A common question most clients face is “What documents do I need in case I get audited by the IRS?” While the IRS doesn’t specify exact documents required, a Taxpayer is required to keep records of any claims made on tax returns. One example of the records typically requested for review by an examiner is the so-called “Nexus”. With respect to the Research Tax Credit, the Nexus is the tool that ties the Qualified Research Activities (“QRAs”) to Qualified Research Expenses (” QREs” ).
A Briefing Paper by the IRS provides for three widely accepted methodologies for accounting for the QREs incurred during a study:
- Cost Center approach;
- Hybrid approach; or
- Project approach.
The first methodology, the Cost Center approach, or departmental approach groups QRAs into categories that are tracked by the Taxpayer. For example, a Taxpayer tracks the Engineering department and its costs within a specific cost center. An appropriate percentage of these costs are included in the study. While this does usually involve some reliance on reasonable estimation, there is over a century of case law supporting estimation for tax purposes.
In the Hybrid approach, costs are captured like the Cost Center approach, but the support is selectively sampled. For instance, the employee allocations are applied to entire categories, while the support and allocations are derived from a sample of the best representative examples available. The Briefing Paper typically frowns upon this approach because of the potential for overstating QREs.
Finally, the Project approach or job costing approach directly ties QRAs to QREs. The Taxpayer often maintains very specific and detailed accounting software, such as a time tracking or job costing system. When fully utilized, this approach tends to result in the most favorable accounting methodology due to its granular detail and ability to effectively tie each QRE to a QRA, thus generating an incredibly accurate nexus.
While there is a clear preference given to the Project/Job costing, 26 U.S.C. § 6001 does not clearly specify a required approach. In short, the most appropriate approach is the most accurate one based upon the Taxpayer’s existing financial and contemporaneous documentation and record-keeping practices.
The requirement for the Research Tax Credit is that the QRAs be identified by Business Component: new or improved product, process, technique, software, invention, or software. By categorizing the projects by its relative business component, a study can be compiled based on actual contemporaneous documentation. Most Taxpayers follow formal or informal record-keeping practices to keep track of activities worked on – this is how they know if their development efforts were effective or not. Relying on the documentation to clearly show the connection between the QRAs and QREs (labor, supplies/materials, or subcontractors) produces a very clear and solid framework to withstand any level of scrutiny.
Whenever possible, DST Advisory Group seeks to utilize project or job costing through Business Components to directly establish Nexus.
DST’s unique approach to conducting R&D studies allows for flexibility and adaptability to best suit the Taxpayer’s needs and existing procedures.