Often, the exercise of an IRS audit falls solely on the Tax Department. Although this is typical for financial audits, this should not be the case for specific Research and Development (R&D) Tax Credit audits. Even though the tax departments are familiar with the operations, they are not able to speak to the nature of the qualified activities with respect to the specifics of the 4-Part Test. They cannot easily identify where the supporting documentation is kept, nor identify how the documentation relates to, or demonstrates, the qualifying nature of the work. This is why it is beneficial for the taxpayer to have a strong technical (R&D or Engineering) representative champion the R&D process.
The Purpose of the R&D Champion
R&D tax credit audits are specifically aimed to evaluate the nature of the qualified activities as they relate to the definition of “research and development” under the tax code. This is a very narrow scope and should be treated with some appreciation of the technical nature of the conversation.
IRS auditors need to assess the qualification of claimed activities against the 4-Part Test—most importantly the Technical Uncertainty and Process of Experimentation—and the specifics of the underlying principles of science or engineering. Furthermore, they need to be able to understand the nature of the qualifying activities and review specific technical documents and/or corroborative records in order to determine the level of that qualification. This is best done by sitting down with an R&D Champion who can speak to the nature of the research and development activities for the company and explain how development efforts extend into and are supported by manufacturing operations.
Therefore, identifying a qualified technical representative to act as a champion for the Research Tax Credit (RTC) at the beginning of the study is critical for a number of reasons:
- Understanding of Engineering: The person who takes on this role should have knowledge of, and experience in, engineering and operations. This will allow them to understand the research activities of the company and identify which ones qualify for the tax credit. In addition, the champion will be more likely to understand the drivers for development efforts (i.e., pure innovation ideation projects, market-driven, customer requests for improved functionality, quality issues, manufacturing constraints, etc.).
- Knowledge of the Company’s Structure: The R&D Champion should be familiar with the company’s internal structure in order to accurately identify the groups, departments, and/or teams who are involved during the various steps of the research activities.
- Efficient Communication: A Champion who has both engineering and operations expertise can help communicate more effectively with the IRS or tax authorities, as well as any auditors who may review the company’s tax credit claim. This can help ensure that the company’s research activities are accurately represented and that the tax credit is appropriately claimed. Internally, they can also efficiently communicate with and be the bridge between the engineering and the tax or finance departments.
- Maximizing Tax Benefits: A knowledgeable Champion can identify all eligible research activities and ensure that the company maximizes the tax benefits available under the Research Tax Credit. The more qualified activities a company can identify and document, the greater the tax benefit it can receive. The individual can also help the company maintain appropriate documentation that will then support the RTC claim.
- Alignment with the Study’s Framework: The R&D Champion offers valuable input to allow for the customization of the study’s framework and ultimate determination of the correct level of business component. Their knowledge and expertise helps to ensure that the project is aligned with contemporaneous documentation, record-keeping, facts, etc.
- Audit Support: In the event of an audit, this individual often helps explain why the activities are qualified to the IRS agent. If an activity is under debate, the Champion can speak directly to its nature as it pertains to the process of experimentation or technical uncertainty. The Champion can then provide first-hand information as to the types of corroborative records that exist and what technical aspect they attest to.
Thus, there are numerous benefits from incorporating a suitable R&D Champion throughout the R&D process. In general, it helps to ensure that an efficient study is put together through alignment with framework methodologies. It encourages compliance with other departments or groups by focusing efforts and interviews with individuals in key areas with eligible activities. Even further, having a champion for the RTC study who has expertise in both engineering and taxation is critical to ensure that the company maximizes the tax benefits available under the RTC while minimizing the risk of an audit.
Most of all, comprehension is increased on all fronts—from external interaction with consultants, internal communication with tax and finance teams and subsequent IRS audits. DST Advisory Group’s team of Tax Engineers, Tax Associates, and Tax Attorneys work together with your R&D Champion to maximize efficiency and ensure that your R&D study is fully protected and substantiated in the event of any review.
Who is your champion?