Affect of research credit final regs. on documentation.

• Author: King, Kathleen L.

The research credit final regulations (TI) 9104, 12/31/03) are a major step forward in defining "qualified research" for Sec. 41 purposes. The changes to these regulations primarily relate to the so-called "process of experimentation" (PE) requirement. Most notably, the final rules describe four core elements of this process and eliminate some restrictive language from the 2001 proposed regulations (REG-112991-01, 12/26/01). Further, they effectively limit the application of certain exclusions from qualified research (e.g., after commercial production, duplication and adaptation) and provide helpful guidance on the Sec. 41(d)(1)(C) "substantially all" rule.

Although the final regulations resolve many questions on defining qualified research, they provide minimal guidance to taxpayers struggling to substantiate their qualifying research activities and expenditures during IRS examinations. Given the emphasis of the final regulations, the PE requirement will probably often be the focal point of these examinations. Taxpayers should expect additional guidance on how to satisfy the PE requirement (likely on an industry basis) but, in the interim, should consider updating their documentation procedures to reflect the final regulations.

Background

Prior versions of the research credit regulations contained specific documentation requirements that elicited significant negative comments from taxpayers. The 1998 proposed regulations (REG-10570-97, 12/2/98) required taxpayers to record the results of their research to satisfy the PE requirement. The 2001 final regulations (TD 8930, 1/3/01) eliminated the specific recordkeeping requirement, but created even more controversy; they required tax payers to prepare documentation at the outset of their research projects describing information they were seeking to exceed or refine the common knowledge of skilled professionals in their field.

Both of these requirements were dropped from later versions of the regulations. Commentators expressed concern about incorporating specific documentation requirements in the regulations due to significant variations in documentation standards among taxpayers and industries. In place of specific documentation requirements, the proposed regulations (REG-112991-01), issued late in 2001, added a reference to the general Sec. 6001 recordkeeping requirements, which provides that taxpayers have to retain records in "sufficiently usable form and detail to substantiate that the...