Companies nationwide use the research and development (R&D) tax credit to generate tax savings based on the resources invested in developing new or improved products and processes. A company’s documentation strategy is one of the most important parts of substantiating the R&D tax credit. This article covers the types of financial documentation needed to help substantiate R&D tax credits.
General Record-Keeping Requirements
There’s no specific record-keeping requirement for the R&D tax credit. Per the tax code and regulations, taxpayers are simply required to “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” This broad requirement for documentation provides taxpayers with some flexibility in documenting qualified research expenditures.
Documenting Qualified Wages
Qualified research expenses (QRE) include labor performed for qualified services—tasks performed on projects and efforts that meet the four primary qualifying criteria and aren’t specified exclusions. Qualified services include those in which employees are directly involved in research, provide direct support for research or provide direct supervision.
It’s important for a taxpayer to establish a methodology for quantifying wages related to qualified services. The preferred method for quantifying wages is a time tracking system that tracks qualified research hours to qualified projects. This enables a taxpayer to create nexus between qualified research activities (QRA) and QREs.
Several taxpayers don’t use a time tracking system, or the time tracking system being used is insufficient to establish qualified research time. The method employed by these companies to quantify qualified wages is to rely on estimates through oral testimony or via time questionnaires. In Cohan v. Commissioner of Internal Revenue, 39 F.2d 540 (2d Cir. 1930), the court allowed for the use of reasonable estimates through credible testimony. This often is referred to as the “Cohan Rule.” Furthermore, in Suder v. Commissioner of Internal Revenue, T.C. Memo. 2014-201, the court stated it was appropriate to rely on credible subject matter expert testimony to support QREs and that it wasn’t required to connect wage QREs to specific business components.
The key to determining qualified wages is to first determine qualified research time percentages for employees involved in QRAs. The qualified research time percentages are applied to the employee W-2 wages to determine qualified wages. Please note there’s a substantially all rule that allows a taxpayer to include 100 percent of the wages for any employee who spends 80 percent or more of his or her time in QRAs. Time tracking and estimating are both methodologies that allow for the determination of qualified research time percentages.
The IRS doesn’t have to accept estimates of QREs if documentation exists to verify the actual amounts of such expenses. Estimation methods are permitted in cases where the sole issue is the exact amount paid or incurred in the QRA. Accordingly, taxpayers should maintain factual support for the assumptions underlying the time estimates to meet the IRS burden of proof. The aforementioned Cohan Rule doesn’t have to be applied if sufficient evidence isn’t produced. In Shami v. Commissioner of Internal Revenue, T.C. Memo. 2012-78, the court disallowed QREs related to executive employees due to lack of substantiation of qualifying time and lack of credible testimony.
Taxpayers only are allowed to include taxable wages in the R&D tax credit calculation. Nontaxable items, such as 401(k) contributions, health insurance contributions and other pretax benefit deductions, should be excluded. Box 1 of the W-2s for employees generally is used to identify taxable wages.
The following are examples of the types of documentation that can be used to substantiate qualified research wages:
- Employee W-2s
- Payroll registers
- Time tracking data
- Time questionnaires
- Interview notes for oral testimony
- Job descriptions
- Meeting minutes
Documenting Qualified Supply Expenses
The Internal Revenue Code defines qualified supplies as any tangible personal property used in the conduct of QRAs, except property of a character subject to the allowance for depreciation. Examples of qualified supplies include components used to fabricate and test prototypes, raw materials used during product or process design or testing and scrapped material resulting from QRAs.
Expenditures for supplies or the use of personal property that are indirect research expenditures or general and administrative expenses don’t qualify for the R&D tax credit. Utility expenses are considered general and administrative expenses; however, if you can prove the research required an extraordinary amount of utilities, you can include an appropriate amount.
Current regulations have expanded the definition of experimental expenditures and thus what can be included as QREs in the R&D tax credit calculation. For example, prototypes that are created and used in R&D and subsequently sold to customers can be included in the tax credit calculation. In Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010), the taxpayer successfully argued that first-in-class ships in the millions of dollars were in fact prototypes eligible as QREs.
The following are examples of the types of documentation that can be used to substantiate qualified supply expenses:
- Chart of accounts
- General ledger
- Purchase orders
Taxpayers should track or allocate qualified supply expenses to applicable qualified business components if possible.
Documenting Qualified Contract Research Expenses
Contract research expenses are amounts paid or incurred to any person (other than a taxpayer’s employee) for QRAs. To include these expenses, the taxpayer must bear the expense of the research even if it’s unsuccessful and retain substantial rights to the research results.
The most easily identified qualified contract research expenses often are recorded and reported in development, engineering, quality or research departments. In some instances, qualified and nonqualified contract research expenses may be commingled. In these situations, where expenses are significant, reviewing vendor names and services should identify potential major qualified expenses. Alternatively, if potential major qualified contract research vendors can be initially identified, reviewing respective vendor accounts payable listings can help determine QREs in a taxable year.
The location of the third party is important in establishing QREs. The federal R&D tax credit requires the R&D to be conducted within the U.S., and states that offer state-level R&D tax credits require the R&D to be conducted within their respective states. All offshore R&D should be excluded from consideration.
The following are examples of the types of documentation that can be used to substantiate qualified contract research expenses:
- Chart of accounts
- General ledger
- Third-party contracts
- Purchase orders
- Form 1099 (for individual contractors)
Taxpayers should track or allocate contract research expenses to applicable qualified business components if possible.
IRS Areas of Concern
The IRS’s preferred method for capturing QREs is a project-based approach where taxpayers can create nexus between QREs and QRAs. Per the Suder case, taxpayers aren’t required to provide a factual nexus bridge between claimed QREs and specific business components as long as there’s reliable evidence to support the QREs. The creation of nexus between QREs and QRAs generally is most difficult with respect to capturing qualified wages. Taxpayers should attempt to create nexus between QREs and QRAs when possible.
The use of high-level estimates can make it difficult to substantiate an R&D tax credit claim. High-level estimates can include the use of interviews to estimate R&D time percentages and judgment samples. A common example is a chief financial officer or chief executive officer making R&D time percentage estimates for everyone in the organization and not consulting with those individuals closer to the QRAs. Taxpayers also should expect to retain additional supporting documentation for high-level employees involved in R&D.
The R&D tax credit calculation is a percentage of the current-year QREs over a base amount. The base amount is calculated using prior-year QREs.Taxpayers are required to maintain consistency in the calculation and must demonstrate consistency between QREs in the credit year and QREs in the base period years. For example, if a taxpayer claims a certain type of expense as QREs in the current year that it never previously treated as QREs, then it must adjust its base period QREs to reflect the inclusion of this type of expense.
Taxpayers also are required to make base period adjustments for any acquisitions or dispositions made during the tax year. Acquisitions and dispositions can have a tremendous effect on the final credit result, and the IRS commonly asks about acquisitions and dispositions during exams.
Financial documentation plays a significant role in substantiating a taxpayer’s R&D tax credit calculation. Qualified R&D time percentages should be reviewed and updated each year. Likewise, supply and contract research expenses should be reviewed to ensure they’re classified correctly and documented appropriately.
If you have questions about R&D tax credit documentation strategies, contact Jason or your trusted BKD advisor.