Research Credit Claims Audit Technique Guide, LMSB-04-0508-030 (May 30, 2008), has been issued by IRS’ Large & Mid-Size Business Division (LMSB) to the field auditors, in response to receipt by the IRS of numerous “pre-packaged research credit (RC) claim studies” that have generated claims for refunds late in audit cycles. LMSB issued this audit guidance to field agents because experience is showing the prepackaged claims to be difficult to audit. A common scenario features a lengthy methodology discussion and an absence of supportive facts.

Relationship of Expense to R&D

The guide indicates a common problem with the taxpayer’s proof of linkage of the expense, which the taxpayer clearly incurred, and the qualified research activity, which also clearly existed. The issue is not whether there was expense and research, but the connection between the two.

A common example is when wages are incurred in a “cost center” that carried on a research activity, among other activities. The allocation of a portion of wages to the R&D activity may be based on the taxpayer’s estimates. Problems that LMSB sees with estimates include (1) that the estimator may not have even been involved with the employees or the research at the relevant time, and (2) that she may have no objective data on which to base an estimate. LMSB views such cases as “arbitrary and unsupported allocations.”


LMSB relies on Eustace v. Commissioner. T.C. Memo 2001-66, aff’d 312 F.3d 1254 (7th Cir. 2002), to reject the application of the “Cohan rule” to substantiation of the linkage of salaries to research activities. Under the Cohan rule, taxpayers used to be able to make ballpark estimates of the business usage of automobiles, etc., at some percentage. LMSB, however, states that “the taxpayer [is] required to tie salaries to qualified activities at the subcomponent level.”

The examiner is to look for contemporaneous documentation and—if there is not documentation—at least oral testimony from persons who were actually on the job and involved in the research or management at the time.

Invalid 280C Election

Normally no deduction is allowed to the extent that a tax credit is claimed for the expenses. However, a taxpayer may elect a reduced credit and more deduction on a timely filed irrevocable election. Evidently, some elections have been invalid (for example, attempts to make them on an amended return) and may necessitate return amendments to increase the credit claimed, which the examiner should allow where appropriate.

Scope of Examination

The taxpayer will be given the opportunity to show that only the additional credits reflected on an amended return need be examined, by differentiating the methodology for the original credit claim (if any) from the amended claim.

Mandatory RC Claim IDR

These Information Document Requests (IDRs) primarily will attempt to ascertain the existence of adequate substantiation; if the taxpayer cannot show such adequate substantiation, the claim may be denied at this point. Taxpayers would do well to immediately provide samples of clearly proper documentation to head off the IRS view that the claim is based entirely on “high level estimation.” However, the guide warns that non-statistical sampling ultimately will not be sufficient. The guide requires “100 percent” documentation, which can be satisfied by valid statistical sampling.

Practice Pointers 

Taxpayers may be, at all stages of dealing with the research credit, (1) incurring expenses, (2) filing original returns, (3) engaging advisors to file amended returns and (4) defending claims for refund on amended returns. Obviously, taxpayer flexibility to strengthen its position declines as it goes later into the process.

Taxpayers at steps (1) and (2), which should include most corporate taxpayers with active businesses, should take heed of the level of substantiation required in this guide and be prepared to gather it on the front end.

Taxpayers engaging advisors to prepare claims for refund should carefully consider the effectiveness of any claim that looks pre-packaged. Such a claim can be detected if it spends more time proving generic methodology than specific facts.

Finally, taxpayers with claims under audit should attempt to put themselves in the auditor’s position of having to operate under this guide, and attempt to anticipate the auditor’s needs. Even if further substantiation must be gathered during an audit, that may be better than losing the entire claim.