Disagreements between taxpayers and the IRS over substantiating the R&D credit.

• Author: Andrus, Mark

In theory, the research and development (R&D) tax credit is an excellent incentive for the more than 18,000 taxpayers who claim credits each year. In fact, the R&D credit is one of the few tax breaks that has consistent bipartisan support--President Barack Obama recently joined with congressional leaders in calling for the enactment of a permanent R&D credit. However, in reality, the incentive effect of the R&D credit has been severely dampened by the fact that defending the credit during an IRS audit can be a long and frustrating process for taxpayers. Over the past few years, many taxpayers that develop new products, employ degreed scientists and/or engineers, and conduct laboratory testing have been shocked to hear the IRS exam teams conclude that these activities do not qualify for the R&D credit. How did reality and theory become so different?

There are several vague and subjective terms in the body of the R&D tax credit law that are interpreted very differently by taxpayers, the courts, and the IRS. Perhaps the most prominent current disagreement is over the term "sufficient documentation" and how to properly substantiate the credit.

Background

There are no specific recordkeeping requirements for the R&D credit other than what is found in Regs. Sec. 1.41-4(d) (4): "A taxpayer claiming the credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. For rules governing record retention, see [section]1.6001-1." Regs. Sec. 1.6001-1 does not provide much additional detail, other than stating that the taxpayer "shall keep such permanent books of account or records ... as are sufficient to establish the amount of ... credits." Thus, the governing statutory rule, Sec. 6001, and the associated regulations require only that the taxpayer maintain permanent records sufficient to establish the amount of the credit.

Further, when the R&D credit was extended in 1999, Congress made it clear that claiming the credit should not impose unreasonable recordkeeping requirements: "The conferees also are concerned about unnecessary and costly taxpayer record keeping burdens and reaffirm that eligibility for the credit is not intended to be contingent on meeting unreasonable recordkeeping requirements" (see H.R. Conf. Rep't, No. 106-478 at 132 (1999)). Similarly, in the preamble to December 2001 proposed regulations, Treasury and the IRS concluded that "taxpayers...