Publication Date - June 2005
* Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
7. SUBSTANTIATION AND RECORDKEEPING
Under the final regulations, a taxpayer must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. See I.R.C. § 6001; Treas. Reg. § 1.6001-1. The taxpayer must clearly establish full compliance with all of the relevant statutory and regulatory requirements. Failure to maintain records in accordance with these rules is a basis for disallowing the credit.
The Service does not have to accept estimates of qualified research expenses if documentation exists to verify the actual amount of such expenses. As set forth above, taxpayers are required to keep records substantiating the amount of any reported, claimed, or affirmatively raised deductions or credits.
The courts will allow the use of an estimation method only where the taxpayer does not have contemporaneous records, and then only as long as the following two conditions are satisfied. First, the taxpayer must establish that it engaged in qualified research activities as defined in section 41(d). And second, the failure to maintain a proper system to capture relevant information cannot be an "inexactitude is of their own making". Estimation methods are permitted only in cases where the sole issue is the exact amount paid or incurred in the qualified research activity. Accordingly, taxpayers must have factual support for every assumption underlying their estimates to meet their burden of proof.
At the commencement of the audit, a meeting should be held with the taxpayer to discuss what type of contemporaneous books and records are available to substantiate the research credit claimed. Contemporaneous books and records should form the basis of the examination, and should be requested, as needed, in examining the particular issues addressed in this audit techniques guide.
The initial IDRs should focus on broad issues relating to information that is usually readily available to the taxpayer. Some examples of requested items are:
Taxpayer’s base amount and fixed base percentage calculations
General info: chart of accounts, organization charts
Acquisitions and dispositions from 1984 through the tax year under audit
Accounting method: Are costs accumulated by department or by project?
Activities: What are they, and why are they eligible for the R&E credit?
Wages: Names, amounts, % of annual wages, departments, job titles & descriptions
Supplies: Categories, how they tie in to general ledger, amounts by category
Contracts: With whom, amounts, categories
It is recommended that the items listed in the IDR be requested via several “bite-sized” IDRs. Pre-determined IDR turnaround time should be established and enforced.
The following information is helpful in understanding the appropriation of company resources or details of research projects the taxpayer conducted during the examination year:
- Materials explaining research activities, including brochures, pamphlets, press releases, and other similar documents.
- Submissions to management, the board of directors, review committees or other similar groups regarding research projects, activities, expenditures, and the research credit.
- Documents prepared by, or on behalf of, internal audit, including quarterly and annual reports that refer in any manner to research activities.
- Minutes, notes, or other similar recordings from budget, board of directors, managerial or other similar meetings concerning research activities.
- Project authorizations, budgets, or work orders that initiates a research project.
- The internal authorization policies for approving a research project.
- Project summaries and/or progress reports and project meeting minutes.
- Field and lab verification data/summary data.
- Research credit studies conducted by outside consultants.
- Papers, treatises, or other published documents regarding the taxpayer’s research.
- Complete copies of contracts (including all modifications), letter agreements, memoranda of understanding, or similar documents for research performed by, or on behalf of, a third party.
Credible oral testimony by individuals with personal knowledge of the issues may be helpful in evaluating and/or supplementing a taxpayer’s contemporaneous documentation. Interviews may be necessary to gather new information, or to confirm, clarify or refute other documentary or testimonial evidence. The interviewee will often be a technical or supervisory person with specialized knowledge of the issue in question. If conducted effectively, the interview can be a very useful examination tool. However, careful preparation is essential.
It is strongly recommended that another IRS colleague assist you during the interview:
as an observer to the interview,
to take notes, freeing you to concentrate on the interviewee’s responses and to formulate your next question,
to pose overlooked questions, and
to provide additional technical and/or administrative support.
Notice 2004-11, (published in the Internal Revenue Bulletin on February 9, 2004), permits the Internal Revenue Service, and Large and Mid-Size Business (LMSB) taxpayers to enter into research credit recordkeeping agreements (RCRAs). 15 This new Research Credit Recordkeeping Agreement program will help alleviate many of the tedious recordkeeping issues that now plague the research credit issue by allowing both taxpayers and the Service to agree upfront what records are necessary to support a taxpayer’s research credit claim. If the taxpayer keeps these records, then disallowance for lack of substantiation will generally not be an issue.
An RCRA applies to future years and, in this way, the taxpayer can take steps to ensure that its research is properly documented before it ever takes place. The best time to propose such an agreement would likely be upon completion of the current examination cycle. At that time, the examiner, CAS, and the taxpayer are in the best position to determine what taxpayer records are necessary. If the parties enter into such an agreement, the taxpayer will know what records need to be kept and maintained in order for the Service to effectively and efficiently audit the credit. This may require the taxpayer to create new records for future years that previously did not exist. In addition, it may be determined that records presently kept, may no longer be needed. Although such an agreement will not resolve other audit issues, such as whether the activities qualify under section 41(d), it should improve and expedite the audit process to the mutual benefit of the parties.
The use of expedited resolution procedures including Advanced Issue Resolution (AIR) and Pre-Filing Agreements (PFA) should be considered, where appropriate. The examiner should also consider issuing a Notice of Inadequate Records 16, pursuant to Treasury Regulation section 1.6001-1(d), if the taxpayer does not keep sufficient or adequate records to support the research credit claimed.
15 Notice 2004-11 Research Credit Recordkeeping Agreements (RCRA)
16 Letter 1022 (DO) Inadequate Records Notice Follow-up , Letter 978 (DO) Notice of Inadequate Records , Letter 979 (DO) Inadequate Record Notice