Publication date: June 2005 *Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations. Note: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date. Chapter 1 | Table of Contents | Chapter 3 2. Determining the scope a. Review Form 6765 Credit for Increasing Research Activities To claim the research credit, a taxpayer must complete and attach Form 6765, Credit for Increasing Research Activities, to its tax return. Form 6765 must be properly completed. If the taxpayer has not properly completed Form 6765 in accordance with its instructions, the examiner should ask the taxpayer to make the appropriate corrections and should obtain the relevant information before proceeding further. While reviewing Form 6765, take note as to whether the taxpayer has elected the alternative incremental credit ("AIRC") and/or whether the taxpayer has elected the reduced rate of credit under section 280C(c). These elections must be properly made on a timely filed original return, with extensions and, where applicable, the taxpayer must continue to use such method unless properly revoked. Form 3800 should likewise be reviewed to verify the proper flow-through of the research credit to the section 38 General Business Credit. Form 6765 requires the taxpayer to allocate QREs among wages, supplies, and contract research expenses. A comparative analysis of the QREs with prior and subsequent years and a review of these expenses, in light of the taxpayer's business activity, are the initial steps in identifying areas with the greatest potential for compliance risk. b. Research Credit claims (not on an original income tax return) An overpayment of tax for a taxable year generated, in whole or in part, by the research credit and not taken into account on a taxpayer's original income tax return may be taken into account by the timely filing of an amended return (e.g., Form 1120X) with the appropriate Service Center or, where applicable, the timely filing of an application for an expedited refund (e.g., Form 1139). In many cases, taxpayers have attempted to claim additional research credits in the course of an audit, without filing a claim for refund with the appropriate Service Center. Notice 2002-44 3 , published in the Internal Revenue Bulletin on July 8, 2002, provides a central filing address for corporate research credit claims while offering a separate filing process to certain taxpayers under audit. In order to receive administrative consideration by LMSB or SB/SE, all claims for credit or refund subject to Notice 2002-44 filed with the LMSB Team Manager/SBSE Manager (and a copy mailed to LMSB-PFTG) must include a completed Form 6765 and must, among other things: Set forth in detail each ground upon which a credit or refund is claimed, Set forth facts sufficient to apprise the Service of the exact basis thereof, and Be verified by a written declaration that is made under the penalties of perjury. Accordingly, LMSB Team Managers/SBSE Managers should return claims for credit or refund subject to Notice 2002-44 that do not comply with these requirements to the taxpayer for correction. The acceptance of the claim and examination of the claim should be delayed until such deficiencies are corrected. c. Prepackaged submissions Over the past several years, there has been a growing trend whereby taxpayers or their representatives submit prepackaged material to support their research credit claims. These prepackaged submissions are usually delivered to examiners in multiple binders, and often set forth the methodology employed in preparing the research credit claim. Examiners have generally found that these prepackaged submissions fail to substantiate that the taxpayer paid or incurred qualified research expenses as claimed, and instead are found, after extensive review, to contain information not germane to the audit. In addition, examiners may be unnecessarily restricting their audit to the taxpayer's methodology for capturing QREs and the prepackaged submission, as opposed to examining the research credit claimed. Audit adjustments based solely upon critiques of the taxpayer's methodology and prepackaged submissions, in many cases, stand little chance of being sustained in Appeals or in court. It is strongly recommended that examiners resist relying exclusively upon these prepackaged submissions. Instead, the examiner should independently determine the documents and other information necessary, including testimony, to substantiate the taxpayer's claim for the research credit. To the extent that these documents and information are already contained in the binders, the taxpayer can reference the needed information quickly and at the appropriate time, thus conserving audit resources. This procedure should be explained to the taxpayer early in the audit to avoid any misunderstandings. As previously stated, deficient refund clams filed during the examination should be returned to the taxpayer for completion. Certain documents may be created in the course of performing such a study that can be of enormous value. Although not part of the binders usually submitted to the Service in connection with a research credit study, the following documents should be routinely requested when auditing the research credit predicated upon a study: All documents concerning the taxpayer's claim for the research credit that are not part of the study should be requested from the study provider and the taxpayer. Such documents would include, but not be limited to, any back-up or workpaper files retained by the study provider. All analyses of the taxpayer's risk or exposure on the positions taken in the study should be requested from the study provider and the taxpayer. IDR/summons language should be drafted to capture these types of documents, and used any time that a research credit study is audited. Importantly, these are neither tax accrual workpapers nor are they audit workpapers, so any administrative restrictions applicable to requesting such information are not applicable here. Any claims of privilege asserted by the taxpayer or study provider in response to a request for this information should be coordinated with your local counsel and the Research Credit Technical Advisors. d. Review the taxpayer's research credit computation workpapers The taxpayer's research credit computation workpapers (including the base amount computation workpapers), including years for which a claim for refund has been filed, should be reviewed. Reconcile the amounts reflected on the taxpayer's workpapers to Form 6765. The taxpayer should be asked to explain any discrepancies between the workpapers and Form 6765. Preparation of a spreadsheet reflecting comparative years' workpaper summary data will help identify any obvious trends from year to year. Current year's QREs will be reported as wages, supplies, and contract research expenses. The workpapers may indicate whether the taxpayer is computing the research credit directly from general ledger accounts (i.e., listing the specific expenses that qualify) through either a cost center/departmental approach, or through a project accounting approach. A copy of the taxpayer's chart of accounts and any accounting and finance procedures relating to the costs treated as QREs by the taxpayer should be requested. If the taxpayer computed the research credit using a cost center or departmental approach, the workpapers should identify each cost center or department by its appropriate cost center or department name and/or number. Detailed descriptions of cost centers or departments should be requested. If the taxpayer computed the research credit using project accounting, each project should be identified by its name and/or number. Project descriptions should be obtained, as well as the list of products or processes to which the research projects relate. The workpapers should also reflect the amount of each type of QRE (wages, supplies, and contract research expense) included in the computation. If the taxpayer is a member of a controlled group of corporations or trades or businesses under common control under section 41(f)(5), the research credit computation workpapers should include all members of the controlled group required to aggregate under section 41(f)(1). Under the aggregation rules, QREs and gross receipts of a controlled group of corporations, and trades or businesses under common control, are aggregated. One credit is computed, and is then allocated to the group members. The mechanics of this computation should be reviewed. Additionally, related Forms 1065 and K-1 should also be reviewed for flow-through research credits. e. Plan the audit strategy The goal of any research credit examination is to verify taxpayer compliance in the most efficient and effective manner possible. LQMS case quality standards regarding: planning the examination, inspection and fact-finding, development, proposal and resolution of issues, and workpapers and reports must be addressed, while at the same time, considering current Service audit policies and initiatives related to case currency, cycle-time, and audit risk assessment. For example, LIFE, PFA, and case currency considerations may require tailoring the audit because of limited resources and/or shorter cycle times. The following audit approach is recommended: Review the research credit computation. Determine whether the expenses claimed for the research credit are QREs under section 41(b) (i.e., wages, supplies, and contract research expenses). Determine whether the activities constitute qualified research under section 41(d). Audit the consistency requirement (base amount computations). Address substantiation and recordkeeping requirements. Examination of the research credit is unique, in that it requires, in part, an evaluation of technological activities to determine the qualification of research related to a business component. The decision whether to engage a specialist (engineer/computer audit specialist) or an outside expert should be made during the planning stage. If the activities are highly technical, consider requesting the services of a specialist. A computer audit specialist (CAS) is helpful in extracting and sorting electronic data such as general ledger information and payroll records. A CAS can also assist in formulating sampling methodologies, as well as in assessing the technical aspects of software development or information technology activities. Industries and sub-industries, e.g., Pharmaceutical, Aerospace, and Motor Vehicle, are occasionally appropriated funds for the hiring of outside experts. The respective Technical Advisor should be consulted to ascertain whether funding exists and/or for information concerning experts specializing in these industries. The referral should specify the area of expertise needed, as it is beneficial for the engineer or expert to be familiar with both the taxpayer's technology and industry. Audit strategy should be contemplated, and an initial planning meeting should be held with the taxpayer and its representative, if applicable, to gain a general understanding of how the taxpayer reached its return (or claim) position and formalize a general audit plan. All members of the audit team involved with the research credit issue, including local counsel as needed, should attend this meeting. Specialists/experts should be consulted before finalizing the audit plan/timeline. Consider sending a letter or issuing an Information Document Request (IDR) prior to the meeting, addressing potential subjects for discussion and documents to be produced. Consider requesting that a taxpayer contact be designated for the research credit issue. Some potential issues for discussion and documents to be produced at the meeting are as follows: Who prepared the research credit computation workpapers? What methodology was employed for capturing QREs reflected in the research credit computation workpapers (e.g., estimates, interviews, sampling, surveys, and reviews of contemporaneous documents)? What documentation and other substantiation are available to support the taxpayer's claim for the research credit (including the base years)? Was this documentation prepared contemporaneously with the research activities? What legal standard(s), if any, did the taxpayer employ to determine credit-eligibility? An assessment of the timeframe within which the examination will be conducted should be carefully addressed and actions to be taken should be planned within this constraint. Consider the audit history of the issue with each particular taxpayer and the number of years to be examined, as well the possible use of expedited resolution procedures. Taxpayer cooperation is critical in determining whether such expedited procedures are advisable. Techniques should be employed to streamline the inspection and fact-finding process. Statistical or "judgment" sampling methodologies, where appropriate, may be employed. Relevant records must be identified and secured. IDR response procedures should be established, and ongoing lines of communication maintained with the taxpayer throughout the examination. It is desirable to schedule with the taxpayer, in a chronological fashion, the examination processes, and procedures during the planning phase. At the meeting with the taxpayer, determine whether the taxpayer sent surveys/questionnaires to employees. If so, request copies of these surveys/questionnaires and responses and have the taxpayer show how these were used in the research credit computation. Request any instructions that accompanied the surveys/questionnaires. Also, determine whether the taxpayer conducted interviews of current (and former) employees and contractors in order to formulate their determination. Advise the taxpayer that this information may need to be corroborated through supporting documentation, and additional interview procedures may be implemented for the examination. A tour of all relevant company operations, including research facilities, should also be considered and arranged. In planning the audit strategy, the Research Credit Technical Advisors are available to provide suggestions to effectively allocate audit resources to those issues that pose the greatest compliance risk. 3 Notice 2002-44, Research Credit Claims Chapter 1 | Table of Contents | Chapter 3
