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R&D Tax Credit: Why Documentation Matters, Especially for Technology Companies

June 26, 2024

In today’s competitive landscape, technology companies are at the forefront of innovation. Whether developing cutting-edge software, pioneering new hardware solutions, or enhancing cybersecurity measures, these companies continually invest in research and development to stay ahead. The federal research tax credit (also called the Research & Development credit or R&D credit) offers a valuable opportunity to offset some of these costs, fostering further innovation and growth. However, as highlighted in recent cases such as Moore v. Commissioner, the key to securing this benefit lies in documentation.

Why Technology Companies Should Pay Close Attention to R&D Documentation Practices

In Moore v. Commissioner, the company, Nevco Inc., a manufacturer of electronic display systems (i.e., scoreboards), claimed the R&D credit for research and development expenditures used to improve its products. In question were the president/COO’s salary and bonus included as wages for the R&D credit.

The IRS disallowed the claim, leading to a court case that highlighted several documentation pitfalls, some of which included:

  • Properly categorized time tracking: The company did not bifurcate between qualified and non-qualified time spent on research projects.
  • Absence of contemporaneous documentation: Nevco did not maintain records contemporaneously, raising questions about the accuracy and reliability of their claims.

This case serves as a powerful reminder that documentation is crucial for substantiating R&D tax credit claims.

Sample Documentation Scenario

They key to establishing sound documentation is understanding what information is already available and being tracked. This can significantly reduce the burden on the development team, and it can improve the accuracy and capture of qualifying expenses. But don’t stop before the finish line. Additional documentation and/or analysis will still generally need to happen to make sure activities are being tracked and documented in line with the tax rules.

For example, many teams use Jira and similar tools for project tracking and management. These tools can be highly effective in documenting who worked on the project, the projects undertaken throughout the year, and the issues encountered during the project. However, these tools often do not capture the larger uncertainties or challenges and the interactions between different issues. Said differently, a company might have identified five distinct issues from the tool, and each one of these may not seem overly significant as a stand-alone issue. However, the real issue was the coordination between not only these five issues but also the other software issues.

For this reason, it may make sense to prepare a separate summary of the project using the Jira data for examples to document how the project meets the four-part test (i.e., the tax credit requirements). 

Some companies that are capitalizing time spent on development to their balance sheet might be tempted to use the same methodology for the credit not knowing there are variances between what gets capitalized for financial statement purposes versus the tax credit. While the financial statement tracking can be a very good starting point, some modifications are generally required.

Implementing Best Practices

To avoid the pitfalls illustrated by Moore v. Commissioner, technology companies should adopt practices that make sense for their organization, which may include:

  1. Detailed project narratives: Document the objectives, uncertainties, experimentation methods, and technological aspects for each R&D project.
  2. Technical reports and notes: Maintain comprehensive records of experiments, results, and iterations.
  3. Employee time logs: Keep precise logs of employee activities, including timesheets that link hours worked to specific R&D projects.
  4. Expense tracking: Accurately track all expenses related to R&D activities, ensuring proper categorization and justification.
  5. Centralized Document Management: Use document management systems to organize and store all R&D documentation in a centralized, easily accessible manner.

Avoiding Back Taxes, Penalties, and Interest

Inadequate documentation can lead to the IRS disallowing the credit, resulting in back taxes, interest, and penalties. Proper documentation protects companies from these financial setbacks by substantiating their claims and ensuring compliance with IRS regulations.

Preparedness for Audits

The IRS scrutinizes R&D tax credit claims rigorously. Comprehensive and contemporaneous documentation helps companies withstand audits by clearly demonstrating that their activities meet the IRS’s criteria for qualified research.

Transactions and Due Diligence

Transactions are common in the technology industry and can move quickly. Typically there is a due diligence process where the buyer looks at a company’s tax return and tax return documentation for potential issues – big or small. Smaller tax issues might be disregarded or accounted for in the purchase price or escrow amount. Bigger issues could be deal-killers. Having clear and organized documentation helps avoid these last-minute surprises.

Claim Credits With Confidence

For technology companies, the R&D credit is a vital tool to support ongoing innovation and growth. However, the benefits of this credit can only be fully realized with documentation. By ensuring that all R&D activities are thoroughly and accurately documented, tech companies can confidently claim the credit, avoid compliance issues, and continue to drive technological advancement. The lessons from Moore v. Commissioner make it clear: proper documentation is not just a best practice, it’s a necessity.

KSM’s professionals can advise on documentation and provide suggestions on other ways to take advantage of R&D credits. For more information, please contact a KSM advisor or complete this form.

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