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Substantiating Your R&D Tax Credit Claim

Companies claiming an R&D tax credit are required to have documentation to substantiate the value of the credit being claimed. The current record-keeping requirement is general and vague, and the IRS has not provided significant guidance as to what documentation is acceptable to substantiate R&D tax credits. Direction regarding substantiation must be gleaned from what the IRS considered unacceptable in past court cases.

Project documentation is the most defensible form of substantiation. Project documentation may demonstrate R&D activities meet the four-part tax definition of qualified research so long as the documentation is specific to the company claiming the credit and does not contain a significant amount of boilerplate text that could be used for multiple companies. Qualified research activities should be documented contemporaneously when possible, including project descriptions that address the four-part test and any relatable exclusions.

Oral testimony and estimates may be used in instances where contemporaneous documentation does not exist and should be based on underlying documentation, where possible. Consideration should also be given to who is providing the testimony and estimates. Subject matter experts should be knowledgeable regarding employees’ roles and responsibilities and/or project-related details. Generally, they will be a direct supervisor/manager with direct involvement or oversight of the R&D activities. Highlighting technical training, education and/or prior work experience will bolster the credibility of their testimony and estimates.

In Legal Guide to the Research Credit by Alex Sadler, he summarizes the following general principles established by various authorities regarding substantiation:

  • Taxpayers have an obligation to keep records showing that the claimed costs are QREs (qualified research expenses).
  • The failure to keep records in a particular manner (so long as such records are in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit) should not serve as a basis for denying the credit.
  • Taxpayers are not required to substantiate their research credit claims with any particular types of documents.
  • There is no requirement that QREs must be accumulated on a project or business component basis.
  • Taxpayers are not required to provide a factual “nexus” or bridge between claimed QREs and specific research projects or business components so long as the taxpayer provides reliable evidence to support its qualified services allocations and supply and contract research QREs.
  • Taxpayers are permitted to substantiate their claimed qualified research activities and QREs with credible testimony by fact and expert witnesses.
  • Where a taxpayer establishes that it engaged in qualified research but lacks the records to establish the exact amount of QREs, a court should estimate the amount of QREs on the basis of testimony and other reliable evidence in the record.
  • Taxpayers must provide the court with a reasonable basis upon which to make an estimate.
  • The person making qualified services percentage allocations should have a reasonable working knowledge of the research credit and section 41’s requirements.
  • Uncorroborated time allocations by a tax department employee who was not involved in the research or by highly compensated executives with no scientific backgrounds run the risk of being rejected as an insufficient basis upon which to make an estimate, particularly when the allocations are made a year or more after the taxable year in which the research was conducted.

Companies should organize their supporting documentation in advance when claiming R&D tax credits. The focus should be on the quality of information rather than the volume. Generating and providing voluminous records does not establish the basis for claiming a credit. Credible testimony should be provided by fact and expert witnesses.

Earnd R&D Tax Credit Experts can help you document your qualified research activities to establish the substantiation you could need for an audit situation.