Every year, the US government allocates billions of dollars to support innovative businesses that develop or improve technologies, products, materials, and processes through the R&D Tax Credit program. Eligible small businesses and startups can use these credits to offset up to $250,000 per year in social security taxes, which typically comes back as a refund check from the IRS.
While the R&D tax credit forms may look straightforward and don’t require you to submit technical documentation (an R&D study) with your filing, the IRS can audit your claim up to three years later and will expect to see contemporaneous documentation (meaning you documented the work as you performed the R&D-eligible activities) to support your claim.
Trying to recreate documentation after the fact is a sure way to have your claim reduced or denied in an audit, which could mean paying back what you received—plus interest and possible penalties. Still, in the rush to access funding, some businesses cut corners, follow bad advice, or make poor decisions.
The IRS is now stepping up enforcement—including adding R&D credit fraud to its “dirty dozen” list of tax scams—so many businesses that made mistakes or poor choices when claiming R&D credits could soon face some tough consequences.
Counting on not being audited is always risky, and with the federal government now cracking down, this is an especially bad time to take chances. While you can’t eliminate audit risk entirely, there are steps you can take to avoid unnecessary scrutiny.
Five key things to keep in mind as you prepare your next R&D tax credit study:
1. Know what qualifies—and what doesn’t
The IRS has strict rules about what kind of work can qualify as research activities. Everything you claim for the R&D credit must pass their four-part test.
This means that “substantially all of the research activities” must be aimed at developing new or improved functionality, performance, reliability, or quality of a business component—such as a product, process, technique, invention, formula, or computer software that you plan to sell, lease, license, or use in your business.
You also need to follow a systematic, science-based “process of experimentation” to resolve a technological uncertainty. Uncertainty exists if the information you have does not establish whether development or improvement is possible, how to achieve it, or whether the design of the business component is appropriate.
A process of experimentation must fundamentally rely on principles from the physical or biological sciences, engineering, or computer science. It involves identifying the uncertainty, outlining one or more alternatives to resolve it, and then evaluating those alternatives—using modeling, simulation, or a systematic trial-and-error approach.
Unfortunately, many R&D consultants don’t pay close attention to all research activities, which means non-qualifying work often gets claimed. This creates a major risk for businesses, since it makes it much easier for the IRS to reduce or reject your claim during an audit.
FIND OUT IF YOU QUALIFY FOR R&D TAX CREDITS – FREE ASSESSMENT
2. Always prepare an R&D Study
With the rapid growth of startups, there are more and more independent R&D consultants and firms promising to help you claim R&D tax credits in just minutes. The main problem with this approach is that the IRS has issued specific guidelines about qualifying research activities.
If a firm promises a guaranteed claim amount for your startup in minutes, they’re probably just looking at your payroll and accounting data—without doing the due diligence needed to confirm your product development work actually qualifies.
Since you’re not currently required to file the technical R&D study, many small businesses skip it to save time. Plus, if your technical teams haven’t been diligent about documenting all their work, gathering the right documentation for the R&D study can be a manual and time-consuming process.
But what many startups don’t realize is that the R&D study acts like insurance for your R&D tax credit claim. Since the IRS can audit your claim for up to three years after you file, you’re carrying unnecessary risk for a long time if you don’t prepare it.
In fact, if you can’t fully support the amount you claimed during an audit, you’ll have to pay back all or part of the credit—with penalties and interest.
3. Avoid generic, copy-paste R&D studies
On the flip side, some R&D consultants do prepare a technical report—but the quality is questionable. In most cases where the IRS has denied all or part of a claim, it’s because of a lack of supporting evidence or documentation about the R&D work performed.
Low-cost providers often lack in-house technical expertise, so they can’t accurately describe the technological aspects of your work—and sometimes use copy-paste R&D studies. These generic reports are a red flag for the IRS and put your R&D credit at risk of being denied.
Plus, since these firms don’t have the technical know-how to prepare a strong report (if they prepare one at all), they probably can’t show how your R&D work addressed technological uncertainties or relied on a process of experimentation.
4. Don’t make up employee time tracking
Since you need to document all R&D work as it happens (keeping records during the period the work is performed), it’s not a good idea to estimate after the fact how much of each qualifying employee’s salary can be claimed.
Many R&D consultants will tell you to claim 100% of the salary for all qualifying employees, but you need to ask yourself: can you actually prove that these employees spent 100% of their time on work that meets the IRS’s four-part test, as detailed in their audit guidelines?
5. Make sure you have a process to capture documentation as you go
One of the most important parts of any R&D study is documentation. Which projects are you claiming for? How many hours did your employees actually spend on R&D? What work did they complete? This is just the beginning. R&D claims backed by accurate, contemporaneous documentation are the least likely to be audited.
But many R&D consultants skip this step or collect minimal documentation, since it can be time-consuming to make sure the claim is fully supported. This is often where corners get cut to save time and boost profits.
Even if they tell you it’s not worth spending hours on documentation because the IRS works on the honor system, remember: the IRS has officially warned against improper tax credit claims (including the Research Credit) by putting it on its “Dirty Dozen” list.
Bottom line: if you have the right documentation to support your R&D claims, you’ll reduce the risk of making unsupported claims—and lower your chances of being audited by the IRS.
FIND OUT IF YOU QUALIFY FOR R&D TAX CREDITS – FREE ASSESSMENT
How Should I Choose My R&D Tax Credit Provider?
There are hundreds of so-called “R&D tax experts” in the US. Many target software companies in Silicon Valley, have slick websites—you name it. Some even offer an audit guarantee. But these are usually just marketing tactics to create a false sense of security.
Most of these R&D firms simply connect your payroll systems to their software, claim 100% of all R&D-related expenses, and hand you a generic R&D study to submit to the IRS.
In reality, these firms don’t proactively prepare the audit documentation you’ll need, because the process is tedious. They’re betting that your claim won’t be audited at all, and often leave you on your own if you are audited.
If you do get audited, you and your team will have to dig through thousands of records to find supporting evidence and prove how much time your team spent on these projects. Most R&D consultants won’t help with this, so it could take three or four weeks of your lead engineer’s time—time that could have been spent building your product.
As you start looking for an R&D tax credit provider, ask yourself:
- Does the R&D firm have in-house technical experts who understand the specific technology your startup is working on?
- Do they provide a detailed technical report along with the financial statements?
- Do they supply contemporaneous documentation of the R&D work performed and solid evidence for the expenses claimed?
- Will the R&D study they prepare stand up to an IRS audit? If you’re audited, will the IRS accept it—or will they deny part or all of your R&D credit?
- Will the R&D firm help you defend your claim if you’re audited by the IRS?
Remember, the IRS can audit any R&D study for up to three years. Why take the risk just to save a few dollars now? In the long run, this mistake could cost you thousands.
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When you work with Boast.ai, our AI-powered software connects directly to your tech stack. Our algorithm automatically reviews thousands of project management tickets and git commits to generate the audit documentation the IRS requires, organizing your project management system (like JIRA, GitHub, etc.) tickets and git commits by R&D project.
Our platform also uses timestamps from your project management data and git commits to create timesheets for your employees, matched to the R&D projects. And for every claim and every project, it auto-generates the audit documentation you’ll need.
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