Taking This Business Credit Could Increase Your IRS Audit Risk

The IRS audited 2.3% fewer returns in fiscal year 2022 compared to 2021, the Internal Revenue Service Data Book shows. But even with fewer audits, the agency kept a close watch on credits and deductions that posed a high risk for fraud and abuse. One of the biggest red flags for the IRS is the research and development (R&D) credit. It's one of the most closely monitored tax breaks, with R&D credit claims often involving inflated wages, overstated expenses, and claimed routine activities as qualifying research.

The R&D credit has been part of the tax code since 1981. It was set up to boost innovation by covering part of the qualified research expenses. Examiners will test the technical process of experimentation. They'll also check the financial accounting criteria for each claim. Any gaps — like missing project specs, time-tracking data, or clear definitions of business components — can trigger a full disallowance of the credit. Businesses claiming R&D relief need contemporaneous records and time logs to justify every dollar, or they risk triggering an IRS audit.

Corporations and businesses file thousands of IRC Section 41 claims for the research and experimentation (R&E, commonly called R&D) tax credit, adding up to hundreds of millions of dollars. The sheer number and size of these claims led the commissioner to label research credit claims a top compliance issue. It holds Tier I status, which is attributed to matters with high strategic importance, ensuring these credits receive dedicated resources and specialized attention.

Some firms pushed R&D credits too far. The IRS put R&D credit abuse on its Dirty Dozen tax scams list from 2016 to 2019. In response, the IRS enforced stricter claim reviews in October 2021. Taxpayers seeking refunds had to provide detailed descriptions of research, names of qualified individuals, and business components involved. But starting June 18, 2024, the IRS eased early claim requirements. Businesses no longer have to submit employee names or research outcome details upfront. That move lowers the risk of unexpected audits. Still, the IRS can request these details during examinations.

The IRS intensified its focus because it found common gaps in submissions. Prepackaged research credit studies from consulting firms often fail to prove that taxpayers actually paid or incurred the claimed qualified research expenses. Examiners see unsupported allocations where estimated percentages are applied to whole departments' wages without proper documents.

Proper documentation starts from day one of the research, not when the audit notice shows up. The IRS wants taxpayers to keep records that clearly prove their claimed expenses qualify for the credit. That means keeping contemporaneous records — notes and files made during the actual research work. Those build the base for any solid defense of an R&D credit claim.

Still, the best safeguard is what the IRS calls Research Credit Recordkeeping Agreements (RCRAs). This formal process, detailed in Notice 2004-11 and the IRS Audit Techniques Guide, lets taxpayers work with the IRS ahead of time. Together, they set what records are needed to support future research credit claims. Companies keeping these agreed-upon records generally avoid disallowance for lack of substantiation, though audits can still occur.

Big companies with at least $10 million in assets and GAAP-audited financials can choose the ASC 730 Directive safe harbor. By applying the Directive's methodology and reporting the Adjusted ASC 730 amount on Form 6765, they treat those expenses as qualifying Qualified Research Expenses (QRE) without extra project-level proof for that portion. But they still must keep detailed project records to support any additional QREs. That means linking each dollar to real research with time logs, technical specs, and test results showing the systematic process Section 41 requires. Firms that build systems following these rules cut audit risks and strengthen the credibility of their claim.