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New Audit Guidelines: Will Your R&D Tax Credit Documentation Invite an Audit?

The Large Business & International (“LB&I”) division at the IRS examines and enforces compliance on the largest and most complex companies and tax issues. The Research & Development Tax Credit is one such tax issue, which the IRS has found consumes significant examination resources. In order to ensure that LB&I uses its resources to maximum effect, the IRS has determined that it needs to manage its resources in a more efficient manner when dealing with research credits.

To this end, the IRS issued an updated directive on March 10th, 2020, establishing new guidelines for when and how a research issue should be evaluated for audit. In order to ensure that these guidelines are being followed, the IRS has laid out a series of steps that must be undertaken before involving the Research Risk Review Team (“RT”) – experts who specialize in R&D tax credits under §§ 41 & 174 specifically.  The RT is a national strategic initiative to identify high-risk research issues under audit and consists of subject matter experts, engineers, revenue agents, and other specialists.

This directive does not address Research Issues Campaign Inventory or Compliance Assurance Process (“CAP”) program cases.

How Will This Change Impact My Business?

In order for RT to involve themselves in examining a research issue under audit, either the specialist or case manager must determine that examining the issue is necessary. If both the specialist and case manager assigned to you agree not to examine a research issue, the RT will not become involved. Once the RT becomes involved, taxpayers can expect the scope and intensity of their audit to increase substantially, as well as imposing additional administrative burdens on your engineering staff that distract from business goals.

These preliminary reviews by the specialists and case managers are often centered around documentation and substantiation and whether the taxpayer demonstrated the requisite nexus between their Qualified Development Activities and the Expenditures that arise from those activities.

Examiners and case managers will most likely focus on apparent issues, like insufficient substantiation and documentation. In order to reduce the likelihood of the RT team being brought in, Frazier & Deeter highly recommends ensuring that companies observe best practices when substantiating and documenting an R&D tax credit.

Timely documentation of your R&D activities is especially important when considering that IRS R&D audits often occur several years after tax return filing. It is important to contemporaneously capture research credit information and documentation from knowledgeable subject matter experts that may leave the company.  Timely documentation of the research activities is imperative so that these activities can be properly substantiated for the research tax credit, and ensures that valuable institutional knowledge and memory isn’t lost, which could leave your company in a difficult position when the IRS comes calling, even if the RT isn’t involved.

How Can We Help?

Frazier & Deeter’s Research & Development Tax Credit Team has over 50 years of combined experience working with the R&D tax credit. The CPAs, engineers, and attorneys on our team will help guide you through the process from beginning to end, from identifying, documenting, monetizing, and when needed successfully defending your R&D claim. The best practices we help your team implement will not only reduce your audit risk, but also add efficiency to any future R&D studies that you may perform.

Whether you’re a new startup just getting off the ground, or an established player in your field, the R&D tax credit can provide enormous value to your company. Let us know how we can help!

Authors & Contact Information

Gates, Elmore CPA – gates.elmore@frazierdeeter.com

Thomas A. Zavieh, CPA – Partner – Tommy.zavieh@frazierdeeter.com

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