The research credit is self-assessed and the IRS tests it by examination, which US practice calls an audit. Most claims are never examined. Those that are tend to turn on the same handful of questions, and the outcome is usually decided by what was written down while the research happened rather than by what is argued afterwards. This page describes how an examination starts, what is asked for, how to respond and what can follow.
How reviews start
Research credit claims can be selected for examination through the IRS's normal return selection processes, whether the credit is the reason the return was chosen or the credit is examined as part of a wider review of the return. Refund claims on amended returns receive particular attention because the IRS can reject a claim that does not contain the required business component information without opening an examination at all.
The examination must start within the limitation period, normally three years after the return is filed. A credit carried forward and used in a later year can be examined when that later year is examined, so the originating year's records matter for as long as the carryforward lasts.
What is requested
The examiner issues information document requests. The Audit Techniques Guide that guides them sets out the areas examined, and the first request usually covers all of them.
| Area | Typical request | What satisfies it |
|---|---|---|
| Business components | A list of the components claimed, with a description of each and the information sought to be discovered | The Section G workpapers, with project charters and design briefs |
| Four-part test | Evidence that each component satisfies each part | Design documents, test plans, test results, build logs, for each component |
| Wages | The employees claimed, their roles, the hours or percentages allocated, and the basis | Time records by project, job descriptions, the payroll register, the allocation method |
| Supplies and contract research | Invoices, contracts, proof of payment, the risk and rights analysis for contracts | Purchase records coded to components, agreements dated before the work |
| Exclusions | Why the claim excludes post-production, adaptation, duplication, funded and foreign research | The exclusions analysis in the workpapers |
| Calculation | The base amount or prior-year QREs, gross receipts, the method and the elections | Prior returns, Form 6765 workpapers, the reconciliation to the ledger |
| Section 174 | Consistency between the costs claimed for the credit and the costs treated as research or experimental expenditure | The section 174 schedule and its reconciliation to the QREs |
Examiners also interview the people who did the work. The interviews test whether the technical narrative is the engineers' own account, which is one reason the academy teaches that narratives are written with the technical lead rather than for them.
Responding to a review
- Answer the request asked. Provide what the information document request lists, organised by business component, with an index. Volume is not a defence; organisation is.
- Use the technical lead. The engineer who recorded the uncertainty in March is the best witness to it. Prepare them for the interview; do not substitute an advisor for them.
- Reconcile the numbers first. Before any discussion of eligibility, show that every dollar of QRE traces to payroll and the ledger. Unreconciled numbers lose credibility for the whole claim.
- Concede weak points early. A component that cannot be evidenced should be withdrawn, in writing, before the examiner finds it. The rest of the claim is stronger for it.
- Keep the record of the examination. Every request, every response, every interview note. It is needed if the case goes to Appeals.
Outcomes, penalties and appeals
Adjustments. The examiner may accept the claim, reduce it by removing components or costs, or disallow it. A reduction is reflected in a revenue agent's report with the additional tax, interest from the original due date, and any penalty.
Penalties. The accuracy-related penalty is 20% of the underpayment attributable to negligence or a substantial understatement of income tax. It does not apply where the taxpayer had reasonable cause and acted in good faith, and documentation prepared at the time is the best evidence of both. A credit built on reconstructed estimates is exposed to the penalty as well as to the adjustment.
Appeals. A taxpayer that disagrees with the examiner's report can request a conference with the IRS Independent Office of Appeals, which considers the hazards of litigation and can settle. If Appeals does not resolve the case, the taxpayer can petition the Tax Court without first paying, or pay and sue for a refund in a district court or the Court of Federal Claims. Research credit cases in the courts turn repeatedly on the same points: whether the uncertainty existed at the outset, whether the activities were a process of experimentation, whether the taxpayer bore the risk in funded work, and whether the wage allocations had a credible basis.
Illustrative example
Orrin Devices, a hypothetical electronics company, is examined on a US$180,000 credit covering six business components. For four components it produces design reviews, test logs and time records that match the claim; the examiner accepts them. For one, a firmware update, the records show mainly post-release bug fixing; Orrin withdraws it. For one, a customer-funded sensor, the contract gives the customer all rights and pays fixed milestones; the examiner treats it as funded research. The credit is reduced to US$140,000, no penalty is proposed because the claim was documented and the weak components were conceded, and the case closes at examination without going to Appeals.
Related pages
- The records that decide an examination
- Funded research: risk and rights
- Limitation periods and refund claims
- Guide: responding to a tax authority review
- Program: Advisor and Practitioner Program
Official sources
Educational content only, not tax advice. See the disclaimer.