Companies Need Forward-Facing Models to Substantiate Research Credit

Article champions more effective methods for contemporaneous documentation of research credit claims

Aug 31, 2010, 11:15 ET from WTP Advisors

WHITE PLAINS, N.Y., Aug. 31 /PRNewswire/ -- Companies seeking a tax credit for engaging in research and development need to overhaul the way that they substantiate their claims if they want to avoid having their credit disallowed, according to a recent article in the BNA Daily Tax Report by Jeff Malo, a Director at WTP Advisors.

Since 1981 the federal government has provided an incentive for companies to annually increase their domestic research and development expenditures in the United States.  The incentive is known as the "R&E (research and experimentation) Tax Credit."  Companies that claim the credit usually substantiate their claim as part of the tax compliance process, meaning that documenting credit eligible activities may not take place until a year or more after qualified research is completed.  

Malo warns that the "look-back" approach to substantiating research credit claims leaves taxpayers vulnerable to claim disallowance.  

"Look back studies frequently use questionnaires or surveys asking research personnel to reflect on qualified research activities that may have occurred during the course of one or more prior tax years," says Malo; "the IRS has criticized these types of studies for generating high level estimates of qualified research expense - particularly as it relates to wage and salary expense."  

Malo, a former litigator at the US Department of Justice Tax Division, offers an example of the weakness of a rear-facing study if a tax dispute over a research credit claim were to go to court:

"If I were to cross examine a research scientist who estimated that 80 percent of his time last year was qualified for the credit, I would ask him how much of his time was qualified during the week of, say, February 2nd through February 9th.  Then I would ask how much of his time was qualified from April 15th through April 22nd.  If he couldn't answer my questions in sufficient detail, I would have clearly demonstrated that his 80 percent estimate was arbitrary and capricious, and I would have raised questions as to whether any of his credit eligible activities were properly documented to support his employer's research credit claim," he says.  

In an age of increased demand for tax revenue, Malo predicts that IRS standards for substantiating research credit claims will only become more stringent.  

"The question is not whether you've engaged in qualified research activity, the question is whether you have properly substantiated the qualified research you conducted.  The only facts you have are the facts that you can prove in court.  If the IRS knows that a taxpayer doesn't have the documentation needed to defend its claim in court, what incentive does the Service have to allow it?" Malo says.

Malo argues that research personnel should capture and create the contemporaneous documentation needed to build a solid record that a taxpayer could successfully defend in court.  

The benefits of a forward facing approach are twofold:  first, a properly substantiated claim is less likely to be disallowed in the first place, and second, if the claim is disallowed, the taxpayer is in the best position possible to defend its claim in court.  

The research credit is just one example of how tax planning can be improved by looking ahead to tax controversy and building a record designed to withstand judicial scrutiny.  

"The best way to avoid controversy is to prepare for it," says Malo, "A taxpayer can only defend its position if the IRS knows that the taxpayer is ready to satisfy its burdens in court.  Taxpayers need advisors who know that the lifecycle of taxation does not end with a tax filing or an examination.  Taxation ends with the judicial process, and taxpayers who plan for that end game will always fare better than those who do not."    

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