A research and development (R&D) audit is an examination of your company’s compliance with the relevant R&D tax credit legislation. The audit consists of a thorough review of your claim(s), from a scientific/technological and a financial/tax technical perspective.
The likelihood of enduring an R&D audit is a question of “when” and not “if.” That’s why it’s incredibly important to properly prepare for your R&D tax credit claims and have the right documentation ready in the event of an audit.
Here are the three most critical aspects of preparing for a successful R&D audit:1. Understand how far back the IRS or the CA Franchise Tax Board goes to audit your company’s R&D tax credit.
Generally speaking, the IRS may go back three years, and the CA Franchise Tax Board four years, to examine your company’s R&D tax credits. However, an important R&D audit exception is carryforward R&D tax credits from an otherwise closed year to an open year. In this scenario, the taxing authority may adjust the unused carryforward from the closed period to the open period, and assess tax for the open period (if the carryforward adjustment was applied in an open tax year).
2. In the event your company has an R&D audit for one year, find out if you need to be concerned about previous tax years as well.
Whether you’re using a fixed-base percentage or applying the immediate three years prior of qualified expenses to calculate the R&D tax credit, a convention, known as the “consistency rule,” requires you to use similar assumptions and calculations from year to year when determining your current-year credit. These prior years may be subject to an R&D audit, because any R&D tax credit carryforwards may be open for a current-year examination.
3. Discover if your company has the proper “contemporaneous documentation” for an R&D audit.
When defending your R&D tax credit under an IRS and/or state tax audit, one simple saying applies: “Documentation is key!”
One area of R&D audit documentation that’s critical to sustaining and maximizing credit claims is “contemporaneous documentation.” Your company must provide contemporaneous documentation produced during your research and development activities.
Contemporaneous documentation may be used to support all essential elements of the R&D tax credit, including:
- New or improved business components
- Technological uncertainties
- Process of experimentation
- Activities technological in nature
Contemporaneous documentation may include (but is not limited to) the following records:
- Emails discussing technical challenges
- Lab notes
- Test results
- Validation analysis
- Bug logs
- Design and functional specifications
- Technical drawings
R&D tax credits claimed without the proper contemporaneous documentation are at risk of being denied by the tax authorities. Prior to an R&D audit, it’s important to review and gather the appropriate documentation to achieve a favorable result.
Be Prepared To Show Project Nexus
Section 41 of the IRS code requires your company to identify qualified research and development expenses (QREs) by business component. According to the IRS Audit Techniques Guide on R&D tax credit claims, some studies used to support these claims lack “nexus” between QREs and the business component.
If your company keeps highly detailed books and records, as well as documents employee time reporting by project, be prepared to show a detailed report of employee time spent on qualified R&D projects. If your company does not have this information, you may need to allocate the amount of time spent by each employee performing qualified services to qualified R&D projects.
Ready to start preparing the right R&D tax credit documentation required by the tax authorities so you’re never at risk of an audit? Call 866-444-4880 or click here to speak directly with an experienced tax expert at Corporate Tax Incentives.
