Documenting the R&D Credit

There is no specific documentation requirement mentioned in the regulations. The current regulations simply state that a taxpayer claiming research tax credits must retain records in a sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. They also refer to the general record retention requirements found in Regs. Sec. 1.6001-1. 

Although the acceptable types of documentation have not been specifically defined, it is critical to accumulate and retain documentation in support of the QRA. The taxpayer must retain documentation that illustrates nexus between QREs and qualifying activities.  Numerous taxpayers have had all or a portion of R&D credits disallowed upon IRS audit due to the lack of acceptable documentation. Ultimately, documentation created in conjunction with the qualifying research is most preferable for the substantiation of activities. Some examples of contemporaneous documentation are included at the end of this section.

To substantiate its qualified research, a taxpayer must prepare and retain documentation on paper or electronically. Numerous court cases over the years reflect difficulties by the IRS and taxpayers in administering the research tax credit. Some of the most recent court cases, such as U.S. v. McFerrin (docket no. H-05-3730, S.D. Texas, vacated and remanded, 5th Cir., 2009) and Union Carbide Corp. v. Commissioner (TC Memo 2009-50), have addressed research credit substantiation and credible documentation, a key issue in IRS exams. In these cases, the courts ruled that the taxpayers, in the absence of certain contemporaneous records such as a time tracking or project accounting system, may still estimate research and experimentation expenses by looking to testimony of credible personnel and other available evidence. 

The IRS has issued a couple of Audit Technique Guides that discuss the importance of documentation and the need to shy away from boilerplate documentation, however, there is no narrowly defined documentation requirement laid out in these techniques.  The following is an excerpt from one of the guides:

“Submissions . . . delivered to examiners in multiple binders. While the submissions often set forth the methodology employed in preparing the research credit claim, the submissions frequently fail to substantiate that the taxpayer paid or incurred qualified research expenses ("QREs") as claimed. In addition, audits may have been restricted to evaluating the taxpayer's methodology for capturing QREs found in the prepackaged submission, as opposed to examining the research credit claimed on the amended return.”

Examples of contemporaneous documentation include:

1. Internal status reports
2. Emails
3. Minutes, notes, or other similar recordings from budget, board of directors, managerial or other similar meetings concerning research activities.
4. Lab notebooks
5. Patent applications (see discussion below)
6. Product specifications
7. Test result reports
8. Project timelines
9. Diagrams & drawings
10. Engineering reports

Note that if there is a patent associated with a project, generally speaking that is a good indicator that the associated activities will qualify for the R&D credit. The issuance of a patent is conclusive evidence that a taxpayer has discovered information that is technological in nature that is intended to eliminate uncertainty concerning the development or improvement of a business component.  However, the issuance of a patent is not conclusive evidence of qualified research, as the taxpayer still must meet the other activity requirements of section 41.  

Including attorney fees related to patent applications in the R&D credit is very controversial. Typically, attorney fees related to the patent are not qualified for the credit. They are 174 expenses, but they are not necessarily qualified for the credit under Sec. 41.  As the patent application process typically occurs after the R&D phase of product development, it seems that expenses related to the patent process should not qualify.