Document Collection Strategies for Research Credit

This article will expand the discussion by focusing on document collection procedures and strategies to ensure the substantiating documentation can be accessed efficiently and effectively in response to an Internal Revenue Service (IRS) examination.

As indicated in IRC §6001 and its corresponding regulations, taxpayers must keep records in sufficient form and detail to substantiate any reported, claimed, or affirmatively raised deductions and credits. The courts, specifically in Cohan v. Commissioner, allow the IRS to make estimates when a taxpayer lacks contemporaneous records of research credit expenditures. However, the IRS can take a much harder line against the taxpayer in accepting research credit expenditure claims if the “inexactitude is of their own making” (i.e., the failure to keep and maintain records is the fault of the taxpayer). The Cohan decision therefore does not mean the IRS can as a rule deny all expenditures when a taxpayer cannot provide a reasonable basis to make the estimate (e.g., see the Fifth Circuit Court of Appeals discussion in its 2014 Shami v. Commissioner ruling). But, these statutes, regulations, and rulings underscore the importance of maintaining an adequate system to collect and store such substantiating records.

It is of critical importance that business organizations that conduct research assign a specific person or department the responsibility for keeping track of and maintaining substantiating documentation. This person or department must understand any special documentation rules (i.e., FDA rules for pharmaceutical companies) that apply to the particular business or regulatory environment. The person or department in charge should have an outstanding working knowledge of the company’s research process and how it maintains relevant materials. This is essential to advance research credit claims effectively.

R&D projects typically generate a substantial amount of research documentation often making it impractical to collect and analyze all research documents during the tax return preparation process. This does not suggest that taxpayers should postpone document collection until audited by the IRS as documentation often becomes more scarce and difficult to collect as time passes. Thus the responsible person or department must identify the critical documents to collect initially and those that can wait for later collection.

The initial collection should include, at minimum, the standard operating procedures (SOP) for the R&D process and project plans for all projects. Project plans are particularly useful as they are written in plain language, provide an overview of the overall project, offer high-level descriptions of the major phases of each project, list the functional departments involved in the research, and often highlight risks or uncertainties involved in developing a new product. Project plans also typically prevent IRS auditors from claiming that they did not know the type of available documentation and offer insight into other documents produced during the project.

A great record keeping strategy will have the responsible person or department set aside a collection of sample documents. Ideally, this collection should include the entire set of research documents for a single project. The project chosen should be representative of the company’s typical R&D process and illustrate the breadth and depth of the research conducted. In conjunction, the taxpayer should collect documents from other projects on a sample basis showing different aspects of the research process in order to demonstrate that it conducts its research in a consistent manner.

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