IMGCAP(1)]The federal Research and Experimentation Tax Credit has had no shortage of publicity.
The potentially lucrative credit has been heralded by taxpayers, taxpayer advocates and industry groups for the lucrative tax savings it can provide as a reward and stimulus for investing in qualifying research activities.
Last month, a taxpayer saw the major portion of an R&D tax credit claim rejected by the Tax Court in Basim Shami and Rani Ardah, Et Al. v. Commissioner. So what do practitioners need to know about R&D credits? How should they advise clients to proceed in an area that could be very beneficial, but is also subject to significant IRS scrutiny? Clients that qualify should receive benefits, but how can a practitioner be sure that the claims would withstand IRS review?
As was well-publicized in 2007, the IRS released new audit directives to manage increased activity and interest surrounding the federal Research and Experimentation Tax Credit. In 2009, two court case decisions, Union Carbide Corporation & Subsidiaries v. Commissioner (T.C. Memo 2009-50) and United States v. McFerrin (570 F.3d 672), produced Tax Court decisions that have provided further guidance and clarification regarding R&D Tax Credit claims. This year, another significant case was decided.
The Tax Court decisions of the past three years have helped taxpayers understand the acceptable methods of qualifying and substantiating research activities. The first decision, Union Carbide Corporation & Subsidiaries v. Commissioner, produced an important memorandum decision on March 10, 2009. This Tax Court memorandum most notably permits the use of “close approximations,” as determined by the “Cohan Rule” (Cohan v. Commissioner, 39 F.2d 540, 543-544), when qualifying and quantifying research activities.
The second decision, United States v. McFerrin (570 F.3d 672), helped further define “qualified research” and a “process of experimentation” in a June 9, 2009 decision from the United States Court of Appeals for the Fifth District. And last month, the Shami case reinforced the importance of contemporaneous documentation and supporting testimony, especially when management wages are included in qualified research expenditures, or QREs.
The Union Carbide court memorandum allowed the use of oral testimony and close approximations to sufficiently substantiate qualified research expenditures under the Cohan Rule. This memorandum supported the use of the Cohan Rule and provided the following insight into the R&D credit:
• Clarification of the Discovery Test, which previously required qualified research activity to involve discovering information far beyond the taxpayer’s existing knowledge. The Union Carbide memorandum emphasizes that this test only necessitates qualified activity to involve an effort to discover technological information.
• Activity relating to the development of the manufacturing method may be qualified, even if conducted after a product is ready for commercial production. However, efforts must be made to identify and separate production costs from qualified research costs.
• With regard to maintaining consistency when qualifying and quantifying research activities in the base years and the credit years, the consistency of the particular type of records is not required. Also, the consistency rule was determined to apply at the entity level —not the control group level—when the credit is computed and applied to an aggregate group of companies.
The original United States v. McFerrin case decision disallowed McFerrin’s entire $472,092 R&D Tax Credit claim. The credit claim was rejected on grounds that trial and error was not an acceptable form of experimentation, qualified projects did not demonstrate a high level of innovation, qualified research activities (QRAs) did not expand or refine existing principles, and insufficient project detail was provided.
The McFerrin district court decision was overturned in the United States Fifth Circuit Appellate Court in June 2009. The appellate court determined that the 2004 Final Regulations should have taken precedence in the ruling. These regulations provide the following guidelines for qualified activity:
• Discovery of new information does not need to be revolutionary. Rather, the discovery of new information must be intended to eliminate uncertainty re¬garding the development of a final product or process design, the taxpayer’s ability to produce the design, or the technique used to develop the product or process.
• Qualified experimentation can include systematic trial and error and virtual or physical simulations and modeling.
• Qualified activity must involve uncertainty during product or process development, identification of alternative solutions, and an evaluation of alternatives.
Recently, the decision in Shami highlighted the importance of properly qualifying and documenting management wages. In this instance, the taxpayer hired another outside provider to develop R&D credit claims for tax years 2003, 2004 and 2005. The provider included nearly $30 million in management wages over a three-year period for two individuals whose titles and educational backgrounds did not indicate a strong likelihood that they would materially participate in qualifying research.
In addition, the taxpayer failed to provide any documentation that established how much, if any, time was spent by management performing R&D activities. The court found the provided testimony to be unreliable and contradictory. The IRS is very clear in its expectations for substantiating management involvement in qualifying research activities. Taxpayers and practitioners should be meticulous in maintaining and presenting contemporaneous evidence to support such inclusions.
Tax examiners have not raised any immediate objections to reliance on personal interviews, detailed questionnaires, or the proper utilization of the Cohan Rule supported by valid, contemporaneous documentation. We have found IRS examiners to be reasonable in their application of the code and regulations, provided that taxpayers have made the necessary effort to identify activities that truly meet the requirements for qualifying activities, and that records are kept or developed which create nexus between activities and expenses.
We have settled full IRS examinations of clients’ research credit claims without the IRS making any proposed adjustments by submitting a detailed response to the IDR Form 4564 with supporting documentation attached. The IRS expects credit calculations to be supported with reliable, contemporaneous documentation and that QRAs will be provided with detailed explanations of how they meet statutory definitions.
TJ Sponsel co-founded McGuire Sponsel to deliver specialty tax services to leading local and regional CPA firms across the country. He has helped
