The “Most Interesting Man in the World” of R&D Tax Credits

By Jason Massie, CPA, Esq. | Article in the Tax Executive

Remember the Dos Equis beer ads where a bearded, distinguished-looking older gentleman wrestled bears, had drinks with Castro, and climbed Everest with his mom on his back as the bombastic voiceover recounted his daring exploits?

“Bear hugs are what he gives bears. He lives vicariously through himself. His mom has a tattoo that says, ‘Son.’ He is . . . the Most Interesting Man in the World,” the narrator would announce. At that point, the actor would speak the tagline, “I don’t always drink beer, but when I do, I prefer Dos Equis. Stay thirsty, my friends.”¹

Today you will learn about the most interesting man in the world of research and development (R&D) tax credits. Let’s call him Dan Smithfield, which, of course, is not his real name.

Before we get to Dan, though, I want to catch you up on what has been going on with the research credit since 2021.

New IRS Demands

The Internal Revenue Service has had eighteen months to fully educate agents on the Siemer Milling and Little Sandy Coal Co. cases, the Chief Counsel memorandum on refund claims, and proposed changes to Form 6765 (Credit for Increasing Research Activities). Two things you need to know for 2023. The IRS has a new focus on business components (BCs), and it wants more documentation related to the process of experimentation (POE) prong of the four-part test. BCs and the POE may not be four-letter words, but they are quickly becoming a taxpayer’s worst nightmare.

Congress initially didn’t want the R&D credit to be burdensome for taxpayers: “Eligibility for the credit is not intended to be contingent on meeting unreasonable record keeping requirements.”² But, in September 2021, the IRS issued the Chief Counsel memorandum notifying taxpayers that numbers on refund claims related to R&D tax credits aren’t enough. Additional details and supplemental explanations are needed. The IRS wants to evaluate your claim promptly, and computations don’t paint a complete and accurate picture of what is going on. You must now provide BC information, detailed qualified research expenses, and documentation of employee-level activities. While initially impacting refund claims filed after January 2022, the effective date has been pushed out another year. It’s not just for refund claims, since we see similar requests made at Exam and Appeals. Form 6765 changes are also coming with the 2023 or 2024 filing season. You’d better get ready now, because the BC and POE train has left the station and is not slowing down any time soon.

What About Dan?

What does this have to do with Dan, and why is he the most interesting man in the world of R&D tax credits? Cue the voiceover: “Dan Smithfield has worked for only one company his whole career (thirty-plus years, which is pretty rare nowadays). He is a black belt in Lean Six Sigma. Dan motivated engineers to complete 22,000 R&D surveys annually to support his claim for a nearly $100 million R&D tax credit. He is . . . the most interesting man in the world of R&D tax credits.” Switch to Dan, who says, “I don’t always speak R&D tax credits, but when I do, I prefer to gather information by business component. Stay out of trouble, my friends.”

Did you catch the part where I—er, the announcer—said 22,000 R&D surveys a year for a nearly $100 million R&D credit? Dan was gathering information for his company by business component—BC—ahead of its time. He could see the future in his crystal ball and worked up a masterful system. Let’s unpack this a bit further, because I am sure readers are wondering how to comply with new IRS requirements.

By way of background, like many of us Dan was an accounting undergrad who took his first job (his only job) with a well-known equipment manufacturer. Working in traditional finance roles, Dan was a good soldier moving up the corporate ladder. About fifteen years into his career, he discovered R&D tax credits and opted to work with the tax department.

In Dan’s first interaction with the IRS, his company didn’t do so well. In fact, Dan recalls, the IRS picked on his company specifically for its lack of documentation to support the R&D credit it was claiming. The IRS was quite underwhelmed by the information the company had gathered to support the credit and proposed adjustments to put the company in its place. There wasn’t much Dan could do at the time, but that experience got him thinking.

Dan was a Lean Six Sigma black belt. If you are unfamiliar with that designation, it is for professionals who have mastered Lean Six Sigma philosophies and principles, including systems and tools. An individual with a black belt has proven team leadership skills, understands team dynamics, and masterfully delegates roles and responsibilities. Dan began to learn more about the R&D credit and quickly realized that the R&D engineers at his company were the most valuable players. To gather more from them, he would have to include them and involve technology.

He would need to create new processes.

When I look back at Dan’s success with the R&D credit, his finance background taught him the company’s inner workings. He learned profit and loss, cost centers, department leaders, and systems. He understood what generated revenue, the product development life cycle, fixed assets, and inventory. With such comprehensive knowledge of the company, he could see that a system built around the existing engineering process was a crucial first step in gathering more information related to BCs for the IRS.

Here are five takeaways I got from Dan based on the system he developed.

Tip #1: Create the System

Steve Jobs, who knew a thing or two about designing products for people, once stated at a conference, “You’ve got to start with the customer experience and work backward to the technology.” When you work at a company with many engineers doing different things, think of them as your “users.” Try to put yourself in their shoes. Their primary job is engineering, and they don’t report to you, the tax person. Yet you need a lot of information from them. Why not try to design your process around them? Leverage information they already have in their files. Design tools that are easy for them to use.

Dan created an easy-to-use survey tool, but that wasn’t the only key to his success. He knew the following:

• engineers want a clear understanding of the R&D credit, the process, and the benefit to them (“What’s in it for me?”); and
• if you are going to engage engineers, do it promptly (not after the year has closed). Engineers want full transparency on deadlines for when you need the information, they want plenty of lead time, and they need the freedom to provide input about when their people can best fulfill your request.

Two examples come to mind. We work with a major retailer that doesn’t release any code in Q4, because it doesn’t want bugs to interfere with ordering and shipping during the crucial holiday season. We learned that their engineers prefer to talk in Q4 because they begin working on new projects in Q1. After some brief education sessions, these engineers were able to complete innovation questionnaires, provide documentation, participate in interviews, and give good feedback, all before the tax year had closed. In fact, they were eager to get everything to us before the year-end holidays. At another client, a major software company, they try their best to complete projects by year-end, so we don’t talk with them until Q1. Asking simple questions can help gain buy-in and support for the timing of your outreach.

A few other things we have learned along the way:

• engineers want easy-to-use tools and self-help resources;
• engineers want simple instructions without taxspeak or legalese and a logical process to follow;
• engineers want the ability to ask questions and have them answered promptly; and
• engineers want to be able to respond to requests on their own time.

Tip #2: Assess What Tools to Deploy

Dan’s company used SAP and a time-tracker module. The company wasn’t interested in spending a ton of money on new tools or software. But, with what he already had, Dan was able to cobble together a survey-generating machine. At your own company, what do you have already? You might want to use Cisco’s Webex, Zoom, or Microsoft Teams to host subject matter expert (SME) training or instant messaging. You might want to send Google Sheets or Google Docs to SMEs for them to fill out project-related activities or provide documentation. Alchemer is an easy-to-use survey tool that is relatively inexpensive to purchase and maintain. Tableau allows people to see and analyze data, similar to Alteryx for data science and analytics. Snowflake provides a single platform for data warehousing and data science so you can share real-time data from your engineers. The best software for the job may be the one you already own.

We see a combination of Microsoft products work well to create a seamless process for the SMEs. Most Fortune 500 companies already own Microsoft Teams. Many people use Teams only for video calls or instant messaging, but it is a great tool for SME collaboration. You may want to assign SME tasks via Microsoft Planner, generate task reminders using Power Automate, or design amazing surveys with Forms or dashboards in Power BI. If you really want to be advanced, we are working with Azure on artificial intelligence that will review and summarize documentation. Over 700 software and application tools play well with Microsoft products, so the possibilities are endless.

My advice is to get with your engineers and IT people, design a great process with their help, and then identify the technology that will get you there. Your engineers will be more comfortable communicating, sending documents, and sharing information if everything is done within your corporate environment.

Dan’s Time-Tracking Tool

When Dan looked at the engineering time-tracking tool his company used, he found garbage in, garbage out. He was not able to use the system to support his R&D credits. He therefore began a campaign to educate leaders on the importance of proper time classification. Given his experience with the company, other engineering leads listened. Dan started conducting training and education sessions. After explaining how the R&D tax credit worked, and how proper time-tracking could help, he gained traction with R&D leaders. They understood how tax savings could grow from better compliance. Of course, they also wanted to know if the company would give them more money to spend on R&D. While some companies do this, a more popular incentive program is to provide engineers with company points, kudos, or other recognition. We often provide engineering SMEs with small incentives to help us, such as Starbucks cards, Thanksgiving turkeys, sports tickets, or gift cards.

Tip #3: IRS Can Use Data Against You

If your company does not already have a time-tracking system for engineers, please don’t suggest one. Let me save you a lot of time and wasted effort. It is OK for the tax department to talk with engineering leaders about how the company would use such a system if it had one. Sometimes the tax benefits are substantial, and engineering leaders who already want to change their time-tracking system can add improved tax compliance to the list of reasons for changing. But it is never a good idea for the tax department to push a system on engineers without leadership buy-in. If the critical engineering stakeholders will not use the time-tracking data for their own purposes, the engineers will never fully populate the tool no matter how easy it is to use. The IRS will use time tracking against you as well. To be sure, we see many R&D engineers bank time to “admin,” “overhead,” “maintenance,” and other categories they are not actually working on. In those cases, the IRS has a road map to designate those hours as ineligible for the credit. If you already have a time-tracking system in place, go ahead and suggest tweaks or changes to improve the process and potentially increase your qualified activities and expenses. However, to start the process from scratch and have the tax department birth the idea is not recommended.

Dan Seeks Feedback

Once Dan felt comfortable that he would be gathering more real-time tracking data, he began to work on documentation. The tax department made friends with an engineering leader, who agreed to work with the tax team on the R&D credit. Such a partnership is a crucial piece in building a successful system. With the insider at his disposal, Dan began throwing out ideas to his engineering buddy. In a way, he was user-testing his ideas before he rolled something out to the masses. This user testing became a best practice Dan started using for everything. You’ve probably heard the phrase “measure twice, cut once.” Dan was user-testing with one user, to save time with dozens. Plus, as a one-man show, Dan couldn’t afford to deal with every engineer at the company if he messed up, if instructions weren’t clear, or if his tools weren’t easy to use. By running everything by his engineering counterpart, he was able to better address issues up front and make needed adjustments.

Another thing Dan did at this point was to go to the engineering leaders and ask for feedback. Dan learned the key stakeholders were frustrated with the after-the-fact way that the tax department had gathered information in the past. The process was always disruptive, and the facts were cold. To explain further, when the year would end, the tax department would be given accurate headcount and payroll files for the year. The tax department would review the final engineering time tracking, and then turn its attention to talking with engineers and gathering engineering documentation. Engineers complained that the documentation requested was old, stale, and already filed away. Dan knew that something had to be done. He put on his black belt again and started to work with the IT people. He wondered if there was a way to create a survey process that would live among the time-tracking data. He figured if the engineers started up new projects, then the best way to have them document projects was to provide them with tools they could use to fill out surveys along the way.

Tip #4: Create a Great Survey Process

Engineers at Dan’s company had to fill out a project initiation document (PID) every time they wanted to work on a new project. This part of the engineering department protocol gave leaders a chance to accept or reject a request. Although most requests were approved, Dan learned the information provided on the form was useful for giving him an idea of what the project was about. It was obvious from reviewing the forms that some projects were capital in nature, like purchasing new computers, whereas others were for enhancement projects related to existing equipment the company marketed and sold. Dan decided that the best time to introduce an R&D survey to the engineers was at the outset of the project. Therefore, with his accounting friends who would be opening the new project code in the SAP system, Dan created a few preliminary questions the lead engineer would have to answer. From the responses, the system might generate a flag, which meant Dan had to review the facts further to determine if a survey was necessary. Other projects either got a survey or were designated as a non-R&D project. Non-R&D projects with a substantial number of hours or costs charged at the end of the year got another look from the tax department to confirm they still were not R&D eligible. This is a best practice, since you never want to assume that the original person correctly answers the questions at the beginning of a project, because the scope of the project might change during the year. Dan often found that once engineers were approved for a project, the scope morphed into something totally different than was described on the PID.

Dan didn’t just throw his R&D surveys at the engineers and leave things to chance. Dan had designed the surveys with the engineering leaders, IT, and accounting to ensure that all parties were on board with the new process. His Six Sigma training helped him to be a good project leader and to pull in all proper stakeholders so nobody was left out. We have seen good ideas fail because somebody wasn’t included on the front end. Dan might not have successfully led his company peers in making this happen had he been new to the company. His years of service and the friendships he made along the way gave him the credibility to call in the favors necessary to make this happen.

Gathering Too Much Info?

Dan’s company did open a lot of new projects every year. Some were new products, and others were new features or enhancements. Regardless, Dan was gathering information from his engineers to show the IRS team. The next time the IRS arrived (smugly expecting a lack of documentation), Dan brought out a presentation that included a bullet point on the 22,000 surveys he gathered from the engineers. The IRS agent said, “That is too much for us to review.” As with Goldilocks, the first time there was too little documentation, this time too much—so what would be just right? Dan wasn’t sure, but the IRS had originally asked for more, and he delivered. (Note to the IRS: I guess you do have to watch what you ask for.)

As the process evolved year after year, Dan implemented small improvements along the way based on feedback he got from the engineers. Having to deal with so many engineers and their questions led Dan to draft a document explaining the credit so he could send it out to the engineers to remind them what this was all about. (We now do the same based on what Dan produced, a document we call the SME guidebook.) Other best practices started to become obvious to Dan as well. He started doing short videos as FAQs, conducted training and education sessions for new engineering leaders, and continued fostering great relationships between various tax personnel and the engineering teams.

Tip #5: Dream Big, Start Small

Dan didn’t transform his process overnight. It took years of hard effort and brainstorming. I always meet with companies who like our Teams collaboration tool, but when I assess how they use Teams today, they use it mainly for off-camera video meetings. You can’t jump into using some of the more advanced features of Teams from the start if your employees are barely scratching the surface of Teams now. I’d recommend you discover all the powers of technology for the platform you want to use and develop a reasonable plan on how you want to roll it out. You may find that others in the company are more advanced than the tax department in using the technology. You could be surprised to learn that even though they don’t fully use Teams today, they might be using it more fully in six months. The main point is to start something now. Look at your existing process. Determine if you have gaps between what you usually do and what the IRS asks for concerning BCs and the POE. If you document only a few projects, expect the new Form 6765 to ask for a complete list. If you are using stat sampling, expect some IRS pushback.

Conclusion

As a CPA and lawyer, I thought two professional designations were enough. But I might need to add a third as a Lean Six Sigma black belt. I’m a naturally curious person and always want to improve. I love building up teams and finding ways to make processes more efficient. That said, around 2015 I went on a search for my own holy grail and interviewed over 200 companies across the United States that do the R&D tax credit in-house, with limited help from a provider. I hoped to identify a new gold standard for how to do the R&D tax credit from a process perspective. I thought the largest companies in the country had this figured out.

Time and time again I listened and learned as many name-brand companies told me of their struggles. The common themes were poor systems, many different accounting packages in use, SMEs that didn’t care or weren’t engaged, and IRS troubles. Then one day I got on a call with Dan. Kudos to the man, because the process he told me about was amazing. Anybody who can motivate engineers to complete 22,000 BC surveys a year and generate a credit approaching $100 million is an R&D tax credit hero in my book. Dan, if you are reading this article, imitation is the sincerest form of flattery, in that I now use many tips and tricks you told me about and I am obsessed with improving the R&D process through technology.

Not everybody has the time, energy, or skills to create a system as Dan did. Overkill, you might say. But this is a new R&D world. The IRS wants to see more. It wants information about business components and employee activities. You can sit back, shaking your head about the unreasonableness of it all, but proactive taxpayers are currently working on trying to comply. It might take a year or two, but when Form 6765 changes, you need to be ready. My last Tax Executive article was about Sun Tzu, The Art of War, and how to win the R&D battle. My final piece of advice also comes from Sun Tzu: “Don’t depend on the enemy not coming; depend rather on being ready for him.” Stay thirsty, my friends.