Understand the IRS Audit Process
The IRS may initiate an audit by mail, at an IRS office, or through a field visit to your business. You’ll receive a formal notice detailing the documents required to support the income, deductions, and credits claimed on your tax return. The IRS accepts copies of documents and, in some cases, digital records, but you should always confirm acceptable formats with your auditor.
Key Documentation for R&D Claims
To substantiate R&D tax credits and deductions, maintain:
- Project Documentation: Detailed descriptions of each research project, including objectives, hypotheses, and results.
- Contemporaneous Records: Time-tracking logs, payroll reports, and employee activity records showing who worked on qualified R&D activities and for how long.
- Expense Records: Invoices, receipts, and contracts for supplies, materials, and third-party research services.
- Technical Documentation: Design drawings, test results, lab notes, and emails demonstrating the experimentation process and technological uncertainty.
- Accounting Records: General ledger entries and cost allocations that tie R&D expenses to specific projects.
These records should clearly demonstrate that claimed activities meet the IRS’s four-part test for qualified research: permitted purpose, elimination of uncertainty, process of experimentation, and technological in nature.
Key Documentation for Cost Segregation Claims
For cost segregation studies, keep:
- Engineering and Cost Segregation Reports: Comprehensive studies prepared by qualified professionals, including methodologies, asset classifications, and supporting calculations.
- Construction Documents: Blueprints, architectural plans, construction contracts, and change orders.
- Invoices and Payment Records: Receipts and invoices for all building components, improvements, and renovations.
- Asset Lists: Detailed breakdowns of property components, including acquisition dates, costs, and assigned recovery periods.
- Depreciation Schedules: Updated depreciation schedules reflecting reclassified assets and their new lives.
Best Practices for Organizing and Retaining Records
- Organize by Year and Category: Group records by tax year and type of income or expense for easy reference.
- Provide Context: Annotate receipts and documents to explain their business purpose and relevance to your claims.
- Digitize and Back Up: Store digital copies in secure, cloud-based systems for easy retrieval and backup.
- Retain Records: Keep all relevant documentation for at least three years after filing your return, or longer if you anticipate carryforwards or amended returns may be reviewed.
Proactive Steps to Reduce Audit Risk
- Conduct Internal Reviews: Regularly review your tax returns and supporting documentation for consistency, accuracy, and completeness.
- Stay Informed on Tax Law Changes: Monitor updates to R&D and depreciation rules to ensure ongoing compliance.
- Consult Tax Professionals: Engage experienced advisors for complex claims or when preparing for a potential audit.
Responding to an Audit
- Follow IRS Instructions: Submit only copies of requested documents, organized as instructed in your audit notice.
- Be Timely and Transparent: Respond promptly and provide clear, complete information to minimize delays and misunderstandings.
- Maintain Professional Communication: Keep records of all correspondence with the IRS and consider confirming delivery of submitted documents.
Conclusion
Thorough, well-organized documentation is your best defense in an IRS audit of R&D and cost segregation claims. By maintaining detailed records, understanding audit triggers, and working proactively with tax professionals, you can reduce audit risk and confidently substantiate your tax positions if reviewed.