Recent IRS audit activity reflects increased enforcement attention on the federal Research and Development (R&D) tax credit under Internal Revenue Code Section 41. Although these issues are not new, recent court decisions, particularly Kyocera AVX Components Corp. v. United States and Little Sandy Coal Co. v. Commissioner, have sharpened the Service’s emphasis on contemporaneous documentation, the “substantially all” test, and business component‑level analysis.

Court‑Driven Emphasis on Contemporaneous Documentation: The Kyocera Case

In Kyocera AVX Components Corp. v. United States, the government successfully challenged a large, amended Section 41 credit claim on the grounds that the taxpayer failed to maintain adequate contemporaneous documentation to substantiate its research activities and related expenses. The taxpayer’s amended claim relied entirely on retrospective interviews and estimates prepared well after the close of the tax year, without supporting project records, time tracking, or technical documentation created during the research process.

The court agreed with the government that interviews and estimates, standing alone, were insufficient to substantiate the credit and declined to estimate allowable credits in the absence of reliable underlying records. This decision reinforced the IRS’s long‑standing position that taxpayers bear the burden of proving entitlement to the credit through documentation created while the research was being performed, not reconstructed after the fact.

Recent IRS audits increasingly center on contemporaneous documentation demonstrating technical uncertainty, experimentation, and development as the work occurs. While these audit issues are not new, the Service’s focus has clearly intensified. Practices that once relied on post‑year‑end interviews, generalized narratives, or estimated allocations, including arguments grounded in the Cohan‑rule, are now far more difficult to defend without credible contemporaneous support. As a result, documentation quality has become a decisive factor in the sustainability of Section 41 credit claims.

Renewed Scrutiny of the “Substantially All” Test: The Little Sandy Coal Decision

The IRS’s current audit focus on the “substantially all” requirement is also rooted in recent judicial guidance. In Little Sandy Coal Co. v. Commissioner, the U.S. Court of Appeals for the Seventh Circuit affirmed the denial of R&D credits where the taxpayer failed to demonstrate that “substantially all” of its activities for the relevant business components constituted elements of a process of experimentation.

Although the appellate court rejected certain aspects of the Tax Court’s reasoning, it upheld the denial of the credit because the taxpayer did not present a principled, well‑documented method for identifying which activities constituted experimentation versus non‑qualifying work. The court emphasized that the “substantially all” test must be applied to activities, not to the novelty of the product itself, and that taxpayers must be able to clearly distinguish qualifying from non‑qualifying activities within each business component.

Following Little Sandy Coal case, IRS examiners have increasingly disaggregated projects into discrete activities and evaluated whether non‑qualifying work dilutes satisfaction of the “substantially all” requirement. This has led to heightened scrutiny of projects involving mixed activities such as routine engineering, customization, fabrication, or production support.

Business Component‑Level Analysis as the Audit Baseline

Both Kyocera and Little Sandy underscore the IRS’s broader shift toward business component‑level analysis, a trend now embedded in revised Form 6765 reporting requirements. Recent audits reflect an expectation that taxpayers clearly define each business component, link specific research activities to those components, and directly attribute qualified research expenses to them.

The Service has shown reduced tolerance for broad project groupings or generalized cost allocations. Instead, examiners increasingly expect disciplined project identification, activity mapping, and expense attribution that align with the statutory four‑part test under Section 41(d).

Together, these cases have significantly shaped the IRS’s current audit approach and enforcement priorities. Taxpayers that claim, or are considering claiming, R&D credit should evaluate whether their processes can support the following:

• Contemporaneous documentation demonstrating technical uncertainty and experimentation.
• Clear satisfaction of the “substantially all” test based on activities, not outcomes.
• Business component‑level identification of activities and qualified research expenses.

Is your R&D study exam‑proof?
Questions about an R&D credit audit or concerns about documentation? Feel free to contact me to talk through your situation and next steps.

*Written with assistance of AI*