R&D Tax Credits: Do’s and Don’ts

Welcome to SMB Matters. I’m John Burcu, a Tax Credit Manager at TriNet Clarus R+D. This podcast series takes a close look at the latest news and trends on a variety of topics related to running a successful small or medium-sized business.

Companies across many industries often qualify for the federal research and development (R&D) tax credit. However, claiming the R&D tax credit requires backing up your eligibility with the right documentation. Companies sometimes misunderstand what constitutes required documentation for the R&D tax credit. A simple general ledger line item that says “research expenses” will not do. Here we take a closer look at some “Do’s and Don’ts” when it comes to R&D recordkeeping.

Documentation Do’s

Many companies claiming the R&D tax credit treat formal documentation as an afterthought. Documenting activities retroactively is risky when claiming the R&D tax credit. Don’t wait to gather what you need to demonstrate eligibility and compliance. A contemporaneous, comprehensive documentation process is the best way to maintain IRS compliance.

Documentation should be arranged and organized in advance, including any applicable contracts, and taxpayer and employee testimony. The focus should be on the quality of information rather than on the volume.

Instead of centering solely on technology or research, documentation should be described and presented by applying research tax credit rules. You should organize information by project and on an employee-by-employee basis. Time spent performing qualified and nonqualified activities should also be well-documented.

Your documentation must prove that your company:

• qualifies for the R&D tax credit,
• has conducted the activities for which you are claiming the R&D tax credit,
• meets nexus requirements.

A list of qualified research activities isn’t helpful if the costs cannot be traced to specific projects or activities. Nexus is established if your accounting records connect to your qualified research expenses at the business component level. Also, under what’s called the “Consistency Rule,” you must define your expenses in the same manner from year to year.

Detailed and clearly written reports are your best defense during an audit. If the IRS can’t easily understand the information you’ve submitted about your activities and expenses, the lack of clarity and documentation can impact your final R&D tax benefit. Submitting concise, relevant, and accurate information can play a crucial role in mitigating corporate risk while maximizing access to the benefits your company can claim.

If the IRS disallows your claimed credit, taxes in the year the credit was claimed as well as additional tax years are impacted. This may result in the need to refile prior returns and additional taxes owed. If your R&D tax claim is unsupported, you may be subject to penalties. You should carefully review any reports or studies prepared by your tax preparer to ensure the documentation accurately reflect your activities. Tax preparers who are involved in the preparation of improper claims or R&D tax credit studies also may be subject to penalties.

Documentation Don’ts

The rules outlining the documentation requirement are outlined in Treasury Regulation Section 1.41-4. The IRS Audit Techniques Guide for the Research Credit and the IRS Chief Counsel Memorandum released in October of 2021 provide insight as to how they interpret and administer those rules. Highlights include:

• Documentation should be specific to the taxpayer.
• Submission of documentation should not be prepackaged with a significant amount of generic text that any taxpayer may use.
• Wherever possible, activities should be documented contemporaneously.
• Documentation should include project descriptions that address each section of the four-part test.

Key Takeaways

The best way to help reduce business risk when claiming the R&D tax credit is to work with an experienced R&D tax professionals to support your documentation process. R&D tax processionals provide support through your projects to help provide guidance on qualifying expenses. In the event you are audited and asked to produce documentation, they may help submit the necessary reports to the IRS, answer questions, and keep your business interests in mind.

For companies already claiming the R&D tax credit and those that are just beginning to determine their eligibility, it is critical to be thorough when documenting qualified research activities. To help reduce your tax burden when claiming the R&D tax credit, you have a responsibility to make sure it’s defensible by adhering to IRS guidelines and properly tracking expenses.

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Legal Disclaimer:

This podcast is for educational purposes only. With decades of experience supporting small and medium-size businesses, TriNet has unique insight into HR best practices for businesses. TriNet does not provide legal, tax or accounting advice. The materials in this podcast and the options and opinions expressed herein may not apply to your company or scenario, so you should consult with your own advisors on how best to proceed. Reproduction in part or in whole is not permitted without express written authorization from TriNet.