- Known for its complex rules, the research and development tax credit has long been a focus of IRS audits.
- With the latest wave of audits, the credit’s process of experimentation rules are being used as a basis for disallowance.
- Organizations should understand the importance of the process of experimentation requirement and how to document it to withstand potential IRS scrutiny.
Need help capturing and documenting your R&D credits?
This year marks 40 years since the research and development (R&D) tax credit was first made a part of the Internal Revenue Code. The goal of the credit was to foster American innovation by subsidizing a portion of taxpayers’ R&D costs; and most would agree that the credit has been incredibly valuable in this regard.
While the primary beneficiaries of the credit early on were laboratory-based research and scientific organizations, things have changed quite a bit over the decades. Nowadays, taxpayers in just about every industry — including software, architectural and engineering, construction, and even retail — are claiming the credit, as eligibility has greatly expanded and made the credit more accessible to taxpayers.
The benefits can come at a cost
Few provisions in our tax code rival the complexity, subjectivity, and contentiousness of the R&D credit, all of which have led to litigation between the IRS and taxpayers. In fact, for several years beginning in 2007, the R&D credit was designated as a Tier I issue under IRS audit guidelines, meaning it received the highest level of scrutiny and was essentially guaranteed an audit in many circumstances. The tier system has since been replaced with a compliance campaign model and, not surprisingly, the credit was added to the list of active IRS campaigns in February 2020.
Heightened attention from the IRS shouldn’t necessarily deter taxpayers from claiming the R&D credit if their activities otherwise qualify for the credit. Instead, taxpayers need to be aware of the many factors that can help make their claims supportable.
Recent rulings from the U.S. Tax Court highlight the importance of a basic yet often overlooked requirement of the R&D credit: adequately documenting the process of experimentation (POE) involved in your R&D projects. Although the POE requirement is just one of many when claiming the R&D credit, it seems to be receiving increased attention from the IRS in recent years.
What constitutes a process of experimentation?
There are four threshold requirements when qualifying for the R&D credit. In short, a taxpayer’s activities must:
- Relate to the development of a new or improved business component (think of a business component as the product or process that’s the subject of your R&D),
- Rely of the fundamentals of hard science (e.g., physics, engineering, computer science),
- Be intended to eliminate technical uncertainty relating to the business component, and
- Constitute a POE (i.e., a process designed to evaluate one or more alternatives regarding the development of your business component from a technical standpoint).
The POE requirement is arguably the most important. The credit rules further impose a quantitative threshold where “substantially all” of your activities must constitute a POE, which is defined as at least 80%. Proving the 80% POE requirement can be difficult, especially considering there is no clear guidance for how to establish the threshold has been met.
There’s a favorable provision, however, to assist taxpayers in meeting this requirement. Known as the “shrink-back” rule, it allows the qualification requirements to be applied first at the level of the overall business component; and, if the requirements are not met at that level, they are then applied at the next most significant subset of elements of the business component. In other words, the shrink-back rule is meant to allow taxpayers to meet the POE requirement based on a portion or subset of a larger business component.
Example 1: Assume you’re developing a new airplane wing, and the overall geometry and materials used are based on a known, proven design. In that case, the activities and costs associated with the entire wing likely will not qualify for the R&D credit. But let’s say the wing incorporates an entirely new design for the flaps that required substantial R&D. Likely, the activities and costs associated with the flap design could qualify for the credit using the shrink-back principle.
Example 2: Your start-up software company launches a new online payment processing platform in year 1 that was built completely from the ground up. The entire platform would probably be considered a business component that meets the POE test and shrink-back would not be required in year 1. In year 2, you develop and release a new data protection feature that was not available in the original platform launch. The new feature would be the business component in year 2 against which credit qualification would be measured, rather than the entire platform again.
Renewed focus on the process of experimentation
Even though the POE requirement has been in the R&D credit rules since its enactment, it seems the IRS has begun focusing on it more so than it has in the past. Furthermore, the Tax Court has sided with the IRS on this issue in some recent decisions, thus giving more ammunition to the IRS in challenging future credit claims on these grounds.
When the Tax Court recently issued its decision in Little Sandy Coal Company, Inc. v. Commissioner, it perhaps made the POE rules more onerous. The taxpayer’s shipbuilding activities and projects at issue were fairly robust from an R&D and engineering standpoint, yet the court entirely disallowed the credit claims because the taxpayer did not establish that it met the POE test.
Notably, the court held that the 80% POE test was to be applied to activities rather than physical components of a product. Additionally, the court held that employees involved in the direct support or supervision of R&D — as well as supplies used in the development process — cannot be considered in establishing the 80% POE threshold.
The court’s interpretation of the POE test appears novel, and its opinion has been troubling to many practitioners since it seems to impose overly stringent requirements to an area of tax law that is already difficult for taxpayers to navigate. An overturn at the appellate level is possible for this case; until then, however, taxpayers must consider the impacts of the decision.
How should your process of experimentation be documented?
With a renewed focus in this area, consider how to properly document your POE. Unfortunately, there is no hard-and-fast rule, but there are a few basic considerations to keep in mind.
Project accounting is preferred
Companies using detailed project accounting systems that track employee time and project costs tend to start off on better footing in the event of an IRS exam. As you’d expect, the IRS prefers actual project tracking data rather than the use of estimates when it comes to proving qualified activities and a taxpayer’s POE. This is not to say that estimates are never acceptable; however, the more refined, systematic, and detailed the estimate, the better.
Technical documentation matters
Taxpayers are often called on to provide technical project documentation that highlights their POE. Common examples of such documentation include:
- Design drawings and revisions
- Patent applications
- Technical regulatory submissions
- Release notes
- Product tracking and workflow logs
Retaining your technical documentation is critical. Moreover, compiling it contemporaneously with your R&D activities is the ideal practice.
Compile documentation based on business components
Each business component should be able to stand on its own. The IRS will generally require you to separately account for and document each business component — and catch-all categories such as “Miscellaneous R&D” or “Process Improvements” are easy targets for disallowance. Therefore, the preferred approach is to clearly define, document, and allocate costs to your distinct business components.
Focus on your core R&D team
Documentation highlighting your POE should focus heavily on the core group of scientists, engineers, and designers who are performing your R&D work — rather than individuals who are supporting or supervising it. This is even more important in light of the Little Sandy Coal decision discussed above.
Consider a formal product development process
Organizations that follow a regimented and well-documented product development process often fare better than those without one. Regulatory or industry standards that define how products must be developed and tested, such as those set forth by the FDA or ISO, tend to be strong evidence of the POE involved. However, even organizations not subject to these strict standards may benefit from clearly outlining how their products are to be created, tested, and released.
How we can help
CLA’s national R&D credit team helps organizations across a wide range of industries capture and document their R&D credits. Our approach is tailored to address the issues most commonly encountered in a potential audit. We also work with organizations to develop and implement procedures designed to better document credit-eligible activities and costs.
Contact us to learn how our team can help your organization benefit from the R&D credit.