The IRS has recently issued a new audit technique guideline for activities under Section 41 (LMSB-04-0508-030). This guideline outlines a number of areas with which the IRS exam team has been given a directive on auditing Section 41 R&E claims. In this edition of the BCP newsletter we’ll summarize a few of the key areas outlined in the document as “potential problems.”

Nexus

While the IRS acknowledges that Section 41 does not contain a specific requirement that a taxpayer capture the costs of research under a particular approach or accounting methodology, they do require the taxpayer to identify qualified research expenditures (QREs) by business component (aka., qualified activity). The IRS states that it must meet this requirement in order to establish its entitlement to the research credit.

In other words, a taxpayer must be able to connect specific research projects and the underlying activities to the qualified expenses. Furthermore, the IRS audit guide states that arbitrary and unsupported allocations should not be accepted.

So, What Does this Mean For You? While not mandated or a requirement for the credit, the IRS guide states that a project cost methodology usually provides an accurate measurement of QRAs and should provide the direct nexus with the QREs. If another method is used, it should be prepared in a manner that directly ties the costs incurred with the specific activities being performed. Think of it this way, if an activity being claimed as a QRA is found not to meet the tests for a QRA, can you isolate the cost of that activity and remove it from the total claim?

Substantiation

The audit guide references a “typical research credit claim” example in Eustace v. Commissioner. T.C. Memo 2001-66, aff’d 312 F.3d 1254 (7th Cir. 2002). In this summary the audit guide references that the taxpayer reconstructed the claim based on six employee interviews as to the nature of the activities of the company departments and associated 450 employees.

The Tax Court found the taxpayer did not meet its burden of proof and found that the taxpayer must show what expenses it paid or incurred in the performance of qualified research activities.

So, What Does This Mean For You? This is another area in which Section 41 does not mandate any special record keeping requirements, however in the audit guide the IRS clearly states that the qualified research must directly relate to a new or improved business component. Contemporaneous documentation such as vendor/third party contracts, results/findings reports, engineering working papers, among others are all invaluable to supporting the documentation for a claim. Additionally, if you are basing the claim on employee surveys or oral testimony, ensure that the individuals being interviewed are those directly conducting the QRAs, this will provide a more meaningful and substantiated basis for the claim.


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