Direct Supervision
Understanding the critical link between management activities and qualified research expenses under IRS regulations.
The Legal Definition
Explore the two critical dimensions of Direct Supervision below.
The Meaning
Direct supervision, within the context of the R&D tax credit, specifically refers to the immediate supervision of employees who are engaging in qualified research. According to IRS regulations, this is distinct from general administrative supervision. To qualify, the manager must be directly overseeing the technical conduct of the research—providing technical guidance, reviewing experimental data, or directing the testing process of a specific hypothesis. It is a "first-line" management function focused on the science or engineering, rather than high-level budgetary or personnel management.
The Importance
The importance of identifying direct supervision lies in maximizing the Qualified Research Expenses (QREs). Often, senior technical leads and engineering managers have higher salaries than junior staff. If a company fails to identify their direct supervision activities, they miss out on claiming a significant portion of these higher wages. Properly substantiating direct supervision transforms a manager's time from a standard overhead cost into a qualified research expense, thereby directly increasing the available tax credit and reducing the company's tax liability.
Scenario Analyzer: Valid vs. Invalid
Click on the roles in the organizational hierarchy below to see if their "Supervision" qualifies.
(Doing the Research)
Senior Tech Lead
✅ Qualifies: Direct SupervisionThis role involves reviewing code commits, setting testing protocols for the junior engineers, and guiding the technical direction of the experiment.
Why it matters:
"Even though they aren't writing every line of code, their immediate technical guidance is essential to the research process."
Financial Impact Visualizer
See how capturing Direct Supervision expenses affects your total Qualified Research Expenses (QRE) pool.
Adjust slider to simulate identifying more supervisors.
Total QRE Pool
$1,150,000
Supervision Portion
+$150,000
Breakdown of Qualifying Wage Expenses
Suggest Next Steps
How to further clarify and explain Direct Supervision use more fully to the IRS.
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Establish Contemporaneous Documentation
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Conduct Manager Interviews
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Map the Nexus
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The Regulatory Mandate of Direct Supervision: Compliance, Nexus, and Risk Mitigation in the R&D Tax Credit
I. Executive Summary: Defining the Role and Risk of Direct Supervision
The concept of Direct Supervision is fundamental to determining the eligibility of wage expenditures for the U.S. Research and Development (R&D) Tax Credit, codified under Internal Revenue Code (IRC) Section 41. The Code establishes “Qualified Services” (QS) as the basis for calculating in-house research expenses, explicitly recognizing three categories: engaging in qualified research, engaging in direct support, and engaging in direct supervision of research activities which constitute qualified research.1 This inclusion of supervision wages is critical, as it acknowledges that the technical direction and guidance necessary to execute a process of experimentation are as integral to the research activity as the physical performance of the research itself. Wages paid or incurred for qualified services constitute in-house research expenses, making the proper categorization of supervisory labor essential to maximizing the credit base.2 If substantially all (defined as 80% or more) of an employee’s services during the taxable year consist of qualified services, then 100% of that individual’s wages may be treated as qualified research expenses (QREs), thus dramatically simplifying compliance and increasing the economic value of the credit for high-involvement supervisors.3
The importance of Direct Supervision in R&D tax credit compliance hinges entirely on its narrow regulatory definition, which functions as a strict gatekeeping mechanism against the inclusion of general overhead expenses. Treasury Regulations define Direct Supervision as immediate supervision (first-line management) of qualified research.4 This narrow interpretation requires the supervisor to maintain a direct, technical nexus to the ongoing process of experimentation, such as a research scientist who oversees laboratory experiments but does not personally perform the physical work.4 This strict “one-up” requirement distinguishes qualifying technical management from excluded higher-level management who report to first-line supervisors, even if the higher manager is technically proficient.4 By restricting eligibility to first-line technical oversight, the regulations prevent the erosion of the credit through the inclusion of non-qualifying general and administrative services, which are only indirectly beneficial to research activities.4 Consequently, proper documentation of a supervisor’s function and organizational proximity to the research execution is one of the highest audit-risk areas for taxpayers claiming the R&D credit.
II. The Legal Framework: IRC Section 41 and Treasury Regulations
A. Codification of Qualified Services under IRC § 41(b)(2)(B)
IRC Section 41 provides the statutory foundation for the R&D Tax Credit. Specifically, Section 41(b)(2)(B) defines Qualified Services as labor related to engaging in qualified research, or engaging in the direct supervision or direct support of research activities that constitute qualified research.1 Wages paid for these qualified services are categorized as in-house research expenses.2 This tripartite classification (performance, supervision, support) is a deliberate regulatory structure intended to capture all necessary technical labor, while simultaneously imposing specific constraints on each category to maintain the integrity of the credit.
The structural limitation imposed by the statute is enforced through the “Substantially All Rule.” If 80% or more of an employee’s services during the taxable year are qualified services (in any of the three categories), then 100% of that employee’s wages are treated as QREs.3 For employees whose time splits between qualified and non-qualified activities, falling below the 80% threshold, the required expense allocation must be based on the ratio of time spent on qualified services to the employee’s total paid time, unless the taxpayer can demonstrate a more appropriate allocation method.6 This allocation requirement immediately increases the audit risk for supervisory personnel whose roles are inherently mixed, demanding meticulous documentation to justify any prorated wage claim.
B. Regulatory Differentiation: Direct Supervision vs. Other Qualified Services
Treasury Regulation § 1.41-2(c) provides the definitive technical guidance for differentiating the categories of Qualified Services.
- Engaging in Qualified Research: This is defined as the actual conduct of qualified research, exemplified by a scientist performing laboratory experiments.4
- Direct Supervision: This category mandates immediate supervision (first-line management) of qualified research.4 It requires technical competence and immediate authority over the research execution, consistent with the scenario of a research scientist directing experiments.4
- Direct Support: This includes activities necessary for the research to occur, provided they support personnel engaging in or directly supervising research (e.g., a clerk compiling research data or a machinist fabricating a prototype part).7
This detailed regulatory segregation is a critical mechanism for limiting the credit to genuinely technical and functional roles. The focus on “immediate” and “first-line” status for supervisors ensures that the wages claimed are directly associated with the ongoing process of experimentation, rather than being diluted by high-level strategic planning or general administrative oversight.
C. The Critical Distinction: Direct Supervision vs. General Administration
A primary challenge in claiming supervisory wages involves distinguishing Direct Supervision from non-qualifying general and administrative services. Treasury Regulation § 1.41-2(c) explicitly excludes general and administrative services, or any other services only indirectly of benefit to research activities.4 This exclusion applies regardless of whether the general and administrative personnel are situated within the R&D department or a separate unit.4
The existence of the specific “one-up” restriction to first-line managers confirms the regulatory intent to strictly limit the scope of supervision. If general management activities were acceptable, the term “direct” would be redundant. Therefore, the regulatory definition ensures that proximity to the execution of the Qualified Research Activity (QRA) is the core legal requirement. This focus on functional proximity means the documentation of supervisory time must be demonstrably project-specific and contemporaneous, establishing the required technical nexus. Because a supervisor’s role is often ambiguous—involving technical guidance, personnel management, and administrative tasks—this mixed activity profile inherently presents higher audit vulnerability compared to the documentation required for personnel “Engaging in Qualified Research,” necessitating superior evidence quality.
Table 1: Qualified Services Classification Matrix
| Category of Service | Regulatory Definition | Criteria for Qualification | Exclusionary Principle |
| Engaging in Qualified Research | Actual conduct of qualified research (e.g., conducting experiments) 4 | Technical execution of the process of experimentation; hands-on involvement. | General technical consultation without actual process involvement. |
| Direct Supervision | Immediate supervision (first-line management) of qualified research 4 | Must be “one-up” from the performers; technical guidance and direction on the QRA execution. | Higher-level managers (two-up or more); general administrative or strategic oversight.4 |
| Direct Support | Services in direct support of those engaging or supervising research 5 | Activities essential to the execution (e.g., compiling data, typing reports, making prototypes).7 | General and administrative services (e.g., HR, accounting); services only indirectly beneficial.4 |
III. Nuances of Compliance: The Exclusion of Higher-Level Management
A. Interpreting the “One-Up” Rule: The Exclusionary Standard
The most common point of conflict with the Internal Revenue Service (IRS) regarding supervisory QREs is the application of the strict hierarchy test. The IRS Audit Technique Guides (ATGs) unequivocally state that Direct Supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that higher-level individual is a technically competent “qualified research scientist”.4 This establishes the strict boundary of the “one-up” rule. Specific attention is directed by the IRS to individuals higher than first-line supervisors.4
The mandate to base eligibility solely upon what an employee actually does, rather than their title or job description, reinforces the stringency of this requirement.4 This necessitates meticulous functional documentation, as the formal organizational chart often serves as a primary, easily challenged audit document for high-wage supervisory claims. If the organizational structure places a key leader two or more tiers above the researchers, the supervisory claim is immediately rebuttable under regulatory precedent.
B. Judicial Application: Analysis of the “One-Up” Requirement
Judicial review has consistently affirmed the IRS’s rigid hierarchical boundary. The principle derived from cases like Nevco confirms that a corporate executive, such as a Chief Operating Officer (COO), who was two layers removed from the direct R&D activity, had their claimed supervisory wages disallowed.8 The Court agreed with the IRS that this supervision failed to meet the necessary “one-up” requirement.8
Disallowance in such cases is typically rooted in the failure of the taxpayer to show sufficient support for the portion of the manager’s direct technical work on the new product development, coupled with their documented organizational distance.8 The structural ambiguity surrounding higher-level management functions forces the taxpayer to overcome dual hurdles: first, proving the technical nature of the activity, and second, proving that the time spent was on direct performance (“Engaging in”) rather than non-qualifying supervision or general administration.4
C. The Role of Technical Expertise: Why Skill Alone Does Not Qualify Supervision
A high-level manager’s technical background or expertise is insufficient to qualify their supervisory wages. Even if a manager is a “qualified research scientist,” if their primary function is supervising other first-line supervisors, their work is excluded from the Direct Supervision category.4
While senior research managers may perform some qualified research activities (falling under “Engaging in Qualified Research”), this often constitutes only a “minor fraction” of their overall time.4 This limited technical involvement requires the taxpayer to separate the minor qualifying time from the substantial non-qualifying managerial time. If such an employee fails to meet the 80% “Substantially All” threshold, the required prorated allocation must rigorously justify the time claimed, a task made challenging by the lack of granular, project-specific time logs often maintained by senior staff. Furthermore, if a supervisor’s QRE claim is disallowed because they are too far removed from the first line, that failure can also jeopardize the QRE status of support staff reporting to them (Direct Support), as the necessary qualified link would be broken.4
IV. Practical Application and Allocation Methods
A. Illustrative Example: The Qualified Research Scientist Supervisor
A Research Team Lead manages a team of junior software engineers. The engineers are engaged in iterative testing and debugging of a new encryption protocol to eliminate uncertainty regarding the methodology’s reliability—a clear Qualified Research Activity. The Team Lead reviews the daily test failures, makes technical decisions regarding alternative coding approaches, and provides direction to the engineers on the specific parameters for the next iteration. This Team Lead dedicates approximately 85% of their total paid time to these technical supervision and guidance activities.
- Regulatory Justification: This individual provides immediate, first-line management of qualified research, meeting the definition of Direct Supervision.4 Because their documented qualified involvement (85%) exceeds the “Substantially All” requirement of 80%, the taxpayer may claim 100% of this Team Lead’s wages as QREs.3
B. Non-Qualifying Counter-Example: General Administrative Overhead
Consider the Vice President (VP) of Engineering, who reports directly to the Chief Technology Officer and supervises several Research Team Leads (the first-line supervisors). The VP spends their time reviewing high-level quarterly R&D budgets, approving general capital expenditures, and coordinating resource allocation across multiple non-research divisions.
- Regulatory Justification: The VP is two organizational levels removed from the actual research activity, thereby failing the strict “one-up” test.4 Their services—budget management and resource allocation—are classified as administrative and only indirectly benefit the qualified research, explicitly failing the Direct Supervision standard.4 Therefore, the VP’s wages are non-qualifying QREs.
C. Application of the “Substantially All” Rule (80% Test)
The 80% threshold serves as a critical compliance gate. If an employee meets this threshold, 100% of their wages may be claimed, providing a significant benefit by simplifying compliance and avoiding the complex, high-risk process of hourly allocation.4 If this threshold is not met, the level of documentation required for the resulting prorated claim becomes disproportionately high.
D. Prorated Allocation Methods for Mixed Services
For any employee, including supervisors, whose qualified services fall below the 80% mark but are greater than zero, the taxpayer must allocate the expense. Only the wages allocated to qualified services constitute an in-house research expense.6 The standard methodology, which the IRS accepts in the absence of a more appropriate method, is multiplying the total wages by the ratio of the total time actually spent on qualified services to the total time spent performing all services.6
For supervisory personnel with a lower QRE ratio, the documentation must rigorously distinguish between qualifying tasks (e.g., “approving technical redesign of prototype”) and non-qualifying administrative tasks (e.g., “conducting annual performance review”). The lack of precise, granular time tracking detailing this segregation increases the likelihood of the auditor disregarding generalized estimates or allocations, leading to a complete disallowance of the claimed wages due to insufficient substantiation.10
V. Audit Defense and Substantiation Requirements
A. IRS Audit Techniques Guide (ATG) Focus on Supervisory Roles
IRS ATGs specifically mandate targeted scrutiny for supervisory roles that appear to be beyond first-line management.4 The ultimate objective during an audit is to determine what the employee did and how much time they spent doing it.4 Title or job description is explicitly noted as an unreliable basis for credit eligibility.4
Crucially, the IRS is directed to use interviews to supplement and corroborate written records.4 This is an active audit procedure designed to test the internal consistency of documentation. If a supervisor’s oral testimony regarding their daily role contradicts their time log or their organizational proximity (e.g., they describe their role as reporting strategy rather than directing daily experiments), the auditor has grounds to challenge the taxpayer’s entire allocation methodology, leading to significant risk of disallowance.
B. The Nexus Imperative: Linking Supervisory Wages to Qualified Projects
For supervisory wages to qualify, the taxpayer must establish the necessary nexus between the QREs and the qualified research activities (QRAs).10 Project-based accounting systems are vital for this purpose, as they capture costs at the specific “business component” level, which directly establishes the required link between the expense and the four requirements of qualified research (permitted purpose, elimination of uncertainty, process of experimentation, and technological nature).10 Cost center accounting often fails to provide this necessary level of specificity.
C. Best Practices in Documentation: Contemporaneous Records
The IRS requires taxpayers to retain records in a sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.12 For supervisory wages, this means maintaining employee Forms W-2, payroll registers, and detailed time tracking data.11
Corroborating evidence is essential to support time allocations and organizational structure. Relevant documents include project authorizations, budgets, project summaries, and meeting minutes.11 These records must evidence the supervisor’s specific technical input into the QRA. Critically, all substantiation information must be contemporaneous and available for inspection; reliance on post-hoc estimates or reconstructions is highly vulnerable to challenge.10
D. Emerging Reporting Requirements (Form 6765 Changes)
The proposed changes to Form 6765 (Credit for Increasing Research Activities), expected to be effective starting in 2024, institutionalize the need for highly granular tracking of labor. The updated form requires taxpayers to report Qualifying wages by type (research, supervision, support).14 This change makes the misclassification or undocumented nature of Direct Supervision wages immediately apparent upon filing, signaling a heightened IRS focus on this category and raising the required standard of internal documentation. The increased visibility of segregated supervisory wages creates a higher audit standard, moving away from generalized estimates and requiring detailed, individualized tracking for these high-value personnel.
Table 2: Documentation Required for Supervisory QREs
| Documentation Type | Purpose (Nexus Requirement) | Specific Content Focus for Supervisors | Relevant Guidance |
| Time Tracking Data/Logs | Accurate allocation of time between QRE and Non-QRE activities. | Granular detail of time spent directing specific QRAs, segregated by project and service category (Supervision). | 4 |
| Organizational Charts/Job Descriptions | Establishing the “one-up” (first-line) reporting structure compliance. | Must clearly show the supervisor’s immediate reportees are engaging in qualified research. | 4 |
| Project Progress Reports/Meeting Minutes | Corroborating the supervisor’s technical involvement and guidance. | Supervisor’s specific contributions, decisions, and technical direction recorded contemporaneously. | 11 |
| Oral Testimony (Interviews) | Verification of actual daily activities and functional reporting lines. | Consistency with documented time, project scope, and direct authority over QRAs. | 4 |
VI. Strategic Recommendations for Future Clarification and Utilization (Next Steps)
Given the narrow regulatory definition of Direct Supervision, the rigidity of the “one-up” requirement, and the IRS’s increasing scrutiny of managerial wages, taxpayers must adopt proactive compliance strategies to mitigate audit risk and fully utilize this QRE category.
A. Implementing Formalized Internal Policies for Management Structure and Reporting
The organizational chart is de facto a primary audit document. The first critical step is to mandate an annual, documented review of the R&D organizational structure against the regulatory “one-up” rule.8 This review should clearly delineate the first-line management layer and restrict the official internal use of the “Direct Supervision” category exclusively to personnel in this layer. This minimizes the structural risk identified in judicial precedent. For high-level managers operating two or more tiers removed, internal policies should direct them to document their qualified time solely under the “Engaging in Qualified Research” category, focusing their time logs on evidence of personal technical performance (e.g., advanced problem solving, hands-on design), not technical oversight.
B. Adopting Granular, Project-Based Accounting Systems
Taxpayers should move toward the full implementation of project-based accounting systems that capture labor at the business component level.10 This action provides the necessary evidence to establish the nexus between supervisory wages and specific QRAs. The adopted time tracking system must capture data not only by project but also by service category (research, supervision, support).14 This systematic segregation ensures that when the time ratio allocation is applied, it is supported by robust data, directly addressing the strict allocation requirements of the Treasury Regulations.6
C. Establishing a Formal Methodology for Substantially All Analysis
A formal, auditable methodology must be established to monitor and document all supervisory personnel’s QRE involvement relative to the 80% “Substantially All” threshold.3 For supervisors expected to qualify at 100%, internal job design and time tracking must consistently prioritize QRE activities (80%+). This focus is a crucial risk mitigation strategy because falling below the 80% threshold necessitates the defense of a prorated claim, which carries a significantly higher documentation burden and audit risk.6 The heightened risk associated with prorated claims (due to the difficulty of defending the exact percentage of non-qualified time) underscores the importance of this strategic targeting.
D. Proactive Audit Preparation and Defense Strategy
A critical next step is the development of an internal audit preparedness program, including mock interviews and training specifically tailored for first-line supervisory personnel. This training must ensure that the supervisor’s oral testimony aligns seamlessly with their documented time logs, organizational status, and technical project reports.4 This preemptive measure directly addresses the IRS’s directive to use interviews for corroboration, ensuring that all aspects of the defense narrative—structural, quantitative, and testimonial—are unified and consistent, making a sustained challenge to the supervisory claims highly difficult.
E. Unified Compliance with Form 6765 and IRC Section 174
Finally, compliance strategies must account for the interplay between the R&D credit and the mandatory capitalization requirements under IRC Section 174 (amortization over five years for domestic R&D costs).15 The requirement to segregate wages by type on the updated Form 6765 14 necessitates immediate internal system adjustments. Furthermore, if supervisory wages are disallowed under Section 41, they may still be classified as IRC 174 expenditures, forcing the unfavorable five-year amortization schedule.15 Therefore, clarifying and rigorously documenting Direct Supervision now serves a dual strategic purpose: maximizing the immediate tax benefit of the Section 41 credit and ensuring the stability and appropriate tax treatment of the underlying cost basis under Section 174, thereby mitigating potential negative cash flow impacts resulting from disallowed QREs.
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What is the R&D Tax Credit?
The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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