By Samantha TABER, J.D
Am I going to get audited? This is one of the most common concerns clients have when considering claiming the Research and Development (R&D) Tax Credit. Due to this concern, a surprisingly low percentage of eligible companies claim the credit because they don’t want the headache of an audit. This fear of an audit is usually broken down into two main concerns: What are my chances of getting audited? And, if I get audited, what are the chances that my claim will be sustained and supported?
What are my chances of being audited?
When answering this question, there are a couple of factors to consider. First, on what return(s) is the R&D Tax Credit being claimed? There is a three year statute of limitations for claiming the R&D Tax Credit from the time the original tax return was filed. Therefore, a client will have the option of including the R&D Tax Credit on their original return as well as amending previous years’ returns in order to claim the R&D Tax Credit. For original returns, the chances for a corporation being audited are less than 1%. This means that of approximately 2,000,000 corporate returns filed, only 33,000 have the potential to be audited.
For amended returns, the chances of an audit increase. The R&D Tax Credit does not in itself increase your chances of being audited; however, by filing an amended return to claim the R&D Tax Credit, a client opens themselves up for additional scrutiny because the return undergoes a second examination by the IRS. With that being said, the risk of an amended return being audited is still relatively low, especially given the reduction in IRS funding.
With these percentages in mind, when researching an R&D Tax Credit firm, you may hear the term “Success Rate” tossed around as firms boast that they are 96.5% successful at claiming the R&D Tax Credit without an audit. What these firms are trying to say is that of all of the tax returns filed, 96.5% of the claims do not get audited. As the Success Rate is based on pure chance or a roll of the dice with the IRS, this does not give you a true picture of whether these claims will be upheld once they go to audit. Therefore, the next section more accurately addresses these concerns.
If I get audited, what are the chances that my claim will be sustained and supported?
Once audited, the sustention rate reflects the amount of credits that were successfully allowed by the IRS. To better explain the difference between a “success rate” and a “sustention rate,” please see the chart below.
The amount of the credits upheld directly relates to the amount of support and documentation that the client has in regards to their R&D Tax Credit claim. Therefore, to prevent a claim from being reduced or disallowed, there should be the appropriate substantiation around the credit claim. There are a few major areas that the IRS considers when evaluating the claim.
The first is the documentation to support the qualified activities being claimed as research and development. For an activity to qualify for the R&D Tax Credit, it has to meet a four-part test, as described by the Internal Revenue Code. These requirements, listed below, are each evaluated to determine whether an activity would qualify for the credit. If one part of the test fails, then the activity should be excluded from the R&D claim.
- New or Improved Business Component Requirement
- Elimination of Uncertainty Requirement
- Process of Experimentation Requirement
- Technological in Nature Requirement
Therefore, the IRS evaluates the activities and the documentation around those activities to determine whether they qualify for the credit. The IRS feels that R&D develops documentation and that documentation should be maintained and considered when evaluating a claim for the R&D credit. However, this documentation is not anything specific and could include engineering drawings, plans, layouts, notes, or something as simple as email correspondence.
As certain expenses drive the calculation of the R&D credit, the IRS also considers the financial documentation to support the R&D claim. There are three major buckets of expenses that can be captured towards the credit, including Wages, Supplies, and Contractor Costs. For these expenses, the IRS evaluates the types of raw information generated to support the claims for these expenses.
Furthermore, the IRS then evaluates the link between these qualified activities and the financial documentation. This “nexus,” as it is commonly called, demonstrates, for instance, which employees are working on which qualified activity. Compiling as much documentation as possible to support this connection is a vital component. This documentation could be the names of the travelers in the manufacturing process, names from emails, or names listed on engineering drawings or meeting notes.
Therefore, gathering and maintaining documentation is an essential component to the R&D Tax Credit claim, and BGI’s study process is specifically targeted to substantiate and support this claim. Our study deliverable is intended to be a stand-alone response to IRS examination and we include answers to the IRS Exam Guidelines’ Super Information Document Request. Within our deliverable, we structure the framework for the claim that creates efficiencies in reporting operational business components and nexus. Due to our comprehensive deliverable, a few of our clients that have been audited have received 100% sustainment relying solely on our study deliverable.
For more information, please contact us at (888) 802-5999.
SAMANTHA TABER earned her J.D. from Texas Tech University School of Law and has three years of experience helping companies take advantage of the Research and Development Tax Credit. During that time, she has assisted over 200 clients ranging from small to medium size companies to large publicly held companies. Located in Houston, Texas, Samantha assists in managing the production team and provides our clients with advisory and project implementation services.
 “Fiscal Year 2014 Enforcement and Service Results.” IRS: May 2015. Web. 8 Sept. 2015.