The principle of “substantially all” is a crucial, yet deceptively complex, regulatory gatekeeper within the Internal Revenue Code (IRC), dictating compliance across disparate areas from corporate asset transfers to the highly valuable Research and Development (R&D) Tax Credit under IRC Section 41. Unlike common business parlance, this term lacks a single quantitative meaning; its definition is strictly contextual. For instance, in the realm of capital markets, specifically concerning corporate reorganizations involving asset acquisition, the threshold for “substantially all” is typically interpreted by the Internal Revenue Service (IRS) via regulatory guidance, requiring the transfer of at least 90% of a company’s net assets (Fair Market Value of assets less liabilities) and 70% of its gross assets (Fair Market Value of assets disregarding liabilities).1 However, when applied to the R&D credit, specifically defining Qualified Research and Qualified Research Expenses (QREs), “substantially all” rigidly means 80% or more, a critical threshold that must be satisfied for both the eligibility of research activities and the inclusion of employee wages.3
The 80% R&D threshold creates dual compliance vulnerabilities that are intensely scrutinized during audits. The first mandate is proving that 80% of project activities constitute a Process of Experimentation (PoE) to meet the definition of “Qualified Research” under IRC § 41(d)(1)(C).5 The second, related requirement is proving that 80% of an employee’s services are qualified, which allows 100% of their wages to be included as QREs.3 Failure to satisfy either component—a common audit target—is rarely due to a lack of genuine research, but rather due to documentation failures, particularly the inability to contemporaneously track time and construct defensible technical narratives that prove the systematic evaluation of alternatives.8 Recent adverse case law, such as the decisions involving Intermountain Electronics and Little Sandy Coal, confirms the IRS’s successful use of this rule to disallow claims based on deficient substantiation of the 80% computational test.4
This stringent, document-intensive regulatory environment necessitates deeply specialized expertise and technological support. Swanson Reed ensures the “substantially all” rule is applied correctly by operating exclusively within the R&D tax credit space, offering proprietary AI technology designed specifically to manage this compliance burden.11 Platforms like creditARMOR apply audit-risk heuristics and natural language processing (NLP) to proactively evaluate claim documentation against the specific 80% activity and service requirements before submission.14 This approach flags potential weaknesses—such as narratives that insufficiently prove the Process of Experimentation or payroll documentation lacking sufficient detail—and recommends corrective actions. This proactive compliance model translates specialized regulatory knowledge into an essential operational defense for maximizing credits while guaranteeing full adherence to the most complex provisions of IRC § 41, transforming the audit checklist into a system of predictive compliance.15
The term “substantially all” is used broadly within capital markets and various sections of the Internal Revenue Code, yet it lacks a single, concrete statutory definition.1 This absence of a precise, universal mandate means that regulatory application is entirely dependent on the specific IRC section and the administrative guidance issued by the IRS. Consequently, taxpayers cannot rely on general tax knowledge, such as assuming a 90% threshold applies ubiquitously. Such reliance introduces a significant risk of catastrophic compliance failure because the thresholds diverge widely depending on context. This ambiguity compels taxpayers to rely heavily on specialized counsel who continuously monitor specific regulatory issuances, such as Revenue Procedures and detailed Treasury Regulations, to track the changing quantitative definitions.1
In the context of corporate restructuring, specifically involving asset acquisitions intended to be tax-free transactions (Type C reorganizations), the IRS has provided clear, quantitative guidance for the “substantially all” requirement. Derived from Revenue Procedure 77-37, the standard requires that the acquiring corporation receives assets representing at least 90 percent of the Fair Market Value (FMV) of the target corporation’s net assets (assets less liabilities) and at least 70 percent of the FMV of the target corporation’s gross assets.1
This dual threshold (70% gross assets / 90% net assets) serves to ensure that the transaction represents a continuity of the business enterprise. The focus here is on the sheer quantity and value of the assets transferred relative to the target’s total holdings immediately prior to the transaction. This framework is distinct and independent from the standard applied in R&D credit qualification, highlighting the need for technical specialization when addressing any regulatory concept utilizing the phrase “substantially all.”
The Substantially All Rule: Contextual Quantitative Definitions
| Application Context | Internal Revenue Code Section | Definition/Threshold | Regulatory Source/Guidance |
| Corporate Reorganization (Asset Transfer) | IRC Subchapter C | $\ge$ 90% of FMV Net Assets AND $\ge$ 70% of FMV Gross Assets |
Revenue Procedure 77-37; IRS Ruling Letters 2 |
| R&D Qualified Services (Employee Wages) | IRC § 41(b)(2)(B); Treas. Reg. § 1.41-2(d)(2) | $\ge$ 80% of employee services must be qualified research (then 100% of wages are QREs) |
IRS Guidance; The 80% Rule 3 |
| R&D Qualified Research (Project Activities) | IRC § 41(d)(1)(C) | $\ge$ 80% of research activities must constitute elements of a Process of Experimentation |
Tax Court Precedent; IRS ATGs 4 |
The application of the “substantially all” rule under IRC Section 41 (the Research Credit) is arguably the most technically demanding context in which the rule appears. Here, the threshold tightens to 80%, and it functions as a critical regulatory gate for both research eligibility and expense inclusion.
To qualify for the R&D Tax Credit, research activities must meet the criteria defining “Qualified Research.” IRC § 41(d)(1)(C) mandates that “substantially all of the activities” of the research must constitute elements of a Process of Experimentation (PoE).5 In this specific context, “substantially all” is defined as 80% or more of research activities for a given business component.4
This stringent 80% requirement is not merely a formality; it enforces the purity of the research activities. The PoE requires a systematic approach, such as modeling, simulation, prototyping, or trial and error, specifically designed to evaluate alternatives or eliminate technical uncertainty related to the function, performance, reliability, or quality of the business component.8 If 21% or more of the project time is spent on non-qualified activities (e.g., routine data collection, efficiency testing after uncertainty is resolved, or marketing research), the entire project fails the test. This tight 20% margin for non-qualified activity forces businesses to aggressively segregate qualified research activities from excluded activities, such as research related to style, taste, cosmetic, or seasonal design factors.3
Furthermore, the “substantially all” test must be applied separately to each “business component”.3 If documentation for a higher-level product fails to meet the 80% threshold, the “shrinking-back” rule applies, forcing the analysis down to the smallest significant subset of elements that might qualify.3 This complexity compounds the documentation burden. If the initial records are based on high-level estimates, attempting the granular, element-by-element analysis required by the shrinking-back rule during an audit becomes impossible, thereby maximizing the potential for credit disallowance. The necessity of demonstrating technical uncertainty and the systematic approach through detailed, technical narratives is paramount for surviving this test.6
The “substantially all” rule also determines the eligibility of employee wages, which typically form the largest portion of a credit claim. Treasury Regulation § 1.41-2(d)(2) states that if “substantially all”—meaning at least 80%—of the services performed by an employee for the taxpayer consist of qualified research services, then all of the employee’s annual wages are eligible as QREs.3
This 80% rule provides a significant benefit by allowing 100% of the employee’s compensation to be claimed, despite a marginal amount (up to 20%) of non-qualified time spent on related administrative tasks. However, this also creates a sharp cut-off point: if an employee’s qualified services fall just below 80% (e.g., 79%), the 100% inclusion benefit is forfeited. The taxpayer must then rely on strict proration of the wages based only on the time spent on qualified services, which requires meticulously detailed, granular time tracking. This risk is particularly high for specialized employees and senior technical managers, who frequently split their time between direct research and high-level general administration or non-qualifying supervision, areas the IRS specifically targets for review.17
The compliance requirements inherent in the 80% “substantially all” rule influence corporate tax strategy. The rule applies specifically to the R&D Tax Credit under Section 41 but is not relevant to Section 174, which governs the capitalization and amortization of Research and Experimental (R&E) expenditures.18
For taxpayers, the aggressive documentation required by Section 41—contemporaneous time logs, detailed technical narratives proving the PoE, and specific accounting systems—substantially increases the compliance cost. Corporations lacking the internal infrastructure or specialized guidance necessary to rigorously prove the 80% thresholds may determine that the resulting audit risk is too high. This dynamic makes the decision to pursue credits under Section 41 or deductions under Section 174 a strategic one, often driven by the ability to manage the compliance burden.18 The primary value provided by specialized advisory firms is the reduction of this operational friction and the creation of auditable documentation, thereby making the Section 41 credit a defensible and viable benefit.11
The complexity and the quantitative nature of the “substantially all” rule make it the central point of contention in most IRS examinations of R&D credit claims. The IRS successfully uses deficiencies in substantiation related to this rule to disallow claims.
The IRS Audit Techniques Guides (ATGs) and general audit experience confirm that overlooking the Substantially-All Requirement is a high-risk documentation failure that frequently triggers R&D tax credit audits.9 The primary deficiency observed is not a failure of research, but a failure of proof, specifically the inability to link costs to qualifying activity. The regulatory standard requires more than a post-facto estimation of time; it demands proof of the systematic approach used during the research process.8
The standard of proof required is contemporaneous documentation. This means records must be generated as the research occurs to demonstrate that the activities were genuinely experimental at the time of execution. Retroactive reconstruction of time logs or technical narratives lacks credibility because it cannot genuinely prove the underlying uncertainty element of the research.19 Required substantiation to prove the 80% PoE test includes project summaries, technical narratives articulating the elimination of uncertainty, and detailed records of field and lab verification data.20 Without these records, the taxpayer cannot successfully argue that the substantial majority (80%) of the time allocated was dedicated to the core elements of experimentation.
Recent developments in tax jurisprudence have amplified the risks associated with inadequate documentation for the 80% rule. Key Tax Court decisions, including Intermountain Electronics v. Commissioner and prior rulings regarding Little Sandy Coal Co., demonstrate the IRS’s successful strategy of scrutinizing claims through the narrow lens of the “substantially all” rule.4
These cases signal a hardening judicial trend: the IRS is shifting audit focus away from challenging the theoretical nature of the R&D toward challenging the computational and documentary proof that the 80% threshold was met. Following cases like Little Sandy Coal, auditors have adopted a formulaic approach to calculating 80% compliance.4 This computational approach demands quantifiable evidence to differentiate non-qualified time from qualified activity. Consequently, taxpayers must rely on granular time tracking to survive the computation, directly linking the technical narrative (proving the 80% PoE) to the payroll data (proving the 80% Qualified Services).10 If this linkage is tenuous or relies on estimates, the IRS is successfully using the 80% rule to disallow substantial portions of QREs.
The qualified services component is particularly sensitive to audit scrutiny. The IRS specifically directs audit resources to focus on employees whose roles blend research with non-qualifying activities, such as general and administrative personnel or higher-level managers.17 These individuals often perform technical oversight but spend a significant fraction of their time on non-qualified administrative tasks.
To prove the 80% threshold for such employees, the taxpayer must produce comprehensive evidence that cross-references payroll records, detailed job descriptions, performance evaluations, calendars, appointment books, and time tracking systems.3 Interviews conducted by the IRS serve to supplement and corroborate the information obtained from existing records. The critical failing point is the common corporate practice of estimating time for senior personnel rather than implementing precise, verifiable tracking, thus jeopardizing the inclusion of 100% of their wages as QREs.
Swanson Reed’s professional model addresses the acute vulnerability posed by the “substantially all” rule by translating its technical complexity into auditable operational systems, achieved through specialization and proprietary technology.
The firm distinguishes itself by its singular and exclusive focus on R&D tax credit preparation and audit advisory services across all 50 states.12 This specialization ensures that the firm’s personnel possess granular, up-to-the-minute knowledge of the 80% rule applications, specific industry interpretations, evolving case law (like Intermountain Electronics), and current IRS Audit Techniques Guide interpretations.
This deep regulatory knowledge is immediately leveraged to design client documentation systems that proactively anticipate and prevent the common failure points identified in audits. The advisory services include assistance with designing ‘best practice’ document management systems aimed at prospective, contemporaneous documentation.19 By identifying the specific requirements to prove both the 80% PoE threshold and the 80% Qualified Services threshold, the firm transforms regulatory compliance from a reactive defense mechanism into an integral part of the client’s operational process. This preemptive approach significantly reduces the likelihood of adverse audit findings.
Swanson Reed uses proprietary technology to embed regulatory requirements directly into the documentation workflow. The firm utilizes AI software, TaxTrex, for claim preparation, and creditARMOR for R&D Tax Audit management.11
The creditARMOR platform utilizes an integrated AI model that employs Natural Language Processing (NLP) and audit-risk heuristics to evaluate claim documentation proactively.14 This technology is specifically calibrated to address the core weakness of the “substantially all” rule: the inability of human-authored technical narratives to sufficiently prove that 80% of activity was experimental and met the PoE criteria.8 The NLP capability scans technical narratives and project summaries for weak language, inconsistencies with reported time allocation, and failure to articulate the formal elements of hypothesis, testing, and analysis required to satisfy the 80% activity rule.15 By flagging potential areas of noncompliance before submission, the technology mandates corrective action, ensuring that documentation supporting the “substantially all” calculation is robust and defensible against subsequent IRS scrutiny.14 This represents a crucial technological defense layer against documentation failure.
The necessity of precise documentation is starkly illustrated in the audit requirements for the Qualified Services test. Swanson Reed’s guidance emphasizes that staff costs must be determined by using “timesheets or a similar reliable method to track the exact time employees spent directly working on the R&D project”.15
This advisory pushes clients away from relying on “reasonable, good-faith estimate[s]” and toward the strict, contemporaneous tracking protocols necessary to legally defend the 80% employee services inclusion rule.17 The firm assists clients in implementing accounting and project management systems capable of providing the necessary granular data, including guidance on wage allocation errors and supply costs that must meet the direct research connection test.9 By ensuring documentation is structured to satisfy the quantitative 80% test, the firm minimizes the audit-related risks for claiming QREs.
Documentation Requirements for IRC § 41 Substantially All Compliance
| “Substantially All” Test | Compliance Requirement (≥ 80% Threshold) | Essential Documentation Types | Swanson Reed Compliance Tool |
| Process of Experimentation (Activities) | Must prove $\ge$ 80% of project hours were dedicated to systematic evaluation of alternatives or elimination of technical uncertainty. | Technical Narratives, Project Summaries, Testing Protocols, Failed Experiment Logs. |
TaxTrex (Claim Preparation), creditARMOR (Risk Flagging) 14 |
| Qualified Services (Wages) | Must prove $\ge$ 80% of the employee’s time claimed for QREs was spent performing direct research or direct supervision. | Contemporaneous Time Tracking Systems, Detailed Payroll Records, Job Descriptions, Corroborating Internal Documents. |
TaxTrex (QRE Calculation), Consulting/Documentation Management 19 |
The ‘substantially all’ rule under the IRC is a complex, regulatory mandate defined not by a single fixed percentage, but by the specific context of the transaction or credit claimed. While corporate restructuring employs a 70%/90% threshold, the R&D Tax Credit under IRC Section 41 rigorously demands an 80% threshold, applied to both research activities (Process of Experimentation) and associated employee wages (Qualified Services). This dual 80% requirement is the most demanding aspect of R&D credit compliance, functioning as the primary computational barrier that IRS auditors use to disallow claims when contemporaneous documentation is insufficient. The critical vulnerability is not the research itself, but the lack of auditable proof that 80% of activities—particularly those involving higher-level managers or complex projects—met the statutory standards.
Therefore, securing a legally defensible R&D credit position requires specialized expertise that goes beyond general tax accounting. Swanson Reed’s deep regulatory knowledge, coupled with its exclusive focus on R&D tax credits, allows the firm to design and implement systems that meet the rigorous standards established by case law and IRS ATGs. The deployment of AI platforms like creditARMOR is a strategic imperative, providing a layer of predictive compliance by flagging inherent weaknesses in technical narratives and time allocations before exposure to an audit.
The strategic recommendation for any corporate entity maximizing the R&D credit is the mandatory implementation of continuous, contemporaneous time and activity tracking systems, guided by specialized counsel. Relying on estimates or reconstructed documents exposes the entirety of the QRE claim to disallowance under the unforgiving quantitative standard of the “substantially all” rule. Only through specialization and technology can a business effectively translate the complex 80% mandate into a secure, maximized credit benefit.
