The Research and Development (R&D) Tax Credit is a powerful tool that can help businesses offset the costs of innovation and stay competitive in today’s rapidly changing marketplace. However, claiming the credit requires more than just conducting research and development activities. To successfully claim the R&D Tax Credit, businesses must also provide detailed documentation that supports their claim. Contemporaneous documentation is critical to demonstrate the technical uncertainties faced and the systematic process of experimentation undertaken to address those uncertainties. In this article, we’ll explore why contemporaneous documentation is so important and provide practical guidance on how businesses can create and maintain the documentation necessary to support a successful R&D Tax Credit claim.
The Requirements Set Forth by the IRS
When claiming the Research Tax Credit (RTC), documentation can make or break a claim. Does that mean as a taxpayer you need to supply hundreds of pieces of documentation? No, not at all. In fact, when it comes to documentation, it’s quality over quantity.
As it states in section 41-4(d), “A taxpayer claiming a credit under section 41 must retain records in a sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”
The only guidance provided by the IRS on what constitutes sufficient documentation under section 41 to establish nexus between qualified research activities (QRAs) and qualified research expenses (QREs) is that, in general, the documentation should provide a clear and detailed description of the activities being performed, the purpose of the activities, and how they relate to the development or improvement of a business component.
The IRS does require documentation that shows how expenses are directly related to the QRAs, such as payroll records, invoices, and contracts. The documentation should be contemporaneous, meaning it is created at the time the activity or expense is incurred, rather than after the fact.
Furthermore, the IRS requires that taxpayers maintain documentation that establishes the following elements of the QREs:
- The amount of the expenses,
- The time period over which the expenses were incurred, and
- The nature of the expenses.
The documentation should be organized and easily accessible in the event of an IRS audit.
It’s important to note that the documentation requirements can vary depending on the facts and circumstances of each case, and that the burden of proof is on the taxpayer to establish that the activities and expenses meet the requirements of section 41.
In the event of an audit, an examiner will want to ensure that the business component is not routine, but rather is truly a new or improved product or process. Sufficient and detailed documentation is vital to proving that the claim is qualified.
What is appropriate documentation?
According to the IRS, the documentation should provide a clear and detailed description of the activities being performed, the purpose of the activities, and how they relate to the development or improvement of a business component. This may include project descriptions, research plans, laboratory notebooks, or other similar documents that show the process of experimentation or development. The types of documentation are going to be different for each taxpayer, given the nature of their business, what their qualified research activities are, and how they document their work.
In general, documentation should show the planned approach to the research and the systematic trials or testing that occurred to overcome the uncertainty and ultimately try to meet the objectives. In other words, how the work done meets the Four-Part Test Documentation should:
Demonstrate the permitted purpose: documentation should be related to the activity that shows the intention to create new or improved products, processes, software, formulas, or other similar components that will have a technological application in the taxpayer’s business.
Examples: New product to Taxpayer, new product features, new functionality, inventions, material testing, new tooling, new equipment, pilot line, laboratory scale to full production scale, etc.
Demonstrate a Systematic Process of Experimentation: Documentation that shows the systematic process of experimentation should provide a clear and detailed description of the systematic trial and error process that was undertaken to achieve the intended result. A summary of test results or a summary of tables that imply experimentation is insufficient. Documentation should go a step further and supply enough details to prove the process of experimentation.
- Clear and detailed descriptions of the various alternatives that were evaluated: The documentation should show the various alternatives that were considered and tested, and how they were evaluated. This should include a description of the different approaches or methodologies that were used, as well as any hypotheses that were tested.
- Testing plans and protocols: The documentation should include detailed plans and protocols for how the testing was conducted, including the procedures that were followed, the materials that were used, and the measurements that were taken.
- Data and results: The documentation should include detailed data and results from the testing process, including both successful and unsuccessful results. This should include data on any observations made during the testing process, as well as any conclusions that were drawn from the data.
- Analysis of the results: The documentation should include an analysis of the results of the testing process, including any insights gained from the data and conclusions drawn from the observations made during the testing process.
- Changes made based on the results: The documentation should show how the results of the testing process were used to refine the approach or methodology being tested, including any changes that were made based on the results.
- Timelines: The documentation should also include timelines that show when each stage of the testing process was conducted, how long it took, and when any changes were made.
Demonstrate a Systematic or Planned Approach: Documentation should show that the research project is forward-looking as opposed to retrospective. This can include planning documents such as roll out schedule, launch schedule, quantities of pilot units for testing in-house or in the field.
Examples: Product development list, email communications, design validation, product validation, gated product development system, Production Part Approval Process, Design Failure Mode and Effects Analysis project timelines, Gated development system, quality assurance, pareto analysis, Engineering Change Notice, Engineering Change Request, etc.
- Be Contemporaneous in Nature: Documentation should correlate the QRAs to the claim period. While every business has a different form of record keeping, many businesses opt to use timesheet systems. This might not always be the most appropriate method. However, no matter the form, it is important to implement an appropriate real-time approach to identifying R&D projects and cost.
Demonstrate some Technical Uncertainty: Documentation that helps to demonstrate technical uncertainty should provide evidence that the taxpayer faced significant uncertainty related to the development or improvement of a business component. This uncertainty must be related to the “hard sciences,” such as engineering, computer science, chemistry, physics, or biology. To demonstrate technical uncertainty, documentation should include the following:
- Explanation of the technological uncertainty: The documentation should explain the technical uncertainty that was faced in the development or improvement of the business component. This should include a description of the problem or challenge that was encountered, as well as an explanation of why the solution was uncertain.
- Evidence of prior knowledge or lack thereof: The documentation should provide evidence that the taxpayer did not know, or could not have reasonably known, the solution to the technical uncertainty at the outset of the project. This may include a review of industry standards, academic research, or other sources of prior knowledge.
What is NOT appropriate documentation?
Not all documentation is appropriate to support a claim for the R&D Tax Credit. In general, documentation that is not contemporaneous, not detailed or not relevant to the technical uncertainty or the process of experimentation is not appropriate.
Examples of documentation that may not be appropriate include:
Documents created after the fact: Documentation that is created after the experimentation process has occurred, and not contemporaneous to the activities being documented, may be viewed with skepticism by the IRS and may not be considered sufficient to support a claim for the R&D Tax Credit.
Inadequate or vague descriptions: Documentation that is not detailed enough to provide a clear picture of the technical uncertainty or the process of experimentation may be viewed as insufficient to support a claim for the R&D Tax Credit.
Generic statements or generalizations: Documentation that makes generic statements or generalizations without providing specific details or evidence to support those statements may not be viewed as sufficient to support a claim for the R&D Tax Credit.
Unsupported assumptions or conclusions: Documentation that makes assumptions or conclusions without providing evidence or support for those assumptions or conclusions may not be viewed as sufficient to support a claim for the R&D Tax Credit.
Lack of relevance: Documentation that is not directly relevant to the technical uncertainty or the process of experimentation may not be viewed as sufficient to support a claim for the R&D Tax Credit.
Documentation that is more in the lines of “business” documents: Commercial materials, promotional materials, pricing, marketing, business plans, cost estimating, sourcing, quotations, purchase orders, or material safety data sheets.
Appropriate documentation should be contemporaneous, detailed, and relevant to the technical uncertainty and the process of experimentation. Documentation that does not meet these criteria may not be viewed as sufficient to support a claim for the R&D Tax Credit.
Seimer Milling Co. v. Commissioner
The court case Seimer Milling Co. v. Commissioner (we wrote about this previously here) is a significant case that highlights the importance of documentation when claiming the R&D Tax Credit. In this case, the taxpayer, Seimer Milling Co., claimed the R&D Tax Credit for expenses related to the development of new flour products. However, the IRS disallowed the claimed credit, arguing that Seimer Milling Co. had not provided sufficient documentation to support its claim. The IRS stated, “The record is devoid of evidence that petitioner formulated or tested hypotheses, or engaged in modeling, simulation, or systematic trial and error…”. The IRS argued that the taxpayer had failed to provide detailed documentation of the technical uncertainties it faced or the process of experimentation it undertook. The court ultimately sided with the IRS, holding that Seimer Milling Co. had not provided sufficient documentation to support its R&D Tax Credit claim. The court noted that the taxpayer had failed to provide contemporaneous documentation and that much of the documentation provided was vague and lacked detail.
This case highlights the importance of providing detailed and contemporaneous documentation when claiming the R&D Tax Credit. Taxpayers must be able to clearly demonstrate the technical uncertainties they faced and the process of experimentation they undertook to address those uncertainties. Failure to provide sufficient documentation may result in the denial of the R&D Tax Credit and potentially costly legal battles. Furthermore, this case demonstrates that taxpayers cannot rely on vague or unsupported statements to substantiate their R&D Tax Credit claim. Rather, they must provide detailed and relevant documentation to support their claim.
DST Advisory Group and Our Tax Engineers
If you are unsure of what documentation to provide to your R&D consultants, ask. Our team of Tax Engineers have experience in a vast array of industries, including experience in the machining industries, automotive industries, chemical industries, et cetera. With their first-hand experience and knowledge, they are able to assist in determining whether the documentation provided meets the four-part test or not to help build you a solid claim.