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April 21, 2011

The 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 organizing required research credit documentation is a time-consuming activity that can potentially overwhelm your tax department resources. For tax departments to efficiently prepare research tax credit calculations and supporting materials, it is important to understand the “why, what, and how” of the credit documentation requirements.

A recent edition of Tax Advisor Weekly (Issue 9, 01-Mar-2011: Aiming for a More Perfect World — IRS Reaches Out to R&D Credit Practitioners on Nexus Issue) examined the IRS’s focus on the nexus between qualifying expenses and qualifying activities. This edition supplements that analysis and focuses on methodologies that can be used when qualitatively documenting research credit activities. We also highlight common forms of documentation and how they can be helpful in supporting a taxpayer’s research credit calculation.

Background — Regulatory Recordkeeping Requirement

Treasury has considered and rejected requirements for specific and contemporaneous records to prove entitlement to the research credit in various versions of proposed regulations and the 2001 final regulations that were subsequently withdrawn. The 1998 proposed regulations (REG-10570-97, 12/2/98) required taxpayers to record the results of their research to satisfy the process of experimentation requirement. The 2001 final regulations (T.D. 8930, 1/3/01) 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 (T.D. 9104, 1/04) because commentators expressed concern about incorporating specific documentation requirements in the regulations due to significant variations in documentation standards among taxpayers and industries. In place of specific documentation requirements, Treasury retained a reference to the general Section 6001 recordkeeping requirements, which provides that taxpayers must retain records in “sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”

The preamble to T.D. 9104 acknowledges that substantiating the research credit can be difficult for a taxpayer, and that the administration of the credit may be difficult for the IRS examination team. However, Treasury makes clear that this difficulty does not preclude taxpayer entitlement to the credit. 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.

The consequence of failing to keep sufficient records to substantiate your research credit may be denial of the credit. Case law finds that the taxpayer bears the burden of proving its qualification for the research credit. UCC v. Commissioner (T.C. Memo. 2009-50), a U.S. Tax Court ruling, held that a taxpayer may substantiate its claimed research credit with a variety of documentation and testimony, including reconstruction after the fact. UCC also reaffirmed that oral testimony may be an important part of the documentation package and that the Cohan rule on using estimates was still relevant.

Documenting to the Four-Part Test of Qualifying Research

Because the statute and regulations do not give taxpayers any specific guidance, taxpayers must look to other IRS guidance to determine the scope, volume, and type of documentation required to substantiate research credit activities and amounts. A variety of administrative guidance published by the IRS provides helpful insight into what might be requested, but the best approach to documenting qualitative activities should begin with an analysis of the statutory definition of qualifying research.

IRC Section 41(d) provides that qualifying research activity must meet four tests:

(1) Permitted purpose test: The research must intend to be useful in the development of a new or improved business component — IRC 41(d)(1)(B)(ii).

(2) Technological in nature test: The research be technological in nature — IRC 41(d)(1)B)(i).

(3) Technical uncertainty test: The research must intend to eliminate uncertainty concerning the development or improvement of the business component — IRC 41(d)(1)(A).

(4) Process of experimentation test: The research must substantially involve a process of experimentation — IRC 41(d)(1)(C).

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 certain key questions that documentation should address for each of the four tests:

  • Permitted purpose:
    • What was the goal of the project? Describe the intended improvements to function, performance, reliability, quality or cost (if possible, quantify the level of intended improvement).
    • How was this effort intended to improve upon prior products, processes, formulas or systems?
    • “We were attempting to...”
  • Eliminate uncertainty:
    • What were you uncertain about (capability, method or design)?
    • What were the key technical risks identified during the development effort?
    • “We were uncertain how to (or if)…”
  • Technological in nature:
    • What specific scientific or engineering disciplines were used in the performance of the activity?
    • What technical background or specialized education is required to conduct the research?
    • What is the experience and educational background of individuals who worked on this project?
    • “We use ______ fields of science or engineering...”
  • Process of experimentation:
    • How many different designs, models, versions or prototypes were undertaken during the research process? What were the variables, components or assumptions that were changing (and why)?
    • What problems or failures were encountered? What were the related solutions?
    • What were the lessons learned during the project?
    • Does the company apply a standard development process? If yes, what are the major steps or stage-gates?
    • What special purpose equipment or facilities are used to perform or validate the research?
    • “We tested...”

Although these questions are not all inclusive, they will address many of the key points for each test.

Documentation in Light of Recent IRS Trends

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.

One approach to sustain direct support and direct supervision wages is to demonstrate how the contested individuals impact the progress of the research. This impact can be at any stage of development (i.e., from design phase to review of results), but the more direct (and early) the impact, the greater the chance of sustainment. Meeting minutes or calendars are helpful to demonstrate participation in development team meetings. Emails with review points are also very supportive.

Similar to the arguments for direct support and direct supervision wages, it is critical to demonstrate how supply costs are “used in the conduct of qualified research.” The statutory language is clear that supplies used in the research process should qualify for the credit. Taxpayers should be prepared to describe the trial or experiment in which the supplies were used.

The process of experimentation test generally requires the most attention when documenting the four-part test. The IRS tends to be particularly focused on the “substantially all” requirement for the process of experimentation test. Even if project tracking systems are available, more detailed activity information may be limited. To adequately respond to inquiries on the substantially all requirement, taxpayers should consider the timeline for their process of experimentation (e.g., when did it start and when did it end). Ideally, this timeline will include references to key development milestones that are determined based on a range of documentation sources. Each development milestone should include tasks to be performed and individuals or groups performing those tasks.

Another useful resource to consider when preparing your documentation is the IRS’s Audit Technique Guide: Credit for Increasing Research Activities IRC Section 41 — Substantiation and Recordkeeping, published in June 2005. The IRS has recently noted on several occasions that it is considering updating the guide, but the current version is a helpful resource when anticipating potential information document requests (IDRs). It suggests the following items be considered in an initial IDR:

  • Taxpayer’s base-period calculations (including impact of acquisitions and dispositions);
  • General company information: chart of accounts, organization charts;
  • Costing methodology (department or by project);
  • Description of qualifying activities and why are they eligible for the research credit;
  • Detail of annual wages, departments, job titles and descriptions;
  • Categories of supply costs and how they tie in to general ledger; and
  • Categories of contract research (request copies of large contracts).

Interviews are often the most valuable source of information. Credible oral testimony by individuals with personal knowledge of the issues may be helpful in evaluating and/or supplementing a taxpayer’s contemporaneous documentation. Interviews may be necessary to gather new information or to confirm, clarify or refute other documentary or testimonial evidence. The interviewee will often be a technical or supervisory person with specialized knowledge of the issue in question.

The Audit Technique Guide uses the term contemporaneous documentation as synonymous with project accounting. However, there is no authority found in the statute, regulations or legislative history to support such a requirement. In fact, recognition that capturing costs in departmental cost centers is one way to support research activities is well documented in the regulations’ legislative history. The guide also recognizes (see page 6) that a departmental or cost center approach is acceptable.

Alvarez & Marsal Taxand Says:

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.

It is also important to use documents that are contemporaneous with the credit year. For example, a project plan from 2007 will have limited impact when gathering 2010 documentation. Although projects may span multiple years, the project stage or R&D activities frequently change over time.

The following table outlines how common types of documentation help support the four-part test. It is not intended to cover all forms of documentation.

 Four-Part Test Supporting Documentation
 New or Improved Business Component 
  • Patent applications or intellectual property reporting;
  • Project set-up or initiation forms;
  • Papers, treatises or other published documents on the taxpayer’s research;
  • Marketing brochures or press releases for new products.
 Technological in Nature 
  • Organization charts;
  • Overview of laboratory equipment and facilities;
  • Job descriptions and human resource job postings.
 Technical Uncertainty 
  • Emails;
  • Budgets overruns and missed delivery dates are often helpful to document if projects significantly exceeded plan since this is frequently indicative of technical issues encountered during the development process;
  • Risk registers or lessons learned documents (these documents must include references to technical risks as well as business risks);
  • Presentations to management, review committees or other similar groups on research projects, activities, expenditures, and the research credit.
 Process of Experimentation 
  • Meeting minutes, notes or similar records from R&D team meetings;
  • Emails;
  • Test plans;
  • Field and lab verification data or summary data.

The overall key is to understand your own company such that you understand what documents are created in the course of the research for the business.  A couple of other key considerations for documentation:

  • No matter what the industry or company, more documentation will be available today than tomorrow.
  • Your limited resources should be spent on areas of high risk or high opportunity.
  • Don’t try to document tests to standards that aren’t required. The preamble language to T.D. 9104 effectively limited the application of certain exclusions from qualified research (e.g., after commercial production, duplication and adaptation) and provided helpful guidance on the Section 41(d)(1)(C) “substantially all” rule.
  • Although not required, project-based accounting will generally be considered a better matching of qualifying activities to costs than a cost-center based methodology.
  • Documentation should specify years that tie to the credit years.

Documentation is likely to continue to be an area of contention for the research credit. During recent meetings with the tax practitioners, the IRS mentioned that it was considering updates to the research credit audit technique guide. The research credit should be valued as an asset. Proper documentation will help ensure that the asset will retain its value during an IRS examination.

To hear Kathleen discuss this issue in more detail, please click here to register for her upcoming webcast.

Footnotes

See Research, Inc., DC MN, 6/21/95; Welch v. Helvering, 290 US 111 (1933).

Internal-use software may have three additional tests, but it is outside the scope of this discussion.

Preamble to the 2001 proposed regulations, 2002-4 I.R.B. 404.

Author

Kathleen King
Managing Director, Washington, D.C.
202-688-4213
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For More Information on this Topic, Contact:

Brett Nowak
Managing Director, San Francisco
571-278-9495
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Andrew Martin
Senior Director, Charlotte
704-778-4706

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