For a company’s activities to meet the requirement to be considered qualified research activities (QRAs) it has to fulfill the “IRS Four-Part Test”. The “IRS Four-Part Test” has four requisites:
- New or Improved Business Component: The QRAs must result in a new or improved level of function, performance, reliability or quality. A simple change in the product’s aesthetics doesn’t fulfill this criterion. The candidates need to design, develop or improve products, processes, techniques, inventions, formulations or software to qualify for the Research and Development Tax Credit.
- Technological in Nature: The research and activities must be based on one or more of the following sciences: engineering, software, manufacturing and design, environmental and life sciences, etc.
- Elimination of Uncertainty: The QRAs must intend to eliminate uncertainties concerning the development or improvement of a product, process, technique, invention, formulation, or software.
- Process of Experimentation: The process of experimentation is identifying and evaluating alternatives, performing trial and error experiments, and testing results. The IRS also considers “process of experimentation” when a candidate creates prototypes, models and simulations. Any failed projects, technological in nature, are also considered part of the process of experimentation.
In the case of an IRS audit, a company must be able to present documentation that will support the activities the taxpayer has cataloged as QRAs. To prove that the company conducts research activity, the company must present an R&D project list to the R&D tax consultant. The project list must include any R&D project the company has conducted in the past tax year. The project list needs to include a technical explanatory narrative that addresses the “IRS Four-Part Test” requirements. The project narrative will explain how the company’s projects meet the eligibility requirement and ultimately prove that qualified research activities were conducted by the taxpayer.
The R&D tax consultant will also need other documentation to further support its R&D Tax Credit calculation. Supporting documentation is any record that proves the company’s research activities fulfill the “IRS Four-Part Test”. The following supporting documentation reinforces the existence of a company’s QRAs:
- Testing protocols
- Sketches and design drawings
- Intellectual property documentation
- Photographs
- Prototypes
- Project schedules and status updates
- Laboratory records
- Job descriptions
- Product development procedures
A few of the documents listed above will suffice as evidence of the company’s QRAs in the case of an IRS audit.