VOLUME 1, ISSUE 1
KROST QUARTERLY M A G A Z I N E
THE TECH ISSUE Technology
&
Accounting Industry
Accounting for Net Neutrality COMMON R&D EXPENSE DOCUMENTATION ERRORS
Paren Knadjian leads the Technology Industry group at KROST
What you need to know about Cybersecurity
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CONTENTS KROSTCPAs.com Volume 1, Issue 1 / April 2018
Offices Pasadena Headquarters 790 E. Colorado Blvd. Suite 600 Pasadena, CA 91101 Woodland Hills Office 21800 Oxnard Blvd. Suite 1040 Woodland Hills, CA 91367 Valencia Office 26650 The Old Road, Suite 216 Valencia, CA 91381 Phone: (626) 449-4225 Fax: (626) 449-4471
Principals Gregory Kniss, CPA Managing Principal Luis (Lou) Guerrero, CPA, MBT Principal, Tax Practice Leader Jason C. Melillo, CPA Principal, Assurance & Advisory Practice Leader Jean Hagan Principal, Restaurant Operations Practice Leader
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Cover Photography / Events Anna Chen anna.chen@krostcpas.com
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Global Investment Trends in AI and ML by Paren Knadjian, M&A
Tax Treatment of Cryptocurrency Transactions by Matthew Weber, CPA, MAcc
What You Need to Know About Cybersecurity by Jason C. Melillo, CPA
Accounting for Net Neutrality by Keith Hamasaki, CPA
The Basics of Virtual Currency by Evelyn Fernandez, CPA, MST & Justin Ha
Avoid Common R&D Expense Documentation Errors by Kevin Zolriasatain, CPA
THE TECH ISSUE KROST Quarterly is a digital publication released by KROST CPAs & Consultants headquartered in Pasadena, California. Established in 1939, this full-service Certified Public Accounting and Consulting firm serves clients across a variety of industries. With a focus on recognizing opportunities and creating value, KROST equips clients with tools to make better business and financial decisions for the future.
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INTRODUCING
KROST’S TECH TEAM Hi, I’m Paren Knadjian the M&A and Capital Markets Practice Leader and technology leader at KROST. As a former CEO and COO of two Saas companies, and with over 15 years experience in technology, I know what it means to have trusted advisors on your side when trying to navigate a complex and fastevolving landscape of innovation, disruption, and opportunity. With that in mind, I’ve crafted a team of trusted experts to guide and serve so that you can improve competitiveness and maximize economic value. Each of us has unique experience to bring to the table that has allowed us the ability to serve clients across a multitude of technology verticals. From adtech to artificial intelligence, fintech to virtual reality, our seasoned professionals have the pleasure of assisting incredibly innovative companies to reach their financial goals. MEET PAREN
SUBSCRIBE
Our team produces regular “think pieces” posted to KROST’s website monthly. This issue of KROST Quarterly will highlight some of the most thought-provoking pieces of late. Topics include cryptocurrency, net neutrality, R&D expense reporting, and many more.
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Greg Kniss, CPA Managing Principal
The Tech Team 365 Service Model
CJ Aberin Principal
So Sum Lee, CPA Director - Tax
Paul McVoy Director - R&D
Luis Mego Canta Manager - Energy
Sossi Bekarian, CPA Manager - Accounting
• • • • • • • •
Mergers & Acquisitions Raising Capital & Debt Financing Transaction Support & Due Diligence R&D Tax Credits Tax Planning & Compliance Accounting Support & Acting CFO Financial Modelling & Reporting Internal and External Audits
Experience You Can Trust • • • • • • • • • • • • • • • •
AdTech & Marketing Tech Application & Productivity Software Artificial Intelligence & Machine Learning Big Data Cryptocurrency/Blockchain Cybersecurity E-Commerce EdTech FinTech HealthTech Internet of Things IT Consulting and Outsourcing Mobile SaaS Social & New Media Virtual Reality & Augmented Reality
“The experienced multi-disciplined teams at KROST can provide advisory and implementation service for very specific needs relating to technology, as well as a holistic approach to tackling multiple challenges as a true partner in the development of your business.”
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Global Investment
Trends
in Artificial Intelligence and Machine Learning
by Paren Knadjian, M&A & Capital Markets Practice Leader
B
efore diving into global investment trends in Artificial Intelligence (“AI”) and Machine Learning (“ML”), it may be worth quickly defining them. To quote John McCarthy, widely recognized as one of the preimminent leaders in this space, AI is defined as “The science and engineering of making intelligent machines.” AI systems can perform tasks that normally require human intelligence, such as visual perception, speech recognition, decision-making, and language translation. Machine Learning is a subset of AI. The main characteristic that separates Machine Learning from most AI is its ability to modify itself when exposed to more data; i.e. Machine Learning is dynamic and does not require human intervention to make certain changes. According to Arthur Samuel, another pioneer in this space, machine learning is “A field of study that gives computers the ability to learn without being explicitly programmed.” AI has deeply penetrated virtually every industry from agriculture to adtech, from cybersecurity to manufacturing, from fintech to healthcare. We’re also interacting with AI in our everyday lives from giving voice commands to mobile phones to playing gesture-controlled video games. If the hype around ML is beginning to fade (perhaps overtaken by the hype on cryptocurrencies and blockchain) it may be because it has already become part of virtually every major piece of software, from calendar apps to search engines to sales management software. So, which countries are leading investments in AI and ML and which countries are homes to these investments? Two countries dominate the United States and China.
48%
China Equity Funding Share
According to CB Insights, even though China accounted for only a 9% share of deals going to AI startups globally, it received 48% of all the money going to AI startups globally in 2017, surpassing the United States for the first time. To put this proportion in perspective, in 2016, China accounted for only 11.3% of global funding in this field.
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The Chinese government has a well-funded AI and ML plan that encompasses everything from smart agriculture and intelligent logistics to military applications and new employment opportunities. One area, that may alarm human rights monitors, is China’s deep investment in facial recognition technologies, a substantial$1.64 billion in 2017. One startup, Megvii, already has data on 1.3 billion faces of Chinese citizens and is backed by Chinese insurance companies (Sunshine Insurance Group), government entities (Russia-China investment group), and corporate giants (Foxconn, Ant Financial).1 The United States still dominates globally in terms of the number of AI startups and total equity deals. But it is gradually losing its global deal share. Equity deal share percentage for AI/ML for the period 2013–2017 were as follows:
Non-US Deal Share
23%
77%
2013
25%
75%
2014
31% 69%
2015
US Deal Share
38% 50% 62%
2016
50%
2017
Chinese companies’ R&D efforts are also reflected in their patent activity. AI-related patent publications in China are surging far ahead of patents being published in these spaces by the US Patent and Trademark Office. For example, in deep learning (a subset of ML), patents published in China are 6x what they are in the US.2 But the United States is no slouch. According to data derived from Pitchbook, Venture Capital investments in AI/ML for 2017 amounted to $6 billion invested across 643 deals - that is 26x the value in 2008.3 Continued on page 6
¹Data provided by CB Insights ²Data provided by CB Insights ³Data provided by Pitchbook
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1,400
7,000
1,200
6,000
1,000
5,000
800
4,000
600
3,000
400
2,000
Deal Count
Capital Invested (1000s)
VENTURE CAPITAL AI/ML INVESTMENTS IN US
200
1,000 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Total Capital Invested
0
Deal Count
But what about M&A activity in AI and ML? As both industries are in the early years of development, it is not surprising that there has been a relative dearth of AI/ML deals until the last two years. Most of these exits are through buyouts by large strategic investors with Alphabet, Microsoft, Intel and Apple leading the way. We expect this trend to continue. The largest exits in both 2016 and 2017 came in the autonomous driving space, with GM’s purchase of Cruise Automation for $1 billion and Aptiv’s acquisition of nuTonomy.4 $3.50B
M&A ACTIVITY IN AI/ML IN THE US
100 80
$2.50B
60
$2.00B $1.50B
40
$1.00B 20
$500.0M $0.00M
Deal Count
Deal Value
$3.00B
0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Deal Value
Deal Count
So, what’s next for AI and ML? VC investments and big corporate pockets drive R&D and that investment trend shows no slowdown. For example, ML patents grew at a 34% Compound Annual Growth Rate (CAGR) between 2013 and 2017, the third-fastest growing category of all patents granted. IBM, Microsoft, Google, LinkedIn, Facebook, Intel, and Fujitsu were the seven biggest ML patent producers in 2017.5 In a recent survey conducted by MemSQL and O’Reilly Media, 61% of organizations picked AI/ML as their company’s most significant data initiative for 2018. Of those respondent organizations indicating they actively use AI and ML, 58% percent indicated they ran models in production.6 As technologies go, AI/ML have potential use cases in virtually every industry. It will reshape the way people live and do business. For this reason, AI has been referred to as “the new electricity” by deep learning pioneer Andrew Ng. We do not expect any slowdown in Angel, VC, and Corporate investments and in Private Equity and Corporate buyout activity – perhaps even an emerging trend in IPOs for AI/ML companies, in 2018 and beyond. CONTACT PAREN 6
⁴Data provided by Pitchbooks ⁵Data provided IIFI Claims Patent Services ⁶Data provided by MemSQL and O’Reilly Media
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The Tax Treatment of Cryptocurrency
M
by Matthew Weber, CPA, MAcc, Tax Manager
any taxpayers realized significant gains from the disposition of cryptocurrencies in 2017, and as tax season approached, these taxpayers had to compile accounting reports, review the latest tax guidance, and determine how to correctly report their transactions to the IRS.
Coinbase has a new online tax report:
In the summer of 2017, the IRS narrowed its summons against Coinbase, the largest U.S.based coin exchange, to retrieve information on large trades and other transactions to find unreported income. At the very end of 2017, Coinbase added tax reporting of capital gains and losses using first in, first out (FIFO), which pleases the IRS and helps taxpayers report their transactions since coin trades are currently not reported on Form 1099-B.
Capital gains and losses:
The IRS classifies cryptocurrencies as “intangible property” (a capital asset) because they are not sovereign government-issued money. If you sold, exchanged, or spent a cryptocurrency in 2017, you need to calculate a capital gain or loss on each transaction, including cointo-currency trades, coin-to-coin trades, and purchases of goods or services using a coin.
Coin-to-currency trades and mining income:
Coin-to-currency trades (e.g., the sale of a coin for U.S. dollars) should be reported as a capital gain or loss on Form 8949 just like any stock trade. For example, if you purchased one Bitcoin for $500 in 2016, held it for over a year, and sold it for $10,500 in 2017, then you need to report a long-term capital gain of $10,000, which would be taxed at capital gains tax rates (up to 23.8% in 2017 and 2018). If you held the coin for one year or less before selling it for a gain, you would need to report a short-term capital gain, which would be taxed at ordinary income tax rates (up to 39.6% in 2017 or 37% in 2018). Although capital losses offset capital gains, net capital losses are capped at $3,000 per year, so net capital losses in excess of $3,000 are carried forward to the subsequent tax year and cannot be carried back to a prior tax year. Certain coins can be obtained by “mining,” which requires significant computing power. When a coin miner receives a coin for his or her mining services, he or she should report business income based on the value of the coin he or she received.
Imputed income:
Although coin-to-currency trades and mining income seem straightforward from a tax reporting perspective, most other coin transactions are more complex. Coin-to-coin trades, hard forks (chain splits), and the exchange of a coin for goods or services require the taxpayer to “impute” a sale or exchange transaction to report a capital gain or loss. 8
Coin-to-coin trades:
Many coin traders actively trade one type of coin for another type of coin, and some of these coin traders take the ill-conceived position that they can defer capital gains on cointo-coin trades by inappropriately classifying them as Section 1031 “like-kind” exchanges. A like-kind exchange is a transaction or series of transactions that allows for the disposal of an asset and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset. As of January 2018, the IRS has not yet provided guidance on this matter, but many experienced tax practitioners believe coin-to-coin trades made on coin exchanges do not qualify as like-kind exchanges because they fail one or both of the primary requirements for a like-kind exchange (and both are required). First, one type of coin is not like-kind property with another type of coin. Second, coin-to-coin trades executed on coin exchanges do not constitute a direct two-party exchange, and coin exchanges are not qualified intermediaries in a multi-party exchange. Atomic swaps or atomic cross-chain trading started in August 2017. The new technology allows a direct two-party exchange, bypassing coin exchanges. That may meet one requirement for a like-kind exchange, but the coins must also be a like-kind property for the gain deferral, which is a position that will likely be scrutinized by the IRS.
The effect of the new tax law on coin traders:
Beginning in 2018, the new tax law limits like-kind exchanges to real property. This means taxpayers may no longer utilize like-kind exchanges for artwork, collectibles, and other tangible and intangible property, including cryptocurrencies. The new tax law created Section 199A, which provides a 20% deduction of qualified business income (QBI) for passthrough entities (S corporations, partnerships, LLCs, and sole proprietorships). The 20% deduction of QBI is subject to numerous thresholds and limitations. Unfortunately, a coin trader likely does not qualify for the deduction because he or she has capital gains income, which is excluded from QBI. On the other hand, a securities trader with trader tax status can elect Section 475 mark-to-market ordinary income, which is included in QBI. Taxpayers can deduct coin fees and other expenses that they incurred in 2017, but most will not be able to deduct such fees and expenses beginning in 2018 because the new tax law suspends the deduction for investment expenses.
Coin hard forks (chain-splits):
Bitcoin had a hard fork in its blockchain on August 1, 2017, dividing into two separate coins: Bitcoin and Bitcoin Cash. Each holder of a unit of Bitcoin was entitled to arrange receipt of a unit of Bitcoin Cash. Some Bitcoin holders did not gain immediate access to sell their units of Bitcoin Cash, so they believe they should be able to defer income on the fork transaction until they obtained access to sell their units of Bitcoin Cash or until they outright sell their units of Bitcoin Cash. Coinbase did not support Bitcoin Cash when it forked, but it did add the units of Bitcoin Cash to the accounts of the rightful holders in late 2017. It is reasonable that coin traders should not have to report taxable income on a hard fork until the new coin is time-stamped as a ledger entry, sending the coins to new outputs in the blockchain. Facts and circumstances on hard forks vary widely. An “old fork” could 9
die out if miners collectively switch over to the new blockchain and abandon the old coin. Bitcoin Cash successfully forked from Bitcoin; both trade at higher values today than on the fork date. Hard forks frequently happen, and their initial fair market value varies significantly across coin exchanges. Some tax practitioners believe holders of Bitcoin Cash had dominion and control over the new coin sometime in 2017, and they should recognize ordinary income on receiving it. Cryptocurrency tax reporting is complex and voluminous. Consider two cryptocurrency accounting solutions: Bitcoin.Tax and CoinTracking.Info. The most common approach is the use of the FIFO accounting method for cost-basis on cryptocurrency capital gain and loss transactions. The IRS has not yet stated if it will permit other accounting methods, like the specific identification method allowed for securities. Even if the IRS approves the specific identification method, compliance with the requirement for contemporaneously written instructions to the coin exchange does not seem possible. It is unlikely that a coin exchange would confirm and execute a specific identification. Because the IRS classifies cryptocurrencies as intangible property, wash-sale loss rules likely do not apply. Traders with the trader tax status using Section 475 ordinary gain or loss on securities and/or commodities (Section 1256 contracts) may not use Section 475 on a cryptocurrency because a cryptocurrency is not a security or a commodity in the eyes of the IRS. If you sold, exchanged, or spent a cryptocurrency in 2017, you need to calculate capital gains or losses on your transactions using the FIFO accounting method. And keep in mind that capital gain/loss treatment applies to not only coin-to-currency trades but also to coin-to-coin trades and purchases of goods or services using a coin. Given the current lack of IRS guidance on cryptocurrencies, hopefully, they will provide some answers before the extended due date of October 15, 2018. You should consult your tax advisor in the meantime. ď Ž
CONTACT MATTHEW ď‚„
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S U B S CR I B E TO KR OS T NEWS GAIN ACCESS TO THE LATEST TAX AND ACCOUNTING NEWS UPDATES THAT CAN HELP BOOST YOUR BOTTOM LINE. WE'LL KEEP YOU INFORMED OF CURRENT INDUSTRY NEWS AND WHAT YOU SHOULD PREPARE FOR AS WE LOOK TO THE FUTURE.
What You Need to Know About Cybersecurity
A
by Jason C. Melillo, CPA, Principal and Assurance & Advisory Practice Leader
ll too often we read headlines about major companies that have some sort of breach, Equifax, Target, Sony, Home Depot, just to mention a few. Most people think, “Wow, how could they be that careless and then go about their day?” Recently, the Equifax hack hit home for most Americans because it virtually affected everyone. Most people should be wondering if it can happen to them, it can happen to me and my company. One of the easiest ways for a hacker to disrupt a business today is with ransomware.
There are 6 ways for ransomware to penetrate your network: Inside attacks from phishing emails – Emails appear legitimate but require your username and password via three distinct methods. 1. Request to respond to the email with the personal information requested, which not only allows them access to your computer as you but also grants unrestricted access to your company network. 2. Request to click a link that will automatically download the ransomware to your computer and any immediate network. 3. Downloading attachments from unknown email sender, and after downloading, the ransomware will immediately take over all files and connected network drives. Outside attacks – These are attacks that do not require a hacker to deploy malware from within the physical network of a company. 4. Internet access port – Backdoor program looking for access points to spread malware during a seemingly daily internet routine. 5. USB drives – USB drive hacks have crippled companies for days and some even include location tracking so that hackers can know when someone has brought one into a company. This does not only include USB 12
“One of the easiest ways for a hacker to disrupt a business today is with ransomware.”
sticks but can also be done through any USB cords that have been manipulated. 6. Outside service professionals – These are done through a third-party vendor contracted to work on site who may have access to servers, network ports, or desktop terminals. In May 2017, AICPA released the Cybersecurity Risk Management Reporting Framework Guide. With the overwhelming threats of cyberattacks, the AICPA recognized a need to arm CPAs with the latest cybersecurity audit guidelines to assist the practitioner and client. The cybersecurity risk management examination is part of the AICPA’s SOC reporting, which means that CPAs can provide an opinion on a service of the organization’s system controls. The new framework calls management to take actions and prepare certain information about the entity’s cybersecurity risk management program. There are two sets of criteria proposed by AICPA to be used on this new framework guide- description criteria, and control criteria. Description criteria is used when preparing a narrative description of the entity’s cybersecurity risk management program. Control Criteria is used when evaluating the effectiveness of the controls within the program. We see these two criteria as (1) Can you document what you can do to safeguard your network and data? And (2) What can you do to prevent a cyberattack? This new audit service will result in a cybersecurity report that includes management’s description of the entity’s cybersecurity risk management program, management’s assertion on whether the description is presented in accordance with the description criteria, and a CPA’s opinion on the description and on the effectiveness of controls within the program. We see the cyber threat increasing every day. The new AICPA Cybersecurity Risk Management Reporting Framework Guide provides CPAs with an organized way to help identify significant risks with the tools to correct them. It’s worth taking the necessary actions now to prevent rather than to resolve issues created by cyberattacks such as ransomware. The time to act is now. CONTACT JASON 13
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Accounting for
Net Neutrality by Keith Hamasaki, CPA, Assurance & Advisory Senior Manager
W
hen it comes to technology nothing has taken the business world by storm like cryptocurrency. However, something that slid under the radar and continues to slide under the radar with an everlasting impact are the changes to the Net Neutrality Rules.
Net Neutrality is dead, but what does this even mean?
Net Neutrality is the concept that all internet is created equal. The idea of Net Neutrality forbids selective “throttling” or slowing down the internet for certain content providers (i.e. websites). In December 2017, the Federal Communications Commission voted to repeal Net Neutrality Rules. The overwhelming fear is that consumers will have content either blocked or throttled while trying to access websites or delivery of content. Throttling or blocking content will push businesses to pay internet providers additional fees to maintain consumers’ current internet experience. The change is expected to be a slow rollout and companies will have an opportunity to pay internet providers additional fees to allow their customers to stay in the “fast lanes.” The struggle will be real for smaller businesses that need reliable internet services because fees for paid prioritization are expected to be high.
How do I account for throttling? Whether you are for or against Net Neutrality, your company must be aware of how to account for the transaction. If the fee is an upfront cost from an internet provider, it may appear to be a utility expense. However, you must be mindful of US GAAP because it has a way with words. When this slow rollout occurs, companies will most likely expense as they have always done with utilities. However, the substance of the transaction is not one that should be recognized immediately. There is value in paying for the prioritization right to faster internet. Therefore, this transaction meets the capitalization guidance under ASC 350 Intangibles. Throttling or blocking content As a result, the upfront costs should be recorded as an asset on the date the paid prioritization takes effect. If the will push businesses to pay these agreement with the internet provider has a maturity date, internet providers additional then the amortization should occur over the length of time fees to maintain consumers’ that the internet is prioritized over other competitors.
current internet experience.
CONTACT KEITH
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The Basics of Virtual Currency
by Evelyn Fernandez, CPA, MBT, Senior Tax Manager & Justin Ha, Tax Staff
O
n March 25, 2014, the IRS released Notice 24-21 detailing how existing general tax principles should apply to transactions involving virtual currency. The IRS defines virtual currency as a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Examples of virtual currency include, but are not limited to, Bitcoin, Ethereum, Litecoin, Zcash, and Monero. Virtual currency that has an equivalent value in real currency, or that can be used as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is a prime example of convertible virtual currency. In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax implications. The tax liability is determined on how virtual currency is held and used.
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Virtual Currency Held as Assets For federal tax purposes, virtual currency is treated as property, and therefore, general tax principles applicable to property apply to transactions using virtual currency. This requires for gains and losses upon an exchange of virtual currency to be calculated. To stay in compliance with IRS regulations, virtual currency users should track the gains or losses of each of their virtual currency transactions. Additionally, virtual currency is not treated as foreign currency. Therefore, it does not need to be reported on an FBAR, nor can it generate foreign currency exchange gains or losses. If the virtual currency is held as a capital asset, such as a stock or a bond, then any gain or loss on the sale or exchange of the virtual currency is taxed as a capital gain or loss. Otherwise, the taxpayer realizes ordinary gain or loss on an exchange if the virtual currency is not held as a capital asset.
Virtual Currency Used to Pay for Goods and Services A taxpayer who receives virtual currency as payment for goods or services must include the fair market value of the currency received in gross income. For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. A payment made using virtual currency is subject to information reporting to the same extent as another payment made in property. Employers must report, on a W-2, the amount of wages paid to employees using virtual currency. Also, an independent contractor receiving payments of virtual currency is subject to self-employment taxes. Businesses should report payments to independent contractors in amounts over $600 on Form 1099-MISC. These payments are subject to the same rules as they normally would for 1099 filing requirements.
Tax Reporting for Virtual Currency Miners Mining refers to validating virtual currency transactions and maintaining its transaction ledger. Gross income from mining is includible in a taxpayer’s gross income and is taxed as ordinary income. If the mining activity constitutes a trade or business, it will be subject to self-employment taxes. CONTACT EVELYN
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Avoid Common R&D Expense Documentation Errors
B
by Kevin Zolriasatain, Principal and R&D Practice Leader
usiness owners are often surprised to learn they may be able to claim the Research & Development (R&D) tax credit. The credit was originally created as a way to encourage American companies to conduct R&D activities domestically. While initially thought to apply to large companies with formal R&D departments, “smaller businesses” in a wide range of industries, such as manufacturing, engineering, software development, architecture, pharmaceutical, aerospace and defense, metal foundries, chemical companies and others, have discovered they can also claim the benefit. However, it’s important to be aware of best practices when claiming the credit, especially in areas where issues commonly arise, such as a lack of supporting documentation. Mistakes in documenting qualified research can result in missed opportunities and create problems should the company be selected for an IRS audit. To help clients, prospects and others avoid common documentation mistakes, KBKG has provided a summary of common errors and best practices below.
Common Documentation Mistakes • Lack of Supporting Documentation – R&D tax credit studies are at their weakest when they lack contemporaneous supporting documentation. Studies are often performed after the tax year is closed out. Some studies are comprised simply of a report that summarizes the findings and a brief description, if any, of the qualifying business component. One of the objectives of an R&D tax credit study should be to answer a common question under audit: Why does this business component qualify? In order to properly address this question, it’s important to take a fluid approach to documentation. No two taxpayers are the same. No two projects are the same. As such, taxpayers may need to be creative in the identification of documents that show how projects meet the qualification criteria with specific emphasis on the presence of uncertainty and experimentation. Information such as project records, lab notes, design drawings, photos of the design/build and testing trials, prototypes and patent applications are needed to corroborate customary R&D expenses. Having access to this information is especially helpful in the event of an IRS audit. • Informal Documentation Process – If a company is considering claiming the R&D tax credit for a project, it would be useful to implement a formal documentation process before beginning. Because many companies don’t understand who should be documenting, what they should be documenting and when the process should be occurring, it’s often 18
“It’s essential to ensure the relationship between the expense and qualifying activity is clear.”
left as a task to complete at year-end. When this happens, a single person is often assigned the task of pouring over hundreds of documents to find proof of qualifying expenses. The result is that expenses are often missed, and the potential credit value is diminished. To overcome this, a best practice would be to implement a process that collects relevant information on an ongoing basis, while the R&D activities are occurring. The more thorough the process, the greater the likelihood that qualifying expenses will be captured and used appropriately when claiming the credit. • Lack of Clarity – A common issue in the documentation process is that it’s unclear how the various expenses, personnel or other items relate to the R&D project. Remember that an IRS agent will not be familiar with your business, product or research process. Because they will be the primary judge of whether an expense qualifies toward the R&D credit, its essential to ensure the relationship between the expense and qualifying activity is clear. Avoid incomplete or inadequate descriptions, general statements that sound canned and documentation that is not clearly related to the project. The more you rely on an IRS auditor to figure out how your documentation supports expenses, the greater the risk exposure.
Dangers of Improper Documentation Unfortunately, the IRS doesn’t define what constitutes sufficient documentation to claim the credit, so the burden of proof falls on the taxpayer. Many companies that provide R&D consulting use a packaged template that provides research methodology but little direction or support on expense documentation. This can lead to problems for the taxpayer should the IRS decide to conduct an audit. Recreating expense documentation on demand is not only stressful but can be very difficult or even impossible given the time discrepancy between when a credit was filed and then ultimately reviewed. Imagine having to drop everything to gather invoices, timesheets and other facts from several years ago. In addition, if the IRS disallows the claimed credit, taxes in the year the credit was claimed as well as additional tax years are impacted. This can result in the need to re-file prior tax returns and the possibility of additional taxes being owed. CONTACT KEVIN
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K R O S T C PA S . C O M
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