R&D Audit Preparation Is Essential Despite IRS’s Reshuffling

Since the research-and-development tax credit’s enactment over 40 years ago, it has steadily increased in importance for businesses investing in R&D work.

The disallowance of current expensing of R&D costs that fall under Section 174—effective from Jan. 1, 2022—amplified the credit’s importance in recent years. As the value of the credit has increased for taxpayers, so has the IRS’s scrutiny of the credit.

Taxpayers may wonder how major cuts to the IRS’s workforce will affect the potential of an R&D audit and what audits will look like if they continue. For now, R&D audits are still moving forward, so businesses should ensure they’re prepared for such audits by examining their documentation processes and seeking experts’ counsel.

IRS’s R&D Focus

In recent years, the IRS worked to standardize R&D audits by increasing IRS agent training, implementing a structured audit process, and expanding staff resources. As a result, the credit is more closely examined by agents, documentation required to substantiate the credit has increased significantly, and R&D audits generally are more expensive and burdensome for taxpayers.

While congressional intent hasn’t changed regarding the requirements to claim the credit, taxpayers should know that the IRS has committed significant resources to increasing R&D enforcement and prepare accordingly.

Audits Continue

Practitioners have seen the effects of recent IRS layoffs, including audits being prematurely closed, IRS agents becoming unreachable, and sudden delays in audits that were otherwise moving smoothly.

The IRS is rolling back enforcement efforts on a variety of issues in response to layoffs, but many R&D audits are still moving forward. Although the dust hasn’t yet settled on the IRS’s dramatic administration and staffing changes, early signs indicate the agency may not be rolling back its R&D audit efforts.

Until more information about enforcement plans becomes public, taxpayers should assume R&D audits will proceed as usual. Such audits likely will present several challenges.

Rigid audit structure. The IRS has restructured the way agents examine R&D credits. Historically, R&D audit outcomes lacked consistency because agents had significant discretion in deciding what mattered. The IRS’s shift to a more structured audit approach means more consistent results, but it also can obstruct agents from reaching commonsense conclusions.

Burdensome documentation requests. Years ago, auditors might have been satisfied by business records commonly maintained by taxpayers, but IRS requests are now far more specific and require the production of documentation that many taxpayers normally wouldn’t maintain.

For example, agents have required more documentation over the years to establish how much employee time was devoted to qualified research activity—often requesting hour-by-hour proof of how employee time was spent. Satisfying such requests can prove burdensome and disruptive to businesses that are under an R&D audit.

Challenges establishing technical aspects of R&D work. Agents are requesting more detailed substantiation of the research work taxpayers perform, in keeping with the IRS’s more structured approach to R&D audits. Although the agents or IRS engineers are often unfamiliar with the taxpayer’s industry or area of research, they expect taxpayers to help them understand in detail the research work being performed.

This process can result in a frustrating loop where the taxpayer produces more documentation to prove the technical aspects of their research to the audit team—while the audit team increasingly struggles to understand those technical aspects as the volume of taxpayer documentation rises.

Preparation Is Key

Advance preparation is the key to success in an R&D audit, so it’s a good idea to take several important steps.

Document as you go. IRS agents pay special attention to the taxpayer’s proof of their research activities and want to see documentation that was created while the research was ongoing.

Many businesses don’t keep discarded models or meeting notes on ideas that didn’t make it into production. But they should consider implementing simple documentation practices and a plan to retain documentation that illustrates their research’s successes and failures, which can make a big difference in an audit.

Consider how you’re tracking time. Taxpayers also should think through how they’re tracking the time their employees spend on research projects and make sure they will have supporting documentation in case of an audit.

Demonstrating how much employee time was spent on research activities is a critical part of substantiating the credit. While hourly time tracking isn’t realistic for all businesses, some simple adjustments to daily practices can help taxpayers bridge the information gap.

Involve experts early on. R&D audits can be frustrating for taxpayers who don’t know what to expect or how to navigate the complexities of an audit. Any IRS audit can be tricky, but R&D audits are especially so.

The audit’s outcome can be heavily influenced by the first few interactions with the audit team. Involving tax controversy experts early can help taxpayers establish a strong audit strategy and set them up for a more efficient, less stressful audit.

By conducting an R&D study and implementing strong business practices, taxpayers can reduce the challenges often present in R&D audits and increase the likelihood of a favorable outcome.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jennifer Keegan is a senior manager at Plante Moran specializing in tax controversy with a focus on IRS exam and appeals processes.

Ginger Powell is a partner in Plante Moran’s tax solutions group and leader of its R&D tax credit practice.

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