Each year the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes through the R&D Tax Credit program. Qualified small businesses and startups can use the R&D tax credits to offset up to $250,000 per year in social security taxes, which typically comes as a refund check from the IRS.
While the R&D tax credit forms seem simple and do not require you to submit technical documentation (R&D study) with the filing, the IRS can audit you up to 3 years later and will ask to see contemporaneous documentation (i.e. you documented the work as you performed the R&D eligible activities) to substantiate your filing.
Trying to backfill documentation is a recipe to get reduced or denied in an audit, requiring you to pay back the money you received with interest and potential penalties. However, in a rush to take advantage of the funding, some businesses cut corners, got bad advice, or made poor decisions.
Now the IRS is starting to pay more attention — including adding R&D credit fraud to their “dirty dozen” list of tax scams — and many businesses that made mistakes or poor choices when claiming R&D credits could soon face an unpleasant outcome.
Gambling on avoiding an audit is always a bad idea, and with the federal government now getting serious about enforcement, this is a particularly bad time to try rolling the dice. You may not be able to cut down your risk of an audit to zero, but there are steps you can take to avoid being audited unnecessarily.
Five important things to consider as you’re preparing your next R&D tax credit study:
1. Understand what work qualifies and what doesn’t
The IRS has strict guidelines about what type of work can qualify as research activities, wherein everything you claim for R&D credit must pass their 4-part test.
That means that “substantially all of the activities of the research” must have been used to develop new or improve existing functionality, performance, reliability, or quality of a business component, i.e. product, process, technique, invention, formula, or computer software that you intend to hold for sale, lease, license, or actual use in your trade or business.
You must also undergo a systematic, science-based “process of experimentation” to resolve an area of technological uncertainty. Uncertainty exists if the information available to you does not establish the capability of development or improvement, method of development or improvement, or the appropriateness of the business component’s design.
A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).
Unfortunately, many R&D consultants don’t pay attention to all the research activities to ensure that only qualifying work is claimed. This becomes a big liability for businesses as it’s much easier for the IRS to reduce or reject the claim in an audit.
2. Always prepare an R&D Study
Given the exponential growth of startups, there is an increasing number of independent R&D consultants and/or firms that claim to help you apply for R&D tax credits within minutes. The primary issue with this approach is that the IRS has provided specific guidelines regarding qualifying research activities.
If a firm is guaranteeing an amount they can claim for your startup within minutes, it is likely that they are only looking at your payroll and accounting information without doing proper due diligence to understand if your product development work qualifies.
Since there is no current requirement to file the technical R&D study, many small businesses opt-out of it due to the time it takes to prepare it. In addition, depending on how diligent the technical teams have been at documenting all the work performed, it can be a very manual and cumbersome process to accumulate all the proper documentation needed to prepare the R&D study.
However, what startups don’t realize is that the R&D study is like an insurance policy for the R&D tax credit claim. Since the IRS can choose to audit for up to 3 years once the R&D tax credit claim has been filed, you are carrying an unnecessary risk for a long period of time.
In fact, if you cannot properly substantiate the full amount you claimed during an audit, you are liable to pay back all, or part, of the credit with penalty and interest.
3. Avoid boilerplate R&D studies
On the other hand, there are R&D consultants who may prepare a technical report, but the quality of the reports is questionable. In a majority of cases where the IRS has disallowed a portion or all of the claim, it’s due to a lack of substantiation and/or documentation regarding the R&D work performed.
Due to the lack of in-house technical expertise, low-cost providers are typically incapable of describing the exact technological nature of the work performed and have even been known to use boiler-plate R&D studies. These copy-paste R&D studies are an immediate flag to the IRS and put you at the risk of having your R&D credit disallowed.
Additionally, since these firms don’t have the in-house technical expertise to prepare a strong technical report (if they prepare one at all), they will likely not be able to demonstrate how your R&D work tackled technological uncertainties, or showcase how the R&D work relied on the process of experimentation to carry out research activities.
4. Do not make up time tracking for your employees
Since businesses have to document all R&D work contemporaneously (i.e., work records are kept over the period of time in which they occur), it’s not a good idea to work back and guesstimate how much of the salary can be claimed for qualifying employees.
Many of these R&D consultants will advise you to claim 100% of the salary for all qualifying employees, however, you must ask yourself if you can accurately prove that the employees in fact did spend 100% of their time on work that meets the IRS’ 4-Part Test, outlined in detail in their audit guidelines.
5. Ensure you have a system or process to capture contemporaneous documentation
One of the most fundamental pieces of information to include when filing any R&D study is documentation. Which projects are you filing the claim for? How many hours did your employees actually work on the R&D projects? What work did they complete? This information is only the tip of the iceberg. R&D claims that are filed with accurate documentation collected contemporaneously have the least likelihood of being audited.
However, many R&D consultants skip over this step or collect minimal documentation, as it can be time-consuming to manually ensure that the R&D claim has all the supporting documentation it needs. This is often where corners are cut in an attempt to save time and make profits.
While they may reassure you that it’s not worth it to spend hours preparing documentation since the IRS works on an honor system, remember that the IRS has officially advised against improper claims for tax credits (including the Research Credit) by placing it on its “Dirty Dozen” list.
Simply put, if you have the proper documentation to back up your R&D claims, you’ll decrease the likelihood of making unsubstantiated claims and as a result, being audited by the IRS.
How Should I Choose My R&D Tax Credit Provider?
There are hundreds of self-proclaiming “R&D tax experts” in the United States alone. Many of them gear their sales & marketing messaging towards helping software companies in Silicon Valley, have fancy websites – you name it. Some even provide an audit guarantee. However, these are usually marketing tactics used to instill a false sense of security for their clients.
Majority of these R&D firms simply connect your payroll systems into their software, claim 100% of all R&D-related expenses, and provide you with a boilerplate R&D study that you can submit to the IRS.
In fact, these R&D firms don’t proactively prepare any of the necessary audit documentation because the process is cumbersome. In fact, they simply gamble on the fact that their clients claim won’t get audited at all and often take a backseat approach to defending the audit.
During an audit, you and your team will have to manually comb through thousands of records to find supporting evidence and prove the amount of time your team committed on these projects. Many R&D consultants don’t provide any support for this so it can take 3 or 4 weeks of your lead engineer’s time that could have been spent on furthering product development.
As you begin exploring options in which firm to engage for your R&D tax credit claim, consider the following:
- Does the R&D firm have in-house technical expertise that understands the specific technological nature of the R&D work your startup performs?
- Do they provide a robust technical report alongside the financial statements?
- Do they provide contemporaneous documentation regarding the R&D work performed and adequate substantiation of the expenses incurred?
- Will the R&D study being prepared survive an IRS audit? If audited, will the IRS accept it or will they disallow a portion, if not all, of the R&D credit?
- Will the R&D firm help you defend against an IRS audit?
Remember, the IRS can audit any R&D study for up to 3 years, so why take the risk only to save a few dollars in the short-term? In the long-term, this mistake can cost you thousands of dollars.
Reduce Your Audit Risk with Boast.ai
Once you engage Boast.ai, our AI-powered software integrates directly with your tech stack and our algorithm automatically sorts through thousands of project management tickets and git commits to create the audit documentation required by the IRS by categorizing the project management system (e.g. JIRA, GitHub, etc.) tickets and git commits into the corresponding R&D projects.
Additionally, the platform leverages the timestamps available on your project management data and git commits to generate timesheets for your employees as they correspond to the R&D projects. Lastly, it also auto-generates audit documentation for every claim and every project.
Get the technical expertise you need without any of the marketing tactics or a false sense of security.
To learn more about how we can help your startup claim back thousands of dollars without the unnecessary risk of an IRS audit, get in touch with us now for a free assessment.