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You Need More Documentation
Increased Scrutiny of IRC§41 Requires Additional Information
for Substantiating Claims
by Patrick Donahue

The Research and Experimentation Tax Credit (R&E Credit) has been a highly scrutinized section of the Federal Internal Revenue Code (IRC).  Consequently, Hull & Knarr adopted a policy of conducting engineering based R&E Credit studies that supplemented the accounting of research expenditures.  These engineering based studies relied on contemporaneous and anecdotal information to substantiate the qualified nature of each company’s research projects.  While this documentation standard has proved sufficient to substantiate the qualified nature of projects, IRS Auditors have recently been requesting more documentation that provides nexus between employees and projects.

The change is resulting from an April 2007 IRS Directive that changed the research and experimentation tax credit to a “Tier 1” issue.  Essentially, this means the R&E Credit is among the IRS’s most scrutinized tax incentives.  The status change of the credit within the IRS subsequently changed all of the Field Agents’ approaches to conducting an audit. 

Through evaluation of IRS documents, recent audit experiences, and conversations with IRS R&E Credit Technical Advisors, Hull & Knarr has determined that our past study criteria meets the current documentation standard for substantiating claims of employees directly involved in the conduct of qualified research and experimentation and first line supervisors.  But, IRS auditors are requesting more information that provides nexus between employees qualified research activities.  This is particularly true for individuals not traditionally involved in R&D and qualified research activities.  Individuals the IRS defines as not traditionally being involved in R&D include executive, sales, marketing, and production personnel.

While recent audit experience has revealed Field Agents are applying this methodology retroactively, the auditors tend to understand that credit substantiation did not require the current documentation standard.  Consequentially, IRS Auditor’s are giving credence to previous credit claims if the tax payer’s credit claims are compliant with the current documentation requirements.        

The updated study practices require the tax payers to provide anecdotal and contemporaneous information that directly links employees and ownership to qualified activities.  This documentation includes but is not limited to:

Documentation Providing Nexus

• Time tracking data (even if deemed to have limited reliability)
• E-mails related to qualified projects
• Project lists and Gantt charts that provide project timelines
• Personal log books
• Meeting minutes
• All signed documents relating to R&D

Companies that continue to only collect engineering documentation and time allocation questionnaires extemporaneously, to substantiate credit claims, significantly increase the risk associated with past present and future credit claims.  But this should not supplant the importance of the engineering documentation.   

Project folders remain critical part of Research and Experimentation Tax Credit Studies.  They provide contemporaneous documentation that qualifies activities.  While the organization of folders is different from company, anyone claiming an R&E Credit should maintain the following information.

Product Project Folders

• Gantt charts
• Project meeting minutes
• Preliminary specifications developed internally or by a customer
• Conceptual sketches
• Preliminary calculations
• E-mails regarding design
• Drawing iterations or a drawing showing revision number and description of each revision
• Engineering Change Orders
• Product testing results

Production Process Project Folders

• Production analysis documentation
• Sequence of Operations
• Drawings
• Trial Run/Testing Data
• Any documentation that demonstrates a DMAIC production improvement method
• Define
• Measure
• Analyze
• Implement
• Control

In addition to requiring more documentation providing nexus between a person and activities in the current study period, the new directive is requiring companies that do not elect the Alternative Incremental Research Credit calculation method to provide substantial base period documentation.  This documentation may include:

Desired Base Period Documentation

• Time tracking data
• Project lists
• Drawings
• Test data
• Patents
• W-2s
• Tax Returns or Financial Statements
• Organizational charts

All of this does make substantiating a claim more difficult, but the new Alternative Simplified Calculation Method and proposed bill in Congress is making the credit more lucrative for many tax payers.  The IRS’s goal of the new directive and subsequent audit guidelines are to simply ensure claims are substantiated throughout the year rather that at the end.

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