Conducting an R&D Study Series - Part 3: Creating Workpapers

In the previous parts of our series, we decoded the eligibility criteria by understanding the Four-Part Test for qualified research activities and then focused on gathering the initial W2 wage and contractor information. With that crucial data in hand, the next vital step in conducting a comprehensive R&D tax credit study is to generate structured workpapers, typically in Excel. These workpapers serve as the backbone of your documentation, providing a clear, organized record that ties expenses back to specific individuals and projects, essential for substantiating your claim and preparing for potential IRS scrutiny.

The Importance of Detailed Workpapers

The IRS places a significant burden of proof on the taxpayer when claiming the R&D tax credit. Meticulous record-keeping is paramount to ensuring that every expense included is well-supported and meets the stringent criteria. Workpapers help establish contemporaneous documentation – records created during the research process – which strengthens the credibility of your claim.

Structuring Your Workpapers: Key Columns to Include

To create effective workpapers, you will want to list each individual employee and contractor involved in potential R&D activities and include specific columns for relevant data:

• For Individual Employees:

  • Hire Date

  • Termination Date

  • Full Name

  • Job Title

  • Department

  • State (to differentiate between Federal and State QREs, as California, for example, only includes wages from qualified employees working within the state for its R&D credit calculation)

    

  
  It is crucial to note that while W2 Box 1 wages are essential for the final calculation of qualified research expenses, the actual wage amounts should not be included directly in these employee-level workpapers. This is to protect sensitive employee financial information and ensure it is not part of the survey process with technical leads.

  
  

• For Contractors (Contract Research Expenses):

  • Contractor Name

  • Amount

  • % of Work Performed in the USA (research conducted outside the U.S. or its territories does not qualify)

  • Contractor Country

  • Contractor Location State (for state credit calculations)

    

  
  

  When identifying contractor costs, it's essential to examine General Ledger (GL) detail for professional services accounts or review 1099s. Crucially, contracts with third-party contractors must demonstrate that your company bears the economic risk (the agreement requires payment even if the research is unsuccessful) and retains substantial rights to the research results (the right to use the discovered knowledge, even if non-exclusive). Amounts contingent on the success of the research are considered payment for the product/result and generally do not qualify.

Quantifying Research Effort and Activities

Once you have all employees and contractors listed, you will want to add:

• Qualified R&D % Column: This column will indicate the percentage of each individual's or contractor's time and associated costs that were directly involved in qualified research activities. This percentage is typically determined during discussions with the technical leads of the company, who are often referred to as "Subject Matter Experts" (SMEs). More on this in the next article.

  
  

• Qualified Activities Dropdown Menu: For software development activities, which are frequently eligible for the credit, this menu can include examples such as:

  • Conceptualization / Initial Design

  • Business Requirements Definitions

  • Functional/Technical Specifications Definition

  • Algorithm/Architecture Design

  • Coding / Development / Implementation

  • QA Test Plan/Process/Procedure Definition

  • QA Test Plan Execution

  • Alpha / Beta Testing

    
    

  These activities align with the "Process of Experimentation" requirement, which involves a systematic approach to evaluate alternatives and eliminate uncertainty in the development or improvement of a business component, often through testing, modeling, or trial and error.

  
  

• Project Columns: Include columns where you can list out the larger R&D developments performed during the tax year. These projects demonstrate the company's efforts to develop new or improved functionality, performance, reliability, or quality in their software applications, tools, platforms, and systems.

Once these workpapers are meticulously compiled with the necessary detail, you are well-prepared to begin your technical interviews, which will be the focus of the next article in this series.