There have been significant changes in the way in which the IRS is now dealing with R&D tax credits, the IRS's largest single domestic examination issue handled by the IRS's Large Business and International division.
The reason for the popularity of the Credit for Increasing Research Activities, also known as the research and experimentation, or R&E, tax credit, is its considerable applicability to all businesses. Companies of all sizes file for this credit. In 2021, R&D tax credit filers in the U.S. numbered about 105,000. The name of the R&D tax credit is misleading because not only software, but also any product, process, technique, formula or invention could qualify. Pretty broad! The term R&D is more related to the way in which unknowns are solved, rather than to the complexity of the task.
Some at the IRS believe the R&D tax credit should be made available only to small and midsized businesses. While the work that qualifies for the credit is broad, large businesses make up a major proportion of beneficiaries of the credit. The IRS has tried to limit the financial impact of the credit by tightly enforcing the tax law. In general, the most common sticking point for R&D credits is the requirement to supply valid, contemporaneous substantiation. But the tax law in this area (Section 41 of the Internal Revenue Code) is vague. Many firms filing for the R&D tax credit do not understand what the IRS means by contemporaneous documentation and the other rules.
Even highly paid R&D tax consultants are sometimes blindsided. Because tax returns, R&D tax credit studies and the final IRS audit reports are all confidential by their nature, most taxpayers (and consultants) have no idea how to create documentation that actually meets the IRS's standards. R&D consultants often bring their own opinion of what the IRC is actually asking for to their projects. The vague requirements about documentation such as "documentation must be maintained in a format that is sufficiently usable" and "detailed enough to substantiate that the expenditures claimed are eligible for the R&D tax credit as per IRS Treasury Regulation 1.41-4(d)", make sense to few people, other than tax attorneys and IRS agents. Nowhere are there examples of what is acceptable as documentation. Most companies are "flying blind" when it comes to creating R&D documentation suitable for the credit.
Reasons the IRS changed Form 6765
Many tax advisors wonder why the IRS even changed the 6765 form that was in use for many years. In June 2025, the IRS released a revised draft of Form 6765 for public comment. This revised draft was the result of a longstanding disagreement among various factions at the IRS over how to administer the tax credit.
For several years, a particular faction within the IRS demanded that IRS agents and engineers require taxpayers to substantiate their compliance with the credit in a specific order. In addition, they believed the R&D tax credit should be reserved only for small and midsize firms. This fanatical faction demanded that IRS agents audit the credit by first looking at the business components. A business component is the item that a company sells, leases, licenses or uses internally. It can be any product, process, computer software, technique, formula or invention that a taxpayer intends to sell, lease, license or use internally. Historically, IRS agents and engineers used whatever method was most applicable for a particular situation. The changes in the way IRS R&D engineers were required to interface with taxpayers was not welcomed by many veteran IRS agents.
Over the years, IRS engineers and agents were taught by experienced field employees to ignore the rantings and ravings of the overly zealous group, since following their admonitions would only lead to conflicts between agents and taxpayers. Auditing tax returns depends upon cooperation between the auditee and the auditor. The fanatical group in an ivory tower had no real experience interfacing with taxpayers. They were deaf to the field's attempt at prudence. In addition, IRS attorneys, in a moment of weakness, sided with the overzealous faction's desires, without any thought of the actual goal of the credit, which is to encourage R&D work to be performed in the U.S.
By 2024, a number of experienced field engineering managers and lawyers had retired, allowing the overzealous group to convince management to modify Form 6765 so taxpayers would need to comply more precisely with the Internal Revenue Code regarding business components. The newly empowered group demanded that taxpayers substantiate the four-part test on a business component-by-business component basis. To make sure taxpayers were following this requirement, the group had the Form 6765 modified to add Part G, which requires a taxpayer to specify the actual business components and the information sought to be discovered, prior to filing the initial tax return.
Unfortunately for the supporters of the new Part G requirements, large taxpayers and their Big Four R&D consultants had a problem with this new Part G. The American Bar Association issued a letter to the IRS last month requesting changes to the Part G modification on Form 6765, and the IRS decided to delay taxpayers' requirement to fill out the form section until 2026. In the letter, they claimed that, besides forcing R&D consultants to develop their R&D studies in a different way, taxpayers would now need to document their research in a special way rather than relying on standard accounting records. These large taxpayers often use the ASC 730 Directive or statistical sampling when filing for the credit. It was predicted that the Part G requirement would double the amount of effort these taxpayers and their R&D consultants would need to expend to file for the R&D credit. Previously, many firms would estimate their R&D credits and only develop the actual amounts for placement on a claim, an 1120-X.
The IRS recently modified the rules for filing for the R&D credit. Starting in 2026, firms will need to supply information on a business component basis at the time of the initial tax filing. Previously, most firms estimated their R&D and did not even start working on the actual data until receiving an audit letter. This change in the tax form is causing alarm among R&D consultants.
The influence of court rulings on IRS agents
Recent R&D tax credit court cases will have a significant influence on IRS audits. Very few R&D tax credits are audited, and even fewer go to Tax Court. However, because the Internal Revenue Code is less than explicit about which types of R&D documentation suffice, most IRS agents rely on recent court cases when deciding whether a specific R&D business component qualifies. The language that a judge uses in a Tax Court decision holds sway with most IRS engineers and agents. This is more important in R&D tax credit cases than in most other parts of the IRS code. The IRS rules that refer to the R&D tax credit are vague and leave a great deal of judgment up to the agent handling the case. An IRS agent or engineer will rely on the reasoning of recent tax court cases when qualifying an R&D credit.
Effect of recent Tax Court cases
In documentation, studies or legal/evidentiary standards, the words "retrospective" and "contemporaneous" are typically used as contrasting terms: retrospective means created later based on memory or later information, while contemporaneous means created at the time the events occurred.
In the recent Kyocera case, the Judge criticized Kyocera's use of retrospective surveys and interviews as proof of the qualification of their credit. To add insult to injury, the R&D consultant did not retain records of the interviews with Kyocera's engineers. Historically, R&D consultants from large firms will estimate each year's R&D tax credit. Every three years, within the statute of limitations, many file a claim to substantially increase the amount of the tax credit. Fearless about "poking the bear" and confident of their skills in dealing with the IRS, these unsuspecting consultants bring attention to a firm's R&D credit.
In the Kyocera case, for example, the R&D consultant realized that Kyocera had not kept proper contemporaneous documentation, so the consultant decided to create documentation. The IRC, however, requires explicit contemporaneous substantiation. To do this, the company created and distributed "self-serving" surveys and interviewed SME (aka managers). Kyocera did not compile proper documentation while R&D was underway. The tax law states that the R&D tax credits can be taken for the three previous years or carried forward for the next 20 years. So once the IRS finds a deficiency, as it did in the Kyocera case, the IRS will bring the same level of scrutiny to previous tax years that are being carried forward. Thus, Kyocera's $1.5 million disallowance exploded into a $15 million tax bill.
Another recent case, Little Sandy Coal, concerned a different documentation issue. In Little Sandy Coal, the poor documentation affected the IRS's ability to correctly determine if the "substantially all" requirement was met. For an R&D tax credit to succeed, a taxpayer must show that "substantially all" of the R&D done to a particular business component was a process of experimentation. Substantially all, in general IRC terms, means 80%. So, 80% of the work on a single business component must be performed by researchers. Little Sandy's lack of sufficient contemporaneous documentation made it impossible to prove its work met the 80%" test. Some R&D advisors believe that Little Sandy Coal's ruling was due to Little Sandy not being able to reach the 80% requirement. In fact, the case was lost to the IRS because the lack of "sufficiently usable" documentation made it impossible to prove the 80% requirement! Again, Little Sandy Coal lost millions of dollars in tax credits due to poor documentation.
These two cases, as all settled cases, have a great influence on IRS engineers and revenue agents moving forward. The lessons from these two are pretty straightforward: A taxpayer is responsible for maintaining proper contemporaneous documentation, and having a high-end R&D consultant parachuting in every three years to create valid documentation simply will not work. To the IRS agent, taxpayers who rely on their R&D consultant to create retrospective documentation are analogous to the term "shooting a fish in a barrel." The fish has no chance. Don't be that fish!
Nomenclature and IRS language
Documentation and R&D credit documentation are two different things. Normal engineering documentation documents what happened, such as the hours worked. R&D documentation, on the other hand, addresses the four-part test on a business component-by-business component basis, the qualification of the additional three-part High Threshold of Innovation tests, and the nexus between the activities of engineers and the qualified business components.
At this point, it's not really clear who will win the battle for the future of the R&D credit: the IRS's fanatical group or the American Bar Association and their supporters. Large and complex technical firms feel that, due to their size, the only way to quantify their credit efficiently is through statistical sampling, while the fanatical group believes the credit should be restricted to smaller firms that can qualify their credit on a business component basis.
My suggestion for the rest of us is to hedge our bets in this battle of the behemoths and to create R&D documentation while the R&D is being performed. Otherwise, you risk having the documentation not be considered contemporaneous and, instead, retrospective. The word "retrospective" should ring loudly in the ears of taxpayers planning to file for the R&D tax credit. You will surely start to hear that word uttered by IRS agents much more often.
Add to this the fact that most taxpayers have no idea what the IRS agent is looking for. Hiring a documentation expert to build your R&D dossier, even before your R&D tax consultant shows up, will likely save your firm money overall. Being able to use your dossier as a bargaining chip when negotiating a price for your R&D tax credit study will allow you to negotiate better terms with your R&D consultant in addition to letting you sleep at night.
