In this article by Peter Mehta regarding research credit audits, the author shares and concisely presents both the new IRS LBI directives related to Information Document Requests (IDR's) on Large Business and International (LB&I) audits as well as the Appeals Judicial Approach and Culture (AJAC) rules. If you work in this area I think you will find his commentary very useful. I would also like to share some advice I have given to clients regarding both of these processes based on work in this area.
Note that this is the R&E Credit or the Credit for Increasing Research Expenditures and not really the R&D credit. Recently a conversation I had with my client and with an IRS Appeals engineer stressed this point. R&D expenses are code section 174. R&E credit is code section 41. The IRS Appeals engineer took exception with calling the credit the R&D credit. I am offering this for your consideration when discussing this issue with IRS personnel. You are advised to call it the R&E credit or the Credit for Increasing Research Expenditures.
Regarding the IDR process, be proactive. Insist that all initial IDR's (except for the most general such as a request for the general ledger) be considered draft IDR's to be discussed. The IRS directive indicates this too, but I have found several occasions with my clients when this was not the case. R&E credit IDR’s are not basic IDR’s and should be discussed before being issued.
When it comes to research credit, it is complex, it involves good documentation, interviews, and detailed computations. Since the backup material associated with the research credit was usually compiled and completed some time ago, leave yourself time to retrieve and prepare the information requested including interviews of key personnel. Perhaps the request can be broken down into separate IDR's to obtain wages, supplies and contracts as well as with interviews with key personnel. Perhaps it can be broken down into sample units rather than comprehensive documentation. Discuss interests, develop a positive relationship with the auditors to work collaboratively to obtain the information required. Under promise and over deliver. That is, leave yourself time for unexpected difficulties. Since the documents are typically not in the tax department and not under the tax department's control, check out what might be involved with obtaining the information from other parts of the organization. Leave yourself some float. It is better to provide the information on time or early rather than late. With this new IDR process, indicating that the person was out, or an emergency leave took place with a key person may or may not be accepted by the IRS. That has been my experience helping clients through this new process. Many at the IRS now look at the process as simply that, a process, and follow the rules and time frames regardless of extenuating circumstances. Keep that in mind. A summons may be forthcoming that is very comprehensive simply because something unexpected happened with key personnel at the taxpayer location.
Regarding the AJAC rules at Appeals, the Appeals Division is serious. I have assisted several clients in this arena. Regarding research credit, if the auditor did not ask the right questions and correspondingly you did not provide what was really needed, Appeals only works with what was provided. For an auditor than alleges any of the four tests for uncertainty, experimentation, business purpose, and technological in nature were not met, and that the taxpayer simply adapted the product, this is critical. Ensure you offered interviews to key personnel and document this. Indicate why the project was not simply an adaptation. Personnel interviewed should be coached to not only answer the questions, but to ensure they bring up each of these four points clearly and articulately tying their answers to evidence. If the IRS examiner fails to ask the right questions and alleges adaptation, and therefore non-qualification of a project for example, the taxpayer may not have the evidence at Appeals, because it was not provided to the examination team. Clarifying commentary can be offered at Appeals, but no new information may be provided. Also be sure on exam to clearly tie emails, plans, iterative computations, iterative failures, and iterative evidence of experimentation documentation with various projects. If not, Appeals may deem a higher hazard of litigation on the taxpayer, because this was not clearly presented to the examination team. A higher hazard of litigation for the taxpayer means less sustention of your issue at Appeals. For this reason be sure and both present and articulate this completely during the examination process.
I feel the article by Peter Mehta is right on point, but I wanted to share some personal experiences with you as well based on my experiences with helping clients as a disclosure witness. The IRS has a job to do. I have a tremendous amount of respect for the IRS. I want to see the IRS do the right thing. Sometimes processes can keep the IRS from doing the right thing. Be forewarned and take appropriate steps to ensure you make use of all of your rights during the process.