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How to Handle an R&D Tax Credit Audit

Dealing with an R&D tax credit audit can feel stressful, especially if you’re unfamiliar with the process. Feeling concerned about the possible audit after a successful R&D tax credit claim is normal. You should know that audits are quite rare, but even if you are “lucky enough” to have them, good preparation will let you pass them without any problems.

That’s why our R&D tax credit experts have prepared an article that will help you understand these key points:

By knowing what to expect, you can confidently handle an R&D tax audit and protect your business from potential penalties.

What Triggers an R&D Tax Credit Audit?

There are five main reasons why the IRS might choose to audit your R&D tax credit claim. 

  • Inconsistent claims: if the expenses in your R&D tax credit claim don’t match your supporting documentation, or if there are large differences compared to previous claims, it can raise red flags for the IRS. For example, if you suddenly claim significantly higher credits without explaining the increase, the IRS auditors may want to investigate further.
  • Large or frequent claims: businesses that regularly claim large R&D tax credits are more likely to be audited. While claiming substantial credits is often justified, the IRS wants to ensure the amount accurately reflects your R&D activities.
  • Random selection: sometimes, an audit occurs simply because your return was chosen randomly. The IRS uses statistical formulas to select a certain number of tax returns for audits each year, so even well-prepared claims can be subject to review.
  • Industry profile: certain industries, like pharmaceuticals, software development, or manufacturing, are more likely to be audited because they tend to claim larger amounts for R&D credits.
  • Economic factors: during times of economic downturn or when government budgets are tighter, it is common to see more cases of R&D tax credit audits. The government just wants to make sure that every penny is properly used.

As you can see, most of these triggers are quite difficult to avoid. In many cases, these actions are simply a result of the circumstances, over which you have little or no control. However, your actions can significantly impact the success of the audit.

How to Prepare for an R&D Tax Credit Audit

Proper preparation is essential to handle an R&D tax credit audit successfully. By getting organized and having the right documentation prepared, your chances of passing the audit successfully dramatically increase. Here are the steps you should take:

  1. Organize your documentation. You will need to provide clear records to back up your R&D tax credit claim. Make sure you have project plans, time logs, receipts, invoices, and any other documentation that shows your expenses and activities. Each document should clearly tie back to your R&D projects.
  2. Track employee time and wages. It’s crucial to show how much time your employees spend on R&D activities. Using a reliable time-tracking system that allocates employee hours to specific R&D tasks can help you demonstrate the accuracy of your wage claims.
  3. Work with a specialized tax advisor. An R&D tax credit specialist can help you identify any potential gaps in your documentation. Their expertise can also help you better prepare for the types of questions the IRS might ask.
  4. Understand IRS regulations. Familiarize yourself with the current IRS guidelines for R&D tax credits. Being well-versed in the rules will help you ensure your claim is compliant and prepared for audit scrutiny.
  5. Prepare a clear narrative. The IRS will want to understand the purpose and results of your R&D work. Be ready to explain how your research met the criteria for qualified research activities (QRAs) and how the expenses relate to those activities.

By doing all these steps, your business should be fairly safe from a penalty or a fee. 

What To Do Once You Receive an R&D Tax Credit Audit Notice

We understand that receiving a notice that you will be audited by the IRS is stressful; however, it is critically important to take the first actions as soon as you can. The sooner you will start working on this issue, the higher the chance to successfully pass the audit. Here’s what you should do if you receive an audit notice:

  1. Understand the scope of the audit. Carefully read through the audit notice to understand what aspects of your R&D tax credit claim are being examined. Knowing the specific areas of interest will help you focus your response and gather the right documentation.
  2. Consult your tax advisor. Before you respond, it’s important to involve your R&D tax advisor. They can help you interpret the notice, advise on the best course of action, and prepare the necessary documentation.
  3. Acknowledge receipt of the notice. Once you have reviewed the notice, make sure to promptly inform the IRS that you’ve received it and are ready to cooperate. This shows that you are taking the audit seriously and are willing to provide what’s needed.
  4. Note critical deadlines. The IRS will set firm deadlines for submitting documents and information. It’s important to mark these dates on your calendar and make sure you meet them. Missing a deadline can complicate the audit and potentially result in penalties.
  5. Gather the required documentation. Start collecting the specific records and documents requested by the IRS. This could include emails, project plans, invoices, employee time logs, and more. Always make sure everything is well-organized to avoid delays.
  6. Brief your team. If other employees were involved in the audited R&D projects, make sure they understand the situation and know how to respond if they are contacted by the IRS. Consistency in the information provided is key to avoiding confusion.

What Outcomes You Can Expect from a R&D Tax Credit Audit

Once the audit is complete, the IRS will determine the outcome of your R&D tax credit claim. There are three outcomes from those results:

  1. No Changes. If your documentation is complete and your claim complies with the IRS regulations, the audit may conclude without any changes to your R&D tax credit. This is the best-case scenario, as it means the IRS accepts your claim as submitted, and no further action is required.
  2. Adjustments to the claimed credit. In some cases, the IRS might make adjustments to your claim. This could happen if they find discrepancies in the documentation or if certain expenses do not qualify as R&D under the IRS guidelines. If adjustments are made, the IRS will reduce the amount of the tax credit you can claim, and you may need to pay back the difference.
  3. Penalties or fines. If the IRS determines that your claim was significantly overstated or that you did not provide adequate documentation, they may impose penalties or fines. This can happen if the auditor believes there was intentional misrepresentation or if a large portion of your claim was unjustified. In addition to repaying the disallowed credit, you could face additional financial consequences.

In the event of any adjustment or penalty, you have the right to appeal the decision. If you believe the IRS made an error during the audit, you can work with your tax advisor to present additional documentation and argue your case.

Get Help from R&D Tax Credit Experts

R&D tax credit audits can be challenging, but with proper preparation and the right guidance, you can pass this process without any problems. At FI Group, we specialize in helping businesses successfully claim R&D tax credits and handle audits. Our team of experts can guide you through the entire process, from documentation to representing you during an audit. Whether you’re preparing for an audit or want to maximize your R&D tax credit potential, we’re here to help.

Contact us today for a free consultation to ensure your R&D tax credits are audit-ready

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