R&D Tax Credits: Why Your Report Won’t Cut It
Many businesses assume that the formal R&D report they paid for will fully protect their credit during an IRS audit. Unfortunately, that belief is incorrect. A report alone does not prove or support anything.
While an auditor may read the report, it serves only as an introduction. Most reports summarize tax law, make broad conclusions, and present calculations—but they fail to adequately document the R&D activities necessary for substantiating the credit.
For comparison, imagine a taxpayer trying to support their tax return with only a narrative and summary calculations from a third-party—without real documentation. That approach wouldn’t hold up in an IRS examination, and neither will an R&D report on its own.
What Does the IRS Want? Documentation.
The only way to properly support an R&D tax credit is with contemporaneous documentation—records created during the tax year. The closer in time to the activity, the more credible the documentation becomes. Read on to discover three important sections that should be outlined in your documentation:
1. The Numbers: Wages, Expenses, and Allocations
The credit base consists of wages, expenses, and allocations of the two. Wages are supported with W-2s, and expenses with invoices, 1099s, or general ledger details. Allocations, however, particularly wage allocations, presents a problem.
Most businesses don’t have time-tracking software that records employees’ activities project by project. Instead, allocations are often estimated after the fact, when a third-party consultant asks, “How much R&D did your employees engage in last year?” This retroactive guesswork may not survive an audit.
Even after the Section 174 capitalization requirement took effect in 2022, this practice remains common. To ensure accuracy and avoid inflated percentages, wage allocations should be documented throughout the year, ideally by employees or supervisors, rather than estimated later.
2. The Business Component: What Are You Creating?
To claim the credit, businesses must document what they’re developing. If an idea is selected for R&D, there should be a clear record—such as internal write-ups, proposals, approval documents, or contracts—that establishes the existence of the project.
3. The Process of Experimentation: How Was It Developed?
The IRS also wants proof that the company followed a process of experimentation. Design work should be documented, including blueprints, schematics, or CAD files—even those that were rejected. Meeting notes and calendar entries should capture who was involved and what was discussed.
Testing records should detail who conducted tests, when they took place, and what the results were. This is true particularly if testing consists of iterative adjustments or alterations that ordinarily wouldn’t be documented. The more detailed and organized these records, the stronger the case for the credit.
Don’t Let a Weak Report Put Your Credit at Risk
The R&D tax credit is a valuable financial benefit, but it must be backed by proper documentation. Many companies assume their consultant’s report is enough, only to find themselves unprepared during an audit. Without real-time records of activities, expenses, and experimentation, businesses risk losing the credit entirely.
At CSH, we help businesses maximize and protect their R&D tax credits by ensuring their records meet IRS standards. Our team works with companies to establish proper documentation practices, reducing audit risk and improving compliance.
Is Your R&D Credit Properly Documented?
Don’t wait until an audit to find out. Contact CSH today to ensure your R&D tax credit is supported with the right records.
