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The New IRS – Audit Defense Requirements

The Research Tax Credit has been a controversial area in IRS examinations mainly due to the IRS bias against commonly used techniques relying on estimations and extrapolations. The IRS assumes that all taxpayers claiming the Research Tax Credit are aggressively claiming non-qualified activities and costs. Further support for these misplaced assumptions comes from the IRS Commissioner when he calls the Research Tax Credit his number one concern in domestic tax matters.

As a result, the Research Tax Credit has been designated as an LMSB Tier 1 issue. In announcing the Research Tax Credit’s new “special” status, the Industry Director Directive #1 declared “R&E Credit claims have continued to rise to a level of high strategic importance to LMSB.” Meaning that these claims will receive even more focused attention from the IRS going forward. The Directive continues “A growing number of these claims are based on studies prepared by the major accounting and boutique firms. Typically these studies are marketed on a contingent fee basis and exhibit one or more of the following characteristics:

1. High-level estimates
2. Biased judgment samples
3. Lack of nexus between business component and QREs, and
4. Inadequate contemporaneous documentation”
   
   

As a part of the Tier 1 coordination, the LMSB created a standard opening Information Document Request (IDR). The opening IDR, commonly referred to as “IDR Q” or “Super IDR” is issued to all taxpayers regardless of their size. The IDR broadly questions all aspects of the claim. The IRS has indicated that the purpose of this opening IDR is to determine whether a valid claim has even been filed. If the claim is deemed invalid, IRS personnel won’t even audit the return. However, it is not clear what standards must be met for a valid claim. The opening IDR uses broad qualifying words such as “each,” “every” and “all.” Information must be created specifically in response to the questions asked in the IDR. The IDR opens with “Please answer the following questions. All answers should be complete and specific to the question. Any reference to other documentation without a complete answer to the question will be considered an unsatisfactory response.” This means that those expensive packaged studies prepared by accounting firms or tax services firms will not be accepted.

Once a company has burned up much of its resources and patience, complying with the Opening IDR, the IRS comes back with its follow-up mandatory IDR. This IDR expands on certain questions in the opening IDR. The IDR asks questions about areas the IRS deems as problematic, including the use of estimates, biased judgment samples and lack of nexus between business components and QREs.

The new Tier 1 environment is not as hopeless as it seems. It is important to prepare in advance for a challenging audit experience. On a go forward basis, the easy audit solution is to use technology that addresses and responds to the “problematic characteristics of the Research Tax Credit” indicated by the IRS.

Whatever methodology you choose, here are some important elements to consider. Of particular focus to the IRS is “contemporaneous” documentation. By this they mean documentation that is collected from several sources in real-time to the QRE being performed. Year end interviews or surveys simply do not meet that requirement and auditors have a field day with this kind of reconstructed documentation.

Auditors also look at the “integrity” of documentation. By integrity we mean how reliable the documentation is. Being created and collected contemporaneously is one litmus test, but another is how secure the documentation is after it is reported. If supporting documents are created then edited and modified after the fact, this lowers the integrity of the data. Systems must be in place to guarantee the auditor that once created, documentation is protected and untouched.

Finally, “accuracy and completeness” are paramount. A documentation system is only as good as information fed into it, and if data is incomplete, not supported by other activities, or at times incorrect, an auditor will assume that most if not all of your documentation is of the same quality. A good documentation system must be able to collect data from an unlimited number of sources and relate that data in a coherent, easy to research methodology. Recognizing that an auditor can elect to drill down into documentation at the most finite level, it is critical that your documentation system be able to not only identify, but have available every document reasonably necessary to support every QRE in your Research Tax Credit filing.

It is getting more challenging to retain your Research Tax Credits under IRS §41 audits, but your best defense is a great offense. Prepare from day one by collecting data “contemporaneously”, from a wide range of sources; guarantee the “integrity” of your documentation by demonstrating that every document is untouched from the day it was created; and ensure “accuracy and completeness” by collecting a wide range of supporting data from an unlimited number of sources and linking that data so an auditor can quickly and easily drill down electronically into any QRE to verify the most finite level of documentation.

Today’s newest technology allows companies to meet all of those challenges and more. To learn about the latest electronic collection and documentation systems contact RIX® Technology at info@rixtechnology.com or visit www.rixtechnology.com.

Disclaimer:
As provided in Treasury Department Circular 230, this article is not intended or written by The Miller Group Resource Information Xchange, LLC, to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.