How to be Prepared if Your Clients Research and Development Credit is Audited

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The Research and Development Credit is a nice benefit for taxpayers performing eligible activities. If the taxpayer gets selected for a Federal Tax Audit, this credit has a high probability of being examined. The credit gets audited for a myriad of reasons but based on my experience, two reasons stand out.  Since the credit is a dollar for dollar reduction of the taxpayer’s tax liability, if the auditor can limit or eliminate the credit, it has the potential to be a nice sized assessment. Second, the actual calculation of the credit relies upon assumptions/estimates on the taxpayers part and auditors love gray areas.
In a recent audit that one of my clients underwent, a Research and Development Credit specialist was brought in. The agent only audited this area and brought an extensive level of knowledge to the table. The documentation that was requested and necessary to support the credit is listed below –
1.       W-2’s of the Employees Used in the Credit Calculation
2.       Percentages of the Wages allocated to Research and Development
3.       Methodology used to Determine Percentages Used in Allocation
4.       Job Descriptions of these Individuals
5.       Job Titles
6.       Project Descriptions
7.       List of Supplies Claimed
8.       Contracts and Invoices  for Subcontractors
The agent will then analyze these documents, scrutinizing the activities of the employees and the percentage allocated to R&D activities. Only activities that are directly involved in R&D are eligible. For example, the time of the R&D Department Manager will be reviewed to make sure that activities involving the management of the department are not allocated to the calculation. Only the manager’s activities that are directly related to research and development in the laboratory sense are eligible. 
Another component of the calculation is the amounts paid to subcontractors to do R&D on behalf of the taxpayer. Make sure to have contracts and invoices available.  Lastly, make sure to analyze the supplies listing. Only supplies used directly in the R&D activity are eligible. 
In a perfect world, all of these documents and analyses would be done prior to claiming the credit on the tax return. Unfortunately, due to time constraints and fee sensitivity, the drilling down to source documents is usually not done prior to filing the return. If your client is chosen for audit and the credit was claimed, start gathering the information as soon as possible because auditors love to examine this calculation. 

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