Preparing for an R&D Tax Credit Audit

The Research and Development tax credit is a great way for companies to reduce their tax liability and generate savings that can be reinvested in the businesses. Companies who claim the R&D tax credit must be prepared for a potential audit. Not being ready for an R&D tax credit audit could result in a reduction or complete loss of the credit, plus penalties and interest.

Audits are common for certain tax credits, and the R&D credit is usually on the IRS’s “Dirty Dozen” list. Here are some tips to keep in mind if the IRS or state tax officials select your claim for an audit:

Don’t enter your audit on the defensive or assume this will be an adversarial interaction. You should go in with a positive and collaborative attitude. The goal is to work with the auditor to demonstrate your claim’s validity.

The R&D tax credit was designed to support companies investing in their businesses. It helps to remember that auditors are doing their job to ensure the credit goes to the right companies.

You should provide accurate and complete information and be prepared to answer the auditor’s questions. Keep in mind that the IRS is looking for substance over form, so companies should ensure their R&D activities are well-documented and substantive.

You should ensure you are following the R&D tax credit regulations. This includes ensuring all claimed R&D activities meet the appropriate criteria and that you are recording their R&D expenses properly.

It is crucial to keep proper R&D documentation of all activities and expenses. This should include project descriptions, project timelines, employee time records, and invoices. The documentation should be well-organized, easily accessible, and up-to-date.

Using the wrong percentage for the alternative simplified method or improper use of the fixed base percentage are common mistakes. Similarly, completing the federal or state forms incorrectly is a red flag.

Adjustments to the base period methodology are not unusual as new guidance is released by the IRS or following tax court decisions, but yearly changes are another red flag for auditors. The fixed base percentage under start-up rules is intended to stabilize 11 years after a company’s start of qualified expenditures and revenue. Established companies, barring acquisitions or dispositions, will have a stable percentage starting by the 11^th year of eligibility.

Whoever compiles your credit should use engineers to evaluate and test the credit claim against the requirements, just as the IRS will do during an audit. In-depth interviews with key personnel help the team evaluate activities, making sure only eligible projects are included.

Time-tracking data is the preferred way to determine personnel percentage, but often this isn’t available. It can be tempting to apply a blanket percentage to employees or departments. Individually evaluating personnel is the only viable method. Interviews can help support this detailed approach.

Even if you’ve done an excellent job of segregating costs, entire GL accounts are rarely fully qualified. In many cases, items may be appropriately allocated to a certain cost center, although not all of the items are actually eligible for the R&D credit.

R&D credit audits are not uncommon. To be better prepared, you should keep proper documentation, perform a thorough study, be honest and transparent, and work with qualified professionals.

By following these recommendations, you can help ensure that you are properly claiming the credit and reduce the risk of an IRS or state audit reducing or denying the credit amount. Contact us today to learn more about how we can help your company be better prepared for an R&D tax credit audit.