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The California Research Credit - what is sufficient documentation?
In the course of our audit examinations we are frequently asked, "What type of documentation is required for the California Research Credit?"
We generally look for contemporaneous documentation of a typical business nature supporting the item under examination. "Contemporaneous" simply means the documentation or support should be from the time period of the underlying transactions, services, or activities. "A typical business nature" refers to customary documentation prepared in relation to a given transaction or process.
The difficulty in documenting the California Research Credit results from the fact that each section of Internal Revenue Code (IRC) Section 41 dealing with common components of the credit requires different forms or types of support. For instance, the documentation necessary to support qualified services (IRC Section 41(b) wages, supplies, contract research) is different than that required to support qualified research (IRC Section 41(d) qualified research defined). These types of documentation are, in turn, different from the documentation necessary to support the other computational elements of the credit (IRC Section 41(c) fixed base percentage and average annual gross receipts).
The issue is further complicated by each taxpayer's unique situation. Different taxpayers refer to documentation by different titles, and research operations vary in the degree to which they document their transactions and processes. It is difficult to provide a list of items applicable to every taxpayer. There are, however, research and business documents we typically rely on to support various research credit elements. These include:
- Materials explaining research activities, including brochures, pamphlets, press releases, and other similar documents.
- Submissions to management, the board of directors, review committees or other similar groups regarding research projects, activities, expenditures, and the research credit.
- Documents prepared by, or on behalf of, internal audit, including quarterly and annual reports that refer in any manner to research activities.
- Minutes, notes, or other similar recordings from budget, board of directors, managerial, or other similar meetings concerning research activities.
- Project authorizations, budgets, or work orders that initiate a research project.
- The internal authorization policies for approving a research project.
- Project summaries and/or progress reports and project meeting minutes.
- Field and lab verification data/summary data.
- Research credit studies conducted by outside consultants.
- Papers, treatises, patents and their supporting work papers, letters, scientific articles acknowledging the work, supply invoices, or other published documents about the taxpayer's research.
- Human resource documents including self-appraisals, annual reviews, and time reports.
- Travel and entertainment reimbursement forms.
- Original signed contracts (including all modifications), letter agreements, memoranda of understanding, or similar documents for research performed by, or on behalf of, a third party.
- Federal and state tax returns (including other state tax returns). This would also include apportionment work papers to prepare the various state tax returns.
- The general ledger.
In addition to the documents listed above, credible oral testimony by individuals with personal knowledge of the issues may be helpful in supplementing a taxpayer's contemporaneous documentation. By itself, however, oral or written testimony is not a substitute for contemporaneous documentation. We may need to conduct interviews to provide documentation opportunities, or to confirm, clarify, or refute other documentary or testimonial evidence. We may disallow the credit for corporations who fail to maintain records in accordance with these rules. While there does exist a degree of flexibility in substantiating the credit, it neither relieves nor eliminates a corporation's obligation to keep and provide a record of their qualified research.