How the IRS Evaluates R&D Tax Credit Claims During an Audit

The Research and Development (“R&D”) tax credit under Internal Revenue Code (“IRC”) §41 is a statutory tax incentive, not a discretionary benefit. During an audit, the Internal Revenue Service (“IRS”) does not evaluate whether a taxpayer’s work “looks innovative”. Instead, examiners apply a structured, statute driven analysis grounded in §41, the Treasury Regulations, and the IRS’s formal Audit Techniques Guides.

Understanding this framework is essential to preparing an R&D claim that can withstand IRS examination.

The IRS Audits Against Statutory Requirements, Not Industry Norms

IRS examiners are instructed to evaluate R&D claims based on the requirements of IRC §41 and the related Treasury Regulations, as operationalized through the Audit Techniques Guide (“ATG”) and the Research Credit Claims Audit Techniques Guide (“RCCATG”).

These guides direct examiners to:

Although the ATGs are not tax law, IRS examiners are explicitly instructed to follow them when auditing research credit claims.

Step One: Determining the Scope and Reviewing Form 6765

The audit process begins with a review of Form 6765, Credit for Increasing Research Activities. The ATG instructs examiners to confirm that the form is properly completed and that elections (such as the §280C(c) reduced credit election) were timely and correctly made.

The examiner will compare the current year QREs to prior and subsequent years and assess whether the claimed expenses are consistent with the taxpayer’s business activities, identifying areas of potential compliance risk before proceeding further.

Step Two: Identifying the Relevant Business Components

Under §41, qualified research must relate to a “business component”, defined as a product, process, software, technique, formula, or invention held for sale, lease, license, or internal use.

The IRS requires that the four statutory tests be applied separately to each business component, not at a high company or departmental level. Broad narratives describing “overall R&D” do not satisfy this requirement.

Step Three: Applying the Four Part Test Under IRC §41(d)

For each business component, the IRS evaluates whether the activities meet all four elements of §41(d):

These requirements are codified in IRC §41(d) and expanded in Treas. Reg. §1.41 4.

Failure to satisfy any one of these tests results in disqualification of the related activities.

The Process of Experimentation Is a Central Audit Focus

Treasury Regulation §1.41 4 explains that a process of experimentation requires systematic trial and error, modeling, testing, or simulation undertaken to resolve technological uncertainty, not routine development or implementation.

IRS guidance makes clear that:

Narratives that describe only commercial goals or development milestones, without identifying alternative technical approaches evaluated during the research, often fail under this standard.

Step Four: Substantiating Qualified Research Expenses (QREs)

Once activities are determined to qualify, the IRS evaluates the associated QREs under IRC §41(b) and Treas. Reg. §1.41 2.

The statute limits QREs to:

The regulations place particular emphasis on:

The IRS evaluates whether expenses are directly tied to qualified activities at the business component level.

Step Five: Recordkeeping and Substantiation

The ATG instructs examiners to assess whether taxpayers maintained records sufficient to substantiate both activities and expenses.

While the statute does not mandate specific documents, the IRS examines whether the taxpayer can demonstrate:

Unsupported estimates, post hoc narratives, or undocumented assumptions are commonly challenged.

Key Takeaway: The IRS Evaluates R&D Claims as Technical Tax Positions

IRS R&D audits are not subjective reviews of innovation. They are technical examinations grounded in §41 and the Treasury Regulations, implemented through standardized audit procedures.

Taxpayers who approach the R&D credit as a marketing driven exercise or as a factual narrative untethered from the statute often experience credit disallowance, subject to further penalties and interest. Those that structure their claims around business components, statutory tests, and documented experimentation are best positioned to withstand audit scrutiny.

Withum’s R&D Tax Credit Study Approach

Withum maintains a dedicated team of R&D Tax Credit specialists serving companies across all industries. Our approach is designed to help businesses identify opportunities, maximize federal and state credits, and maintain taxing authority-ready documentation to support, defend, and sustain credits year after year.

We take a fresh look at your development processes, data collection methods, and documentation practices to ensure your R&D tax credit position is accurate, defensible, and optimized.

Complimentary R&D Tax Credit Assessment

Withum offers a no-obligation complimentary R&D tax credit assessment, beginning with a brief 30-minute discussion. This conversation is designed to quickly determine whether an R&D tax credit opportunity exists and how Withum can assist in calculating, documenting, and supporting your credit through our innovative R&D tax credit studies.