Qualified Research Expenses: Substantiation and Recordkeeping

By July 5, 2017 May 2nd, 2018 R&D Tax Credits
IRS regulations state that “a taxpayer must retain records in sufficient usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” The taxpayer has to fully comply with this regulation when collecting all the information needed for an audit.  The IRS states that if a taxpayer fails to maintain the records, they can disallow the Research and Development Tax Credit.

The IRS doesn’t have to accept qualified research expenses (QREs) estimates if the necessary documentation to verify the expenses exist. They will accept estimates if there are no contemporaneous records and two conditions are satisfied:

  • The taxpayer established performance of qualified research activities (QRAs) as defined in section 41(d).
  • The failure to maintain a proper recordkeeping system cannot be an inexactitude of their making.

The taxpayer must have evidence that can support every assumption made to meet the IRS guideline’s burden of proof.

The IRS guidelines state that the initial audit document request should be files that are readily available to the taxpayer. The following are some examples of initial requested documents:

  • Taxpayer’s base amount and fixed base percentage calculations.
  • General information: Chart of accounts or organization charts.
  • Acquisitions and dispositions from 1984 through the tax year under audit.
  • Accounting method: Are costs accumulated by department or by project?
  • Activities: What are they and why are they eligible for the R&D credit?
  • Wages: Names, amounts, percentages of annual wages, departments, job titles and descriptions.
  • Supplies: Categories, how they tie into the general ledger, and amounts.
  • Contracts: With whom, amounts, and categories.

The IRS might also ask for information that will help understand the acquisition of company resources or details about research projects conducted within the examination year. The following are some examples:

  • Materials explaining research activities, i.e. brochures, pamphlets, press releases, etc.
  • Submissions to management, the board of directors, review committees, etc.
  • Documents prepared by or on behalf of the internal audit.
  • Minutes or notes from budget, board of directors or managerial meetings.
  • Project authorizations, budgets, or work orders that initiate a research project.
  • The internal authorization policies for approving a research project.
  • Project summaries and/or progress reports and project meeting minutes.
  • Field and lab verification/summary data.
  • Research credit studies conducted by outside consultants.
  • Paper, treatises, or other published documents regarding the taxpayer’s research.
  • Complete copies of contracts, letter agreements, memoranda of understanding, or similar documents for research performed by, or on behalf of, a third party.

Additionally, an oral testimony by an individual with personal knowledge about the research projects will supplement a taxpayer’s contemporaneous documentation.

To survive an IRS audit, taxpayers are required to keep records that substantiate any expenses reported or claimed. Thus, they have to clearly establish full compliance with all IRS regulatory requirements.

Questions about your company’s substantiation or recordkeeping? Visit the Indago website or email us at [email protected]