If your company relies on the hard sciences or uses technology to create or improve products or processes, then you may be eligible for the federal Research and Development Tax Credit. Fear of being audited makes certain taxpayers (generally smaller companies, with limited resources) choose not to claim the R&D tax credit even if they may qualify.
IRS or state audits can certainly take an extraordinary amount of time and resources to handle. However, misconceptions abound about attempting to claim the R&D tax credit and the likelihood of a future audit, possibly stemming from the credit being a Tier 1 issue (i.e. top priority for review) in the IRS old “tiered” system for tax examinations and enforcement. The IRS discontinued the tiered system in 2012 and now leaves the choice to audit R&D tax credits to the discretion of field auditors. Further, recent taxpayer-friendly law changes and announcements clearly identify the importance of the credit as a matter of tax policy and global competitiveness. This in turn suggests that the IRS will not view R&D credit claims with the same level of skepticism as they did historically.
Bogus R&D Tax Credit Claims
There’s no doubt that some taxpayers that don’t qualify still claim fictitious or egregious credits. If a company that researched Van Gogh’s life tried to claim R&D credit, they would be denied because research in the social sciences (economics, business management, and behavioral sciences), arts or humanities is excluded from the definition of qualified research. However, a company that developed new formulation of artists’ paint would not be excluded, however.
Factors Considered by the IRS to Audit a Taxpayer
Certain factors can increase the likelihood of your R&D credit claim being audited:
- The overall size of your credit claim. The larger your credit claim, the higher the likelihood of audit.
- The credit you claim versus your industry average.
- Filing an amended return that claims the R&D credit can also increase your chances of an audit, as all amended returns routinely receive additional attention from the IRS.
- The industry you are in. If IRS perceives potential abuse within an industry, you may have a higher likelihood of audit.
- If your NAICS business code is one that indicates you may not be eligible, then you probably have a higher likelihood to get audited. Examples of such businesses include hair salons and restaurants.
How to be Successful on an R&D Tax Credit Audit
One secret: documentation, documentation, documentation. Regarding the quantitative aspects of claiming the credit, it is important to substantiate the amounts of your qualified expenses with proper records that clearly demonstrate the nexus between the activities performed and amount of credit you’re claiming. Regarding the qualitative aspects of the credit, it is important to provide documentation and/or create a narrative that addresses the IRS criteria to validate the eligible nature of qualifying R&D activities. Establishing the proper framework for supporting the R&D tax credit significantly increases the likelihood the claimed will be accepted on audit for both original and amended returns.
Other tips for a successful audit:
- Don’t go at it alone or rely on your deliverable alone. Bring in an experienced R&D tax credit specialist.
- Respond timely to information document requests (“IDR’s”).
- Know the IRS audit techniques guides, which the IRS publishes to inform field agents of areas to focus on.
- Treat your IRS agent with respect.
The R&D credit can provide a tremendous benefit to the right companies. Simply filing an R&D credit claim won’t cause an audit. However, working with tax experts familiar with the R&D tax credit and audit process will help to: (1) ensure the R&D tax credit claim will survive an audit (2) to identify efficient processes for supporting the R&D tax credit claimed every year.
Please call us today at 716.847.2651 if you would like to speak with us in more detail about the audit process or to evaluate whether your company may be eligible for the R&D tax credit.