THE RIPPLE EFFECT OF AN R&D TAX CREDIT STUDY S REAL COSTS
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THE RIPPLE EFFECT OF AN R&D TAX CREDIT STUDY’S REAL COSTS By Pamela Sommers
ONESOURCE R&D TAX CREDIT MANAGER ®
THE RIPPLE EFFECT OF AN R&D TAX CREDIT STUDY’S REAL COSTS AN EXPOSÉ OF THE REAL COSTS YOU MAY INCUR BY CONTINUING TO USE A MANUAL PROCESS FOR FILING YOUR TAX CREDIT EXECUTIVE SUMMARY It is mind-boggling that since the early 1990s, the process many companies go through to identify, document, and defend their R&D tax credit has remained virtually unchanged. And with the average corporate tax department’s resource constraints, it is equally perplexing that the methods the departments use to outsource or calculate credit in-house, and meet the Internal Revenue Service’s (IRS) stringent documentation requirements, also remain unchanged. By highlighting the specific areas of the process that are the most time consuming, we will help you understand the major factors that lead to denied credit. We will also show you how common process inefficiencies can increase costs in less obvious ways. Finally, we will present a prescription for safely introducing new automated methods, married with tax technical services, which can help increase your documentation coverage and reduce risk by aligning with the IRS’s own audit techniques guidelines.
INADEQUATE DOCUMENTATION CAUSES A RIPPLE EFFECT OF GREATER COST AND RISKS KEY LEARNING Using antiquated methods can result in less than optimal results in claiming and sustaining the credit.
1. Missed Credit
2. Wasted Internal Staff Time
3. IRS Denials Impact Earnings
In addition to this negative impact, the inefficiencies of manual documentation methods create a ripple effect of additional, less obvious costs that can further impact the company. These “hidden costs” include: • Missed credit opportunity • Time spent managing cumbersome manual processes • Denied credit on earnings For any other functional area that has such a significant impact on the bottom line, continuing with an ineffective, expensive business process would be inconceivable. With budgets tight, resources thin, and a new host of compliance requirements to adhere to, forward-thinking tax professionals are beginning to revamp major processes across all areas of compliance and planning. Replacing manual processes with automation is the starting point. In the following sections, we break down the typical R&D tax credit process into steps usually performed by R&D administrators. To come up with realistic time and cost allocations, we drew upon our current experience working with many ONESOURCE clients, as well as the extensive past experience of members of our R&D tax services group who have worked both for Big 4 accounting firms and within corporate tax departments. We will also illustrate how to reduce costs. As you will see, more than two-thirds of the time preparing the R&D tax credit study is incurred from resource-intensive, significantly manual segments of the process. For a larger company, the impact can be even more severe. Consider a company with a $10 million credit, with engineers in 12 subsidiaries, across both R&D and manufacturing. The larger and more dispersed the R&D staff and fringe credit areas become, the more difficult it is to not only collect, but also identify qualified expenses, making the collection of contemporaneous documentation even more arduous and costly. It may be easy to understand why, when faced with these increasing costs, tax executives generally opt to reduce the scope of their documentation, yet that’s where the bulk of the risk enters into the process.
RESOURCE CONSTRAINTS Claiming the credit requires certain technical domain expertise — at the front end of the process to identify qualified activities and know what activities outside core R&D may qualify, and at the back end of the process to determine appropriate positions relative to the company’s greater tax strategy and to provide audit support. Claiming the credit also requires extensive resources to interview R&D staff and other personnel and document and assemble the requisite supporting credit information. Additionally, if the credit is audited, there’s a range of post-process support needed to handle the IRS’s Information Document Requests (IDRs) and the ensuing examination process. The middle phase of the process – gathering and compiling documentation – is where the highest volume of time is consumed.
Hard-copy material also creates severe limitations. It needs to be recreated from scratch the following year, and it cannot be easily searched for IRS IDRs and reference. Finally, it cannot be used to rapidly compute “what-if” scenarios that can be invaluable during calculation, as well as in later audits. The cost/benefit of conducting manual interviews and packaging up volumes of documentation has always been out of balance. However, without an alternative, many tax professionals are compelled to compromise on contemporaneousness and comprehensiveness, which sharply increases the risk of credit denial. In the same way a pebble dropped into a pond creates ripples beyond its initial splash, knowingly carrying a risk of credit denial – or taking additional steps to try and mitigate it – generates additional costs that can be far less obvious, yet have a much greater impact.
CONDUCTING INTERVIEWS OR DISTRIBUTING QUESTIONNAIRES
THE RIPPLE EFFECT – HIDDEN COSTS OF CONDUCTING THE PROCESS MANUALLY
Gathering contemporaneous documentation at the source (directly from those performing R&D activities) is critical. The auditor guidelines provided by the IRS clearly state that it is the activities of the employees in question, and not their job titles or the amount of credit claimed, that should be the determining factor in whether an auditor judges a credit valid.
In addition to the obvious, hard, up-front time spent preparing your R&D tax credit claim as shown in the image below, there are numerous hidden costs in the process that significantly add to the project’s overall expense.
R&D administrators might conduct in person interviews or send questionnaires to subject-matter experts. Per study, they often spend hundreds of hours scheduling, conducting, distributing surveys, following up, and recording interview information. The sheer cost of this step is what prompts documentation shortcuts and what ultimately ends up costing credit. There are additional drawbacks: with no structured way to store the collected knowledge and with possible resource turnover, you may encounter someone who is not familiar with your processes and have to start from scratch each year.
AGGREGATING EXPENSE INFORMATION Once information has been gathered from the interviews or surveys, an inordinate amount of effort must be spent aggregating hundreds of spreadsheets into a single source, and reviewing R&D expenditures to determine if they qualify for credit.
PREPARING NARRATIVES Almost one-third of the time of your study can result from preparing narratives based on interview notes or questionnaires. This documentation is the foundation of your claim and if it is incomplete, it might be deemed inadequate by the IRS’s own audit guidelines. Worse, more time is spent generating printouts, charts, copying, collating, and assembling binders that contain these narratives.
SERVER R&D Administrators
GUESTS Your tax department
Task Description Staffing and site visit planning File layout planning Create time surveys and wage database Create supplies and contract research database Data review Customize/automate company survey tracking Determine contacts and plan order of review Evaluate payroll data Create/maintain interview schedule Site work plan & budget maintenance File preparation and site summary Review Planning
Hours 10 10 34 24 20 16 20 5 5 5 15 15 179
Assigned Manager Manager Senior Senior Manager Senior Senior Senior Associate Senior Associate Manager
Interviews to disseminate time surveys and instr. (1hr/ proj/dept/cost ctr) Documentation interviews- writer (1.5 hrs/project/dept/cost center) Documentation interviews- writer (1.5 hrs/project/dept/cost center) Reviewer meeting attendance (1.5 hrs/project/dept/cost center) Conduct time surveys and documentation interviews
200 45 30 75 350
Senior Senior Associate Manager
Review surveys, follow up,input qualifying% (1.5 hrs/proj/dept/cost ctr) Determine/input qualifying supply and contract research costs Create output reports Cost review Aggregating and Consolidating Qualifying Research Expenditures
300 25 16 16 357
Associate Senior Senior Manager
Prepare narratives, additional interviews if required (8 hrs/proj) Prepare narratives, additional interviews if required (8 hrs/proj) Narrative First Review (1 hr/proj) Documentation review (1 hr/proj) Documentation of Qualifying Research Activities
240 160 50 50 500
Senior Associate Senior Manager
Summarize site costs Consolidate procedural info, file clean-up, prepare binders (copy, etc.) Computation Computation review Report preparation Report review, closing meeting agenda and meeting Wrap-up and computation
16 64 16 16 16 12 140
Senior Associate Senior Manager Associate Manager
Senior managment analysis review Review and supervision
The negative “big splash” created when you add up the obvious costs in the R&D tax credit documentation process generates a strong ripple effect of subsequent hidden costs. These result from taking shortcuts, making estimates, rolling together disparate R&D activities, and associating them with another qualifying area. 1. The Cost of Missed Credit Opportunity It’s not uncommon for a company to leave 10% to 30% of its credit unclaimed due to the expense and difficulty of effectively documenting it. If you knowingly leave some of your credit on the table because it’s simply too much hassle to document, or if finding additional, heretofore unknown opportunities to increase your claim is important, then automating your document coverage process could mean you no longer have to turn away from either opportunity. 2. The Cost of Internal Staff Time Managing a Cumbersome Manual Process The time and labor of your organization’s staff is another major expense — which can include following up on progress, sending emails, and tracking status in a spreadsheet. Cobbling together the information you need to prepare your tax credit from a varied array of widely dispersed sources can be exceptionally labor-intensive. Automating the process helps you keep track of all your internal surveys and documentation projects, which enables you to work the numbers and organize the supporting documentation in whatever way your internal processes require. Furthermore, every minute your engineers, PhDs, and other qualified researchers spend in an interview is one minute less they could be spending on their core, value-added expertise, so it’s costing you on both ends. Finally, these subject-matter experts can provide the information at any time as long as they have internet access, a convenience they will appreciate. 3. The Cost of Denied Credit Broader, deeper, more targeted contemporaneous document coverage also can enable you to sustain a greater percentage of whatever tax credit you do claim. Two out of three companies are unable to sustain even 80% of their tax credit claim. Automating the process can help you sustain more, largely because automation enables you to increase your documentation coverage. Moreover, sustaining more credit can have an immediate impact on the bottom line. For many companies, adding between $1 million and $2 million in R&D tax credit translates to a penny per share or more in annual earnings. For private companies, money added to – or missed from – the bottom line is often directly reflected in the personal income tax returns of the owners or investors.
AUTOMATING THE R&D TAX CREDIT STUDY Overall, the exorbitant cost of this process forces many tax executives to limit the scope by: • Ignoring known or fringe credit areas because they may be cost prohibitive to document.
SOURCE: IRS AUDIT TECHNIQUES GUIDELINES
• Avoiding contentious areas (such as internal use software) because of high cost/high risk. • Not documenting some activities, hoping the IRS won’t question them. • Rotating divisions or projects, only documenting qualified activities every few years. These hard choices create a ripple effect of additional downstream costs. By bringing technology in-house, you can maximize and sustain your tax credit while reducing the time and cost spent capturing information. Leveraging sophisticated solutions like ONESOURCE R&D Tax Credit Manager can give tax executives more choices, not harder choices. Software with web-based survey tools virtually eliminates the requirement for separate interviewers, regardless of whether they’re from a third-party firm or your own department. You still have the choice to interview selected groups, but with automation choices to make sure the qualities and quantitative information flow accurately to your R&D credit and documentation. Most R&D solutions are designed for corporate tax departments to give you the ability to monitor and track the progress of your R&D tax credit study through sophisticated reporting and viewing features. In addition, web-based surveys sent to engineers, PhDs and other subject matter experts are intuitive for a streamlined experience. The high cost of interviewing research staff causes some companies to rotate their documentation efforts, collecting data from each of their divisions every other year, or less frequently, due to budget constraints. When data is centralized, you have the ability to analyze, calculate your credit, and re-use the data for forecasting, planning, or other purposes. Another costly aspect of the R&D credit documentation process involves creating detailed activity write-ups, project/department descriptions, or what are sometimes referred to as “narratives,” and then preparing binders full of these write-ups. Tax professionals spend hours creating documentation binders with graphics, colored charts, and other material based on volume, not necessarily substance. This exercise is highly labor-intensive and often fails to substantiate the desired credit level. According to the IRS’s Audit Techniques Guide, these pre-packaged submissions “fail to substantiate… qualified research expenses as claimed, and instead are found… to often contain information not germane to the audit.”1 As a result, data collection efforts could effectively double the pre-packaged submission and re-collecting documentation to address examiner questions in a future audit. Further, with new compliance regulations placing more stringent requirements on justifying tax positions and reserve accounts, it is increasingly important for tax departments to focus on what they can do to reduce the likelihood of tax credit denials.
FINDING THE IDEAL MIX Many corporate tax practitioners already believe the optimal solution blends contemporary, proven automation with tax technical expertise, and applies each to the process to maximize credit in the most cost-effective way. This enables you to: • Identify credit previously seen as cost-prohibitive to capture • Increase documentation coverage to sustain higher credit levels and reduce risk • Ensure your documentation is collected contemporaneously to increase sustainability • Reduce costs by relegating the production-oriented tasks to technology • Complete the process in far less time Bringing technology in-house eliminates the cost and risk of narrative and binder preparation. It cuts down significantly on the hours required to go through this step, and it strengthens your coverage. You can deepen the data you collect to support controversial areas, and you can instantly locate specific R&D documents by searching a central repository. Having the data in your own repository also enables you to build on it from one year to the next. This eliminates having to create it from scratch each year, and enables you to look at year-to-year changes to ensure documentation is consistently thorough for specific areas. New resources can pick up where the prior resources have left off. The advantages of using technology are significant: • Information quality is exceptionally high — no one knows the researchers’ jobs as well as they do, of course, so there will be far less irrelevant data and no “re-interviews.” Based on our client feedback, these result in an improved experience for your researchers, engineers, and scientists, which translates into increased responsiveness to your surveys.
All these advantages dramatically drive down the hours required to obtain the information you need – consulting hours and the time your tax staff must spend managing the process. This in turn, enables you to expand both the breadth and depth of your coverage (more qualified expenditures uncovered) and increase your confidence that you’ll be able to sustain a larger percentage of whatever amount you ultimately claim. You could even bring consultants in after you’ve gathered your contemporaneous documentation to analyze the data and help you strategize and prepare your audit defense. You’ll gain more by leveraging their core competencies on a more focused and targeted basis, and you’ll wring the most value out of the information you so cost-effectively accumulated. When choosing the right approach to manage your R&D tax credit process, it is best to consider a solution that gives you maximum flexibility to allocate the bulk of your tax department resources to high-value strategic activity, as well as to find the blend of outside consultants and/or Thomson Reuters professional services that are most cost effective for your organization and your situation.
SUMMARY Much of the costs of preparing your R&D tax credit claim are the obvious visible expenses, incurred through the use of manual processes. Many other costs are harder to see or quantify, but can have a significant ripple effect that causes much greater unforeseen impact. Controlling these costs and sustaining larger R&D tax credit amounts is now within reach. The greatest opportunity comes from re-evaluating your processes and implementing new ways to target documentation, increase coverage,and provide more depth. Using a technology solution to automate your R&D tax credit process offers significant advantages, dovetailing easily with any company’s goals, existing processes, and resources.
• Documentation is current and detailed — the surveys can be done in real-time or any time, and are easy to update and supplement.
Technology solutions uniquely enable companies of all kinds to:
• Information-gathering process is sped up exponentially — you can cut months from the process.
• Manage the documentation process in a fraction of the time
• Managing the process and tracking progress are greatly simplified — you can monitor and update all the administrative task details easily from one “dashboard-style” screen.
• Minimize audit exposure
• Documentation is electronically stored – you can instantly reference data for analysis. It can even be used for future tax credit opportunity when, for instance, an organization brings a new product to market, or when a company emerges from several years of net operating loss. • Tax executives are given more choices – you still maintain the option to conduct interviews key areas, but with the added benefit of ensuring that the R&D descriptions and calculations flow into a repository that is accurate and can be mined through the review process or audit cycle.
• Identify and sustain more research tax credit
• Analyze to determine credit position – at the federal and state level • More effectively defend tax positions • Improve relationships with your R&D team and better protect sensitive information In comparison to “traditional” methods, introducing a solution, like ONESOURCE, optimizes the R&D tax credit process by providing the right amount and right kind of documentation that is essential for maximizing the research tax credit while minimizing cost.