One crucial aspect of managing a business is keeping the books in order. And one of the most common bookkeeping tips you’ll receive is to prepare yourself for the tax season.
With tax season right around the corner, you need to get your paperwork in order to file your tax returns. That sounds simple enough, but there is one aspect of tax season that makes people tremble: Tax audits.
If your business is filing a claim for the R&D tax credit, then you are potentially putting yourself at risk of a tax audit. Fear not, we have brought you a list of tips to reduce the risk of an audit while claiming R&D tax credits.
Should You Fear an IRS Audit?
Truth be told, IRS audits aren’t necessarily as terrible as people make them out to be. For starters, an audit doesn’t always mean that an IRS agent will come knocking. Oftentimes it’s just sending a request for documentation that supports your claim or informing you of a discrepancy in your tax return. This could mean you owe money or, in some cases, that money is owed to you.
However, they do come with a lot of scrutinies, and even if you are in the right, fighting off a claim of an error can be time-consuming. So, it’s not a huge mystery why people prefer to avoid them whenever possible.
Unfortunately, R&D credits come with a higher risk of an audit than other types of tax claims, so you really need to know how to navigate that.
How to Reduce the Risk of an Audit from Claiming R&D Tax Credits
There are a lot of guides out there on avoiding IRS audits in general. People really don’t like being audited. However, when it comes to avoiding tax audits from claiming R&D Tax credits, you’ll want to follow these specific tips:
1. Verify That Your Activities Are Qualified
Step number 1 to avoid a tax audit for your R&D tax credit claim is to ensure that the activities for which you are making the claim qualify for it.
The IRS uses a four-part test to determine what activities qualify. According to the test, your activities must:
Have a Permitted Purpose
They are meant to develop new or improve existing products, processes, techniques, software, or formulas.
Be Technological in Nature
The activities work with engineering, or computer science, biology, or physics.
Work Towards Eliminating Uncertainty
You aren’t completely sure the experiment will work, but the activity is trying to eliminate that uncertainty.
Go Through a Process of Experimentation
You followed a systematic process to identify and work through the previously mentioned uncertainties.
The idea is that you are able to show that your work was aimed at finding solutions or improvements to existing predicaments.
2. Document Everything and Organize Your Paperwork
Keeping a neat and organized record of all transactions and important information is essential to running a legitimate business. This will also help you significantly when it comes time to file for an R&D tax credit claim.
You should assign the collection of all research documentation and associated R&D paperwork to someone to make sure that all the data is in the right hands.
You will need all of it ready to go in order to file your claim properly. If you aren’t already documenting everything, you should start by developing a protocol to do so.
3. Look Into the Audit Techniques Guides
The IRS publishes a series of audit guides called the Audit Techniques Guides to help IRS examiners learn what kind of issues and accounting methods they should expect to see when working with different industries. Luckily for you, they also make these guides available to the public.
Furthermore, they have a few guides specifically for R&D tax credit claims. Taking the time to check them, or at the very least skim through them, will help you understand better what to expect from the process.
4. Have Sufficient Proof
For the R&D tax credit claim, your proof is the be-all-end-all to the IRS. This is especially true if your claim is higher than other businesses within the same industry.
But you really shouldn’t worry about how much you are claiming in credits, only that you can prove that these expenses were indeed within the realm of research and development.
If you send in the necessary paperwork before the IRS comes asking for it, you will save yourself a lot of time and reduce the chances that they perform an audit.
5. Create an R&D Department
A way to ensure that the credit is processed smoothly is by assigning these activities and tasks to a department within your company that’s dedicated exclusively to research and development. It will be much easier to support it as a tax write-off and to ensure that the activities performed qualify under the four-part test.
6. Be Careful With Tax Amendments
One of the most interesting aspects of the R&D tax credit is that you can file a claim for previous years. Usually for the last three to four open tax years. However, you should know that filing such an amendment can significantly increase your risk of an audit.
All amended R&D claims are sent to a designated address, and from the perspective of the IRS, they require more scrutiny.
While we don’t necessarily advise you against filing such an amendment since they give you a much-needed cash boost, you do need to be aware of how they affect your audit risk.
7. Know the Risk Factors
There are a few additional factors that affect your risk of an audit. For instance, the size of the credit you are trying to claim can affect this risk.
Another factor is if your credit is larger than the average amount claimed by other companies within your industry.
Finally, the IRS will be more tempted to audit your R&D claim if they see that it is not common for businesses in your industry to file for R&D expenses.
8. Get Help From a Specialist
The best way to ensure you have a smooth tax season is by speaking with an expert. Someone that can answer your questions about the R&D tax credit, as well as work out all the details and paperwork you need to get your tax return in order.
One of the most common errors that lead to audits is simple math oversights, like addition and subtraction errors. A tax specialist can help you identify these situations.
For the R&D tax credit, in particular, you’ll want to speak with someone that is well versed in dealing with research and development tax regulations. Luckily, there are a number of agencies out there that focus on these credits in particular.
Final Thoughts
Claiming the R&D tax credit or other tax deductions could increase your risk of an audit, but that doesn’t have to be the end of the world. So long as you properly document your processes, ensure you are filing a claim for the right activities, and provide enough proof, you should be fine.
Even if you do get audited, working with tax experts and keeping your books and paperwork in order will keep you out of trouble.
Follow this guide and tax season will come and go without any hiccups.
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