by Patrick Copeland
BKD LLP is an IMA member.
A company’s documentation strategy is one of the most critical parts of substantiating and claiming the research and development (R&D) tax credit. Inadequate documentation might lead to a missed credit opportunity, wasted time or the denial and/or revocation of your tax credits. To help avoid these unwanted outcomes, gathering contemporaneous documentation related to your qualified research activities is imperative. This article will cover the types of documentation needed to substantiate and sustain the claim you make for the R&D tax credit and also provide you with insight to help implement a robust documentation strategy moving forward.
Background Information
While the IRS doesn’t provide a specific list of required documentation, all companies claiming the R&D tax credit are subject to the guidelines as outlined in Code of Federal Regulations (CFR) 1.41-4:
A taxpayer claiming a credit under Section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.
This is a broad definition and could lead to many questions regarding the types of documentation needed to sufficiently detail and protect your claim.
What to Document
Documentation can be broken into two categories—qualified expenses and qualified activities. These two categories go hand in hand to help form the basis of a sound documentation strategy. Qualified expenses fall into three types of expenses:
- Qualified Labor
- Qualified Supplies
- Qualified Contract Research
These are the three fundamental cost areas used to directly calculate the size of your research credit. It makes sense for a company to heavily invest in collecting its relevant costs and providing strong documentation. Typically, this information already is accounted for, but issues can arise if your tax credit claim comes under IRS scrutiny and you’re missing either of these documentation categories. The auditor is going to use expenses and activities to reconcile what you’re claiming. Qualified activities is a much broader category that includes:
- Projects
- Job Descriptions
- Processes
Research activities often aren’t as well-documented as expense-related expenses. Qualified activity documentation grows exponentially as a company increases R&D, making it costly to sort through the data. When the scope of documentation is reduced in either qualified activities or qualified expenses, risk is introduced. This makes it even more critical to develop and implement an efficient documentation strategy.
Where to Start
Much of the documentation needed to substantiate your claim is readily accessible. For your qualified expenses, your daily accounting and managerial activities will yield the majority of documentation needed. The types of documents include:
Wage Expenses
- Wage Forms
- Time Sheets
- Project Schedules
Supply Expenses
- R&D Account (general ledger (GL))
- Testing Account (GL)
- Development Account (GL)
- Invoices
- Order Logs
Contract Research Expenses
- Project/Job Account (GL)
- Vendor Proposal
- Vendor Report
Wages typically make up the bulk of expenses. Tax forms such as W-2s are among the many documents that help provide a clearer picture of wage expenditures. Providing documents such as labor by employee per project is documentation that, when combined with strong activity-based documentation, can help you protect your tax credit claim. Not all of these document types are necessary, but quality is preferred. When claiming supply and contract expenses, accounts set up specifically for R&D will allow for easy expenditure quantification. The more detailed the reporting system, the more equipped you become.
Activity-based documentation is the idea that your company is developing a new and/or improved process, technique, product, formula or computer software that has uncertainty involved. Types of documentation that provide the highest value to your company are documents that help verify your activities align with the “Four-Part Test.”
Many forms of documentation fall into this category. A project-by-project strategy can allow you to capture more projects and help mitigate some of the risk involved if documentation is departmentally based. Documentation for this approach includes:
- Proposals
- Meeting Minutes
- Contracts
- Schematics
- Revision Drawings
- Project Files
- PowerPoint presentations
This is a small fraction of the documentation just one project can generate. If your company takes on many R&D projects, a documentation strategy that captures these types of documents is critical. An IRS examiner will evaluate the employees involved on the project, technical backgrounds, types of activity performed, hours spent on the project, etc. Supporting documentation might include:
- Job Descriptions
- Organizational Charts
- Supervisor Testimony
Lastly, you want to provide a project narrative. These narratives help show whether the project experienced any failures or setbacks over the course of development, which helps prove uncertainty and that reassessment occurred. Narratives can be constructed through documentation. The premise behind a documentation process is to build a project history. Process documentation includes, but isn’t limited to:
- Progress Reports
- Test Logs
- Lab Books
- Bug Fix Logs
Why Document So Heavily?
Your documentation strategy is your best defense for sustaining your research credit. Therefore, presenting an auditor with strong documentation only strengthens the position that qualified research occurred. Most companies are in a continual R&D cycle, and the R&D tax credit represents a considerable savings to those companies. If you lack a strong documentation strategy, you run the risk of missing these tax savings.
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