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:: Credit for Increasing Research Activites - Substantiation and
Recordkeeping
7.
SUBSTANTIATION AND RECORDKEEPING
Under the final
regulations, a taxpayer must
retain records in sufficiently
usable form and detail to
substantiate that the
expenditures claimed are
eligible for the credit. See
I.R.C. § 6001; Treas. Reg. §
1.6001-1. The taxpayer must
clearly establish full
compliance with all of the
relevant statutory and
regulatory requirements.
Failure to maintain records in
accordance with these rules is a
basis for disallowing the
credit.
The Service
does not have to accept
estimates of qualified research
expenses if documentation exists
to verify the actual amount of
such expenses. As set forth
above, taxpayers are required to
keep records substantiating the
amount of any reported, claimed,
or affirmatively raised
deductions or credits.
The courts will
allow the use of an estimation
method only where the taxpayer
does not have contemporaneous
records, and then only as long
as the following two conditions
are satisfied. First, the
taxpayer must establish that it
engaged in qualified research
activities as defined in section
41(d). And second, the failure
to maintain a proper system to
capture relevant information
cannot be an "inexactitude is of
their own making". Estimation
methods are permitted only in
cases where the sole issue is
the exact amount paid or
incurred in the qualified
research activity. Accordingly,
taxpayers must have factual
support for every assumption
underlying their estimates to
meet their burden of proof.
At the
commencement of the audit, a
meeting should be held with the
taxpayer to discuss what type of
contemporaneous books and
records are available to
substantiate the research credit
claimed. Contemporaneous books
and records should form the
basis of the examination, and
should be requested, as needed,
in examining the particular
issues addressed in this audit
techniques guide.
The initial
IDRs should focus on broad
issues relating to information
that is usually readily
available to the taxpayer. Some
examples of requested items are:
-
Taxpayer’s base amount
and fixed base
percentage calculations
-
General
info: chart of accounts,
organization charts
-
Acquisitions and
dispositions from 1984
through the tax year
under audit
-
Accounting method: Are
costs accumulated by
department or by
project?
-
Activities: What are
they, and why are they
eligible for the R&E
credit?
-
Wages:
Names, amounts, % of
annual wages,
departments, job titles
& descriptions
-
Supplies: Categories,
how they tie in to
general ledger, amounts
by category
-
Contracts: With whom,
amounts, categories
It is
recommended that the items
listed in the IDR be requested
via several “bite-sized” IDRs.
Pre-determined IDR turnaround
time should be established and
enforced.
The following
information is helpful in
understanding the appropriation
of company resources or details
of research projects the
taxpayer conducted during the
examination year:
a.
Materials explaining
research activities,
including brochures,
pamphlets, press releases,
and other similar documents.
b.
Submissions to management,
the board of directors,
review committees or other
similar groups regarding
research projects,
activities, expenditures,
and the research credit.
c.
Documents prepared by, or on
behalf of, internal audit,
including quarterly and
annual reports that refer in
any manner to research
activities.
d.
Minutes, notes, or other
similar recordings from
budget, board of directors,
managerial or other similar
meetings concerning research
activities.
e. Project
authorizations, budgets, or
work orders that initiates a
research project.
f. The
internal authorization
policies for approving a
research project.
g.
Project summaries and/or
progress reports and project
meeting minutes.
h. Field
and lab verification
data/summary data.
i.
Research credit studies
conducted by outside
consultants.
j.
Papers, treatises, or other
published documents
regarding the taxpayer’s
research.
k.
Complete copies of contracts
(including all
modifications), letter
agreements, memoranda of
understanding, or similar
documents for research
performed by, or on behalf
of, a third party.
Credible oral
testimony by individuals with
personal knowledge of the issues
may be helpful in evaluating
and/or supplementing a
taxpayer’s contemporaneous
documentation. Interviews may
be necessary to gather new
information, or to confirm,
clarify or refute other
documentary or testimonial
evidence. The interviewee will
often be a technical or
supervisory person with
specialized knowledge of the
issue in question. If conducted
effectively, the interview can
be a very useful examination
tool. However, careful
preparation is essential.
It is strongly
recommended that another IRS
colleague assist you during the
interview:
-
as an
observer to the
interview,
-
to take
notes, freeing you to
concentrate on the
interviewee’s responses
and to formulate your
next question,
-
to pose
overlooked questions,
and
-
to
provide additional
technical and/or
administrative support.
Notice 2004-11,
(published in the Internal
Revenue Bulletin on February 9,
2004), permits the Internal
Revenue Service, and Large and
Mid-Size Business (LMSB)
taxpayers to enter into research
credit recordkeeping agreements
(RCRAs). 15
This new Research Credit
Recordkeeping Agreement program
will help alleviate many of the
tedious recordkeeping issues
that now plague the research
credit issue by allowing both
taxpayers and the Service to
agree upfront what records are
necessary to support a
taxpayer’s research credit
claim. If the taxpayer keeps
these records, then disallowance
for lack of substantiation will
generally not be an issue.
An RCRA applies
to future years and, in this
way, the taxpayer can take steps
to ensure that its research is
properly documented before it
ever takes place. The best time
to propose such an agreement
would likely be upon completion
of the current examination
cycle. At that time, the
examiner, CAS, and the taxpayer
are in the best position to
determine what taxpayer records
are necessary. If the parties
enter into such an agreement,
the taxpayer will know what
records need to be kept and
maintained in order for the
Service to effectively and
efficiently audit the credit.
This may require the taxpayer to
create new records for future
years that previously did not
exist. In addition, it may be
determined that records
presently kept, may no longer be
needed. Although such an
agreement will not resolve other
audit issues, such as whether
the activities qualify under
section 41(d), it should improve
and expedite the audit process
to the mutual benefit of the
parties.
The use of
expedited resolution procedures
including Advanced Issue
Resolution (AIR) and Pre-Filing
Agreements (PFA) should be
considered, where appropriate.
The examiner should also
consider issuing a Notice of
Inadequate Records
16,
pursuant to Treasury Regulation
section 1.6001-1(d), if the
taxpayer does not keep
sufficient or adequate records
to support the research credit
claimed.
15
Notice 2004-11 Research Credit
Recordkeeping Agreements (RCRA)
16
Letter 1022 (DO) Inadequate
Records Notice Follow-up ,
Letter 978 (DO) Notice of
Inadequate Records , Letter 979
(DO) Inadequate Record Notice
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