Required Documentation of the IRC Section 41 Researchand Experimentation Tax Credit

Section 41(a) provides an incremental tax credit for increasing research activities based on apercentage of a taxpayer's qualified research expenses (QREs) above a base amount.

QREs consist of wages, supplies and contract research expenses incurred for qualifying research. Under the Alternative Simplified Credit (ASC) method, the base amount is based on the prior threeyears' QREs. Under the "regular" method, the base amount is based on the prior four years' grossreceipts as well as gross receipts and QREs incurred during the 1984-88 base period.

Regardless of the method used to calculate the credit, per sections 6001 and 1.6001-1, a taxpayermust retain records in sufficiently usable form and detail to substantiate that the expendituresclaimed are eligible for the credit, i.e., QREs and base amounts are substantiated throughcontemporaneous books and records. Failure to maintain records accordingly is a basis fordisallowing the credit.

Substantiating base period amounts can be problematic, especially under the regular method whichrequires contemporaneous documentation dating as far back as the 1984-1988 tax years. Extrapolation of QREs and gross receipts is not considered an acceptable method. For this reason,the ASC is the preferable method where such documentation no longer exists.

For documenting QREs, installation of a project tracking system is strongly recommended. Alternatively, the taxpayer must compile data after the fact, which has less evidentiary value thancontemporaneously tracked expenses and requires more time and resources on the part of thetaxpayer. Estimates are permitted only in cases where qualified RD activity has been established,and the sole issue is the exact amount incurred. Estimates often are not accepted by the IRS onaudit and the taxpayer must bear the expense of going to court in hopes of invoking the Cohan rule.

Some of the items the IRS is likely to request upon audit include: payroll records, analysis of %related to qualifying RD, job titles and descriptions, trial balances, general ledgers, invoices, andcontracts for third-parties performing contract research. Other items of documentation includecharts of accounts, organizational charts, and acquisitions and dispositions from 1984 through theyear of the credit. These records should be organized and maintained for at least seven years, andpermanently in the case of base period amounts.

Phil Dottavio, CPA, EA, MT

Phil Dottavio has over 25 years of experience in individual and business taxation, including 7 yearswith two of the Big Four accounting firms, over 15 years in private industry, and several years inleadership positions at a number of specialty tax firms.

Phil is a Certified Public Accountant in the state of Ohio and is also an Enrolled Agent. He holds aB.B.A. in accounting from Kent State University, Summa Cum Laude, and received his Master ofTaxation from the University of Denver Sturm College of Law.

Phil is a member of the American Institute of Certified Public Accountants, the Ohio Society of CPAs,the American Society of Tax Problem Solvers, the Akron Tax Club, and the Tax Club of Cleveland. He has authored several articles and is a frequent speaker at CPE events, and has served as anadjunct professor at the Cleveland State University College of Business Administration, and BrownMackey College.

Phil Dottavio has over 25 years of experience in individual and business taxation, including 7 yearswith two of the Big Four accounting firms, over 15 years in private industry, and several years inleadership positions at a number of specialty tax firms. Phil is a Certified Public Accountant in thestate of Ohio and is also an Enrolled Agent. He holds a B.B.A. in accounting from Kent StateUniversity, Summa Cum Laude, and received his Master of Taxation from the University of DenverSturm College of Law. Phil is a member of the American Institute of Certified Public Accountants,the Ohio Society of CPAs, the American Society of Tax Problem Solvers, the Akron Tax Club, and the

Tax Club of Cleveland. He has authored several articles and is a frequent speaker at CPE events, andhas served as an adjunct professor at the Cleveland State University College of BusinessAdministration, and Brown Mackey College.

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