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:
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.