries to offset income tax liabilities for eligible activities. By tapping available federal and state R&D tax credits, business owners can increase cash flow toward future initiatives.
Despite this opportunity, there is one thing that may hold some business owners back—the fear of being audited by the IRS. While only a small percentage, less than 5%, of businesses that apply for R&D credits actually get audited, Tax Point Advisors works closely with our clients to maintain precise documentation of R&D activities that align with qualification criteria so that if an audit is required, they are fully prepared.
Less than 33% of companies that qualify for the federal R&D tax credit actually utilize it, due to misconceptions about qualification and the complexity of necessary documentation.
An R&D audit is nothing more than an examination of your business’ compliance with relevant R&D tax credit regulations. Typically, it includes a thorough review of your claims from a financial and tax perspective, as well as a scientific/technical perspective. A number of court cases in the past decade – including companies like Union Carbide and FedEx Corp. – eased the restrictive interpretations of the IRS. Today, the definitions are much clearer on what can be claimed.
R&D tax credit eligibility largely depends on whether the work you are conducting meets the criteria established by the IRS in its four-part test for eligibility: As we’ve covered frequently in past blogs, taxpayers applying for R&D tax credits must have hard evidence of why the qualified activities meet the IRS’ four-part test:
The better your documentation is managed, and the more details you have to back up your credit claim, the greater your chances of success will be under an IRS or state R&D tax credit audit. Tax Point Advisors works with their clients to identify and organize the appropriate and necessary documentation that their clients already produce during a normal course of business. In most cases, the documentation just needs to be organized in a manner that supports their R&D tax credit claim. It is essential that your business maintains an acceptable method to keep documentation, including financial information and project information, to prove the credits being claimed. For example, Tax Point Advisors advises our clients to keep items, including lab reports, prototypes, photos that illustrate the progression of testing and assembly, and additional documentation pertaining to industry-specific testing.
Your documentation must prove that you:
Examples of documentation can include:
Do you have a time tracking system in place for logging employee hours to individual jobs or activities? If your company documents employee time reporting by project, your project manager will be able to generate a detailed report of employee time spent on qualified R&D projects. If you don’t have a time tracking system in place, you may need to allocate the amount of time spent by each employee performing qualified services to R&D projects. Together, with Tax Point Advisors, the appropriate methodology or hybrid of methodologies will be identified to substantiate your credit claim.
As the largest component of most R&D claims, documentation of wages includes Box 1 W-2s paid to staff members for the qualified R&D work that they conducted. Eligible documentation for payroll includes W-2s, payroll registers, interviews, work schedules, or other tracking documents that associate the labor costs with the R&D project.
Supplies needed to carry out qualified research activities should be backed up by a general ledger with supporting invoices. The general ledger should be sorted by R&D activity for easy access.
Contracted Research Services
Payments made to third parties for conducting qualified research activities are eligible for R&D tax credits. Good sources of documentation for contracted services include invoices and 1099s, which summarize all payments made to a vendor during a year.
Additional information that helps to ensure a successful audit includes:
R&D tax credits can be included in the original tax return as well as by amending previous years’ returns to claim the credit. Business owners should be aware of the three-year statute of limitations for claiming the R&D tax credit. Again, for original returns, the chances for a corporation being audited are less than 5%. Filing an amended return does increase the chance for an audit because the return undergoes a second examination by the IRS. However, the risk of an amended return being audited is still relatively low.
If an audit is necessary, it is essential that a business is able to provide documentation that backs up its R&D activity and eligibility. While there are helpful accounting software programs that keep records by each project, you stand the greatest chance for success with the guidance of an R&D tax credit professional who can offer guidance on the most appropriate methodology to fully back up an R&D tax credit claim.
Precision, thoroughness, expertise and strict attention to detail are paramount. For example, Tax Point Advisors helps CPA firms and businesses from all service and industry sectors better document their processes so that fear of an audit will not stand in the way of significant tax savings. We are the only firm that utilizes an IRS defense audit to review our studies before they are completed. This and other best practices are at the core of our audit success rate to date—we have never had a credit lost under audit.
Tax Point Advisors expertly guides our clients through the documentation process, taking on much of the work involved in completing that process. We write an audit-defensible R&D tax credit study report for each of our clients. In fact, our audit rate is under 5% and our industry-leading audit success is unmatched.
We respond to any Information Document Request (IDR) that is presented by any federal or state agency and provide full audit representation to our clients for no additional cost.
The R&D tax credit can be a lucrative incentive for innovative businesses. Given the new permanent nature of the federal tax credit, now is the time to consider whether activities performed by your company qualify for major cash-saving tax credit opportunities.
Tax Point Advisors, a firm with expertise in working with small and midsize companies, works with businesses that may qualify for R&D tax benefits. For more information, call us at 800-260-4138 or please leave us a message below.