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What would you do if you could not receive a refund for overestimating your R&D tax credit? For many businesses, R&D capitalization can lead to a substantial tax refund. However, if the IRS finds your documentation to be lacking, this refund could end up being significantly smaller than anticipated. You can avoid this scenario with the proper preparation. This article explains how to structure your documentation to meet the IRS's requirements.
Haven helps accounting services for small businesses like yours organize their accounting records and prepare for audits so they can maximize their tax credits and avoid costly mistakes.
Table of Content
Why Documentation Matters for R&D Tax Credits
When claiming the R&D tax credit, strong documentation isn’t just helpful. It’s essential. Every dollar you claim must be directly tied to a qualified research activity, and the IRS requires that clear, credible records back these claims. Without that, even the most legitimate innovations can be denied credit.
A Cautionary Tale: Moore v. Commissioner
The importance of documentation came into sharp focus in the case of Moore v. Commissioner, which involved Nevco Inc., a company that manufactures electronic scoreboards. Nevco claimed R&D tax credits for work done to improve its products, including wages paid to the company’s president and COO.
However, when audited, the IRS denied a portion of their credit, and the dispute was taken to court. The outcome revealed two key weaknesses in Nevco’s documentation:
1. Lack of Clear Time Tracking
The company failed to distinguish between time spent on qualifying research and routine or non-qualifying tasks. The IRS and the court needed proof that the time claimed for the credit was explicitly spent on R&D, not general business operations.
2. No Contemporaneous Records
Nevco had not maintained documentation during the research process. Instead, they attempted to reconstruct records after the fact, which undermined their credibility in the eyes of the IRS.
This case highlights a crucial point: Even if your R&D activities are genuine and legitimate, inadequate documentation can lead to a denied claim.
What the IRS Expects
The IRS doesn’t require perfect records, but it does expect a reasonable and consistent method of tracking qualified research and development (R&D) expenses. This includes:
Time-tracking logs or project-based timesheets
Project documentation that outlines the goals, methods, iterations, and results of experiments
Technical reports or memos that detail the research process
Financial records tying wages, materials, or contractor costs directly to specific R&D efforts
Keep Records as You Go
If you’re claiming the R&D tax credit, don’t treat documentation as an afterthought. Track R&D efforts in real time using project management tools or R&D tax credit software, and make sure your technical and finance teams are aligned. A little discipline in recordkeeping now could be the difference between a smooth IRS review and an expensive denial.
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Core Documentation Requirements for R&D Tax Credits
The IRS does not mandate a specific standard for recordkeeping when applying for the R&D tax credit. However, establishing a methodology for capturing and quantifying qualified research expenses can help streamline the process and support claims in the event of an audit.
Understand the Basics: QRAs and QREs
Qualified research activities and qualified research expenses are at the core of the R&D tax credit. Activities to develop or improve products, processes, software, techniques, inventions, or formulas may be considered a qualified research activity. The expenses associated with these activities:
Employee wages
Contractor expense
Supplies and the rental or lease costs of computer
The IRS Four-Part Test for QRAs
The IRS uses a four-part test to determine qualified research activities under IRC Section 41.
The First Part of the Test
Known as the permitted purpose, establishes whether the goal of the research was to:
Develop or improve the functionality
Performance
Reliability or quality of a product
Process
Software
Technique
Invention or formula that was sold, leased, licensed, or used in a trade or business (aka a “business component”).
The Second Part of The Test
Eliminating uncertainty determines whether the activities were intended to discover information that would eliminate technological uncertainty, i.e., capability, method, or the appropriate design concerning the development or improvement of a business component.
The Third Part of The Test
Technologically oriented, it evaluates whether the activities were undertaken to discover information that is technological and where the experimentation fundamentally relied on technological principles of engineering, physical or biological science, or computer science.
The process of experimentation test assesses whether the activities substantially constitute the core elements of a method of experimentation. Did the activities identify technological uncertainty and one or more alternatives to mitigate it, and was a process of evaluating these options conducted?
IRS Recordkeeping Requirements for the R&D Tax Credit
The recordkeeping requirement in Treasury Regulation 1.41-4 states that a taxpayer claiming a credit under Section 41 must retain records in sufficiently usable forms and detail to substantiate that the expenditures claimed are eligible for the credit.
This lack of specific guidance regarding the types of contemporaneous documentation that would satisfy the requirement offers flexibility but also creates uncertainty. Business owners may find it helpful to consult previous court decisions regarding the R&D tax credit for additional guidance on record-keeping.
Types of Documentation to Support R&D Tax Credits Claimed
Businesses claiming the R&D tax credit must retain proper documentation, including contemporaneous books and records, to substantiate eligible qualified research expenses. During an IRS exam, auditors typically ask for samples and/or examples of contemporaneous documentation for the following:
Employee Wages
R&D tax credit qualified expenses may include employee wages (as defined in IRC Section 3401) that are paid or incurred for qualified services (i.e., deductible expenditures under Section 174) that are directly engaged in, directly supervised, or directly supported by qualified research. This includes federal taxable wages reported on Form W-2, as well as bonuses and stock option redemptions.
Nontaxable items such as:
401(k) contributions
Health insurance contributions
Other pretax benefit deductions
Non-taxed income
Must be excluded, even if they were compensation for qualified services performed by an employee. In-house research conducted outside the United States (as defined in IRC Section 7701) is also excluded from qualified research (Treasury Regulation Section 1.41-4A).
Contract Research Expenses
Contract research expenses, as defined in IRC Section 41, means the applicable percentage, but generally 65%, of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.
To determine if otherwise eligible contractor costs are considered contract research expenses, employers may refer to Treasury Regulation Section 1.41-2, which states that an expense is paid or incurred for the performance of qualified research only to the extent that it is done pursuant to an agreement (in writing or otherwise) that:
Is entered into prior to the performance of the qualified research (i.e., not contingent upon the success of the study)
Provides that research be performed on behalf of the taxpayer (i.e., the taxpayer has rights to the results)
Requires the taxpayer to bear the expense, even if the research is not successful (i.e., bears economic risk)
Similar to employee wages, only the portion of the contract amount that is attributable to the qualified research performed within the United States can qualify as a contract research expense (even if 80% or more of the contract amount was for research performed in the United States) (Treasury Regulation Section 1.41-4A).
“Funded Research” Exclusion: Navigating the R&D Tax Credit's “Risk and Rights” Tests
IRC Section 41 further states that any research, to the extent funded by a grant, contract, or otherwise by another person (or a governmental entity), is not qualified research. When considering whether the research is funded, the taxpayer must determine if they bear the financial risk of failure (Section 1.41-2) and retain substantial rights (as per Section 1.41-4A) to the research.
This “risk and rights test” is often accomplished by examining the specific language and terms of any and all agreements, contracts, etc., written or otherwise (along with forms and attachments). Examples include, but are not limited to:
Compensation arrangements (e.g., fixed-price, cost-plus, cost-plus with a cap, etc.,)
Payment terms
Nonpayment terms
IP terms
Warranty terms
Etc.
Applied on a separate contract item-by-item basis. To document contract research expenses claimed as qualified research expenses, business owners may use general ledger account details, invoices, purchase orders, work orders, statements of work, and master service agreements, among other relevant documents, after carefully reviewing the language. They may also find it helpful to refer to previous court decisions regarding “funded research.”
Supplies
The IRS defines qualified R&D supplies as any tangible personal property other than (1) land or improvements to land, and property of a character subject to the allowance for depreciation. To be a qualified research expense, a supply must be directly related to the performance of skilled services, as defined in IRC Section 41. Such expenses can be documented with purchase orders, invoices, receipts, or charts that depict account or general ledger records.
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Related Reading
New Form 6765 Reporting Requirements (Current Update)
The IRS revised Form 6765 for tax year 2024 reporting. This tax form is essential for businesses looking to claim the R&D tax credit. The revisions introduce expanded reporting requirements, especially detailing Qualified Research Expenses (QREs) and business components.
What’s New? Detailed Reporting and Additional Disclosures
The new Form 6765 mandates significantly increased documentation for businesses claiming the R&D tax credit. Detailed reporting of qualitative data is the most notable change. Filers must include descriptions of research activities and business components in addition to expense details.
The IRS also added additional disclosures, including:
Total number of business components
Officers’ wages within QREs
Details of business acquisitions or dispositions
Use of specific accounting methods for QREs
Business Component Reporting: A Mandate With Specifics
The new Form 6765 introduces a mandatory section about business components. Taxpayers must report the top 80% of qualified research expenses (QREs) by business component, up to 50 components. For certain small businesses, there are exemptions.
Sampling Documentation: New Requirements for Using Statistical Sampling
The IRS added a new requirement for businesses using statistical sampling to calculate Qualified Research Expenses (QREs). Taxpayers must now include documentation of their sampling methodology when filing Form 6765.
Best Practices for R&D Tax Credit Documentation
Document activities and expenses as they happen. Waiting until the end of the year or worse, during an audit to piece together records can lead to gaps or inaccuracies.
Capturing real-time data helps demonstrate a direct connection between expenditures and qualifying R&D efforts, a requirement emphasized in recent IRS enforcement trends and court rulings.
Organize Records by Project
Structure your documentation by individual R&D project to show how each activity aligns with IRS requirements. Utilize project management and accounting software to:
Track timelines
Technical milestones
Iterations
Expenses including:
Wages
Supplies
Contractor costs
For each effort. This makes it easier to identify which activities meet the four-part test for qualification.
Use Reliable Time-Tracking for R&D Staff
Your R&D credit will likely include wages as a major qualifying expense, so tracking employee time is essential. Implement time-tracking tools that allow staff to log hours associated explicitly with research activities.
Ensure you distinguish between qualified and non-qualified tasks. This was a major failing in a notable tax court case, where the IRS disallowed a claim due to the lack of bifurcated time data.
Update Documentation Regularly
Projects change, evolve, or get abandoned your documentation should reflect that. Set a regular schedule (e.g., quarterly) to review and update your records.
This includes modifying project scopes, updating testing methods, or logging new technical uncertainties. Regular reviews help keep your claim defensible and aligned with evolving IRS requirements, such as those outlined in the new Form 6765.
Work With R&D Tax Credit Specialists
The rules around R&D credits are complex and subject to change. Specialist advisors can help interpret IRS guidance, identify overlooked qualifying activities, and prepare technical reports for clients. Their insight can also be crucial in audit defence, ensuring that your records stand up under scrutiny.
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R&D Tax Credits for Architects
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