Conducting an R&D Study Series - Part 6: Supporting Documentation

For Part 6 of our series, "Documentation and Compliance," it's critical to understand that meticulous record-keeping is paramount, as the IRS places a significant burden of proof on the taxpayer when claiming the R&D tax credit. This diligence ensures your claim is well-supported, strengthens its credibility, and prepares you for potential IRS scrutiny.

Here's an expanded look at the types of documentation required:

• Payroll Records for R&D Employees (Wage QREs)

  • You need to identify the portion of employee salaries that directly relates to qualified research activities.

  • Box 1 W2 wages are essential for calculating qualified wages, as "wages" are defined as amounts subject to income tax withholding.

  • A special safe-harbor rule states that if at least 80% of an employee's services during the tax year constitute "qualified services," then 100% of all services performed by that employee during that year may be treated as "qualified services". This means their entire Box 1 W2 wage can be included.

  • Companies need to provide documentation that links an employee's time directly to a project or activity. This can be done via a "project approach" (relying on time tracking documentation) or a "departmental approach" (using oral testimony, engineering documentation, job descriptions, and educational background to estimate time).

    
    

• Contracts with Third-Party Researchers (Contract Research QREs)

  • For contract research expenses to qualify, payments are made to third parties for services that, if performed by your employees, would be "qualified services".

  • Contracts are critical because they must demonstrate two key aspects:

    1. Your company must bear the economic risk: The agreement must require payment even if the research is not successful. Payments contingent on the success of the research generally do not qualify.

    2. Your company must retain substantial rights to the research results: You must have the right to use the knowledge discovered (e.g., in developing other products) without additional payment or authorization from the third party. Even non-exclusive rights can be considered substantial.

  • Detailed invoices and payment records are also necessary to verify amounts paid.

  • You are only allowed to capture 65% of the total CR QREs.

    
    

• Technical Documents (Blueprints, Designs, Prototypes)

  • These records provide tangible evidence of your research activities. This can include blueprints, patents, designs, drawings, and prototypes.

    
    

• Project Notes Detailing Objectives, Challenges, Experimentation, and Progress

  • The IRS highly values contemporaneous documentation—records created during the research process—as it strengthens the credibility of your claim.

  • Project notes should include:

    • Project background and objectives.

    • Technological challenges encountered.

    • The process of experimentation used to evaluate alternatives and eliminate uncertainty, such as modeling, simulation, or systematic trial and error.

    • Progress reports and testing results.

    • Identification of personnel involved.

Given that comprehensive support was a continuous consideration throughout the R&D tax credit study process, the meticulously developed workpapers, detailed calculations, thorough surveys, and robust documentation of interviews with Subject Matter Experts (SMEs) will go a long way in substantiating the credit that was generated.

This contemporaneous documentation – records created during the research process – significantly strengthens the credibility of the claim and is essential for preparing for potential IRS scrutiny. The technical side of the documentation includes project background, objectives, technological challenges, process of experimentation, and personnel involved. On the financial side, payroll records, general ledger details, and tax returns for the study years are reviewed.

Therefore, because the process of identifying, qualifying, and documenting R&D activities and expenditures was integrated throughout the study, relying on these comprehensive records, the generated credit is more likely than not to be sustained based on its technical merits.