Substantiating the Research Tax Credit

Editor: Rick Klahsen, CPA

Research tax credits present unusual problems of documentation and support. Substantiating activities and expenses to meet the statutory definition of “research” often requires subjective judgments, subject to disparate interpretations. These issues often play out in contentious IRS examinations of the research credit. Fortunately, developments in the past few months may soon give taxpayers some much-needed guidance in this area.

Ever since the IRS designated research tax credit refunds as a Tier I examination issue, IRS examinations of the credit have become increasingly difficult. IRS examiners routinely deny research tax credit claims by requiring taxpayers to adhere to exacting documentation standards. Although specific documentation standards have never been a part of Treasury regulations under Sec. 41 or other guidance to taxpayers, examiners have imposed strict requirements in order to limit research credit claims.

Developments over the past several months may signal some movement on documentation issues. Two significant cases—McFerrin, 570 F.3d 672 (5th Cir. 2009), and Union Carbide Corp., T.C. Memo. 2009-50—have allowed more flexibility in documenting the research tax credit.

In the McFerrin case, the taxpayer filed a claim for refund for the 1999 tax year based on a flowthrough of research tax credits from four subchapter S corporations. Although the IRS paid refund claims to the S corporation shareholders, it later filed suit to recover the refunds as erroneously issued under Sec. 7405. The case ended up in U.S. district court. The government argued that there was insufficient documentation to support the research tax credit because the taxpayer relied on estimates in determining qualified research expenses. The district court ruled in favor of the government and disallowed the tax refunds based on the research tax credit.

On appeal, the Fifth Circuit reversed the district court and reinstated the tax refunds. The court held that taxpayers can use a fair estimate of time and expenses to calculate the credit. “But the court should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.”

Shortly after the Fifth Circuit issued its decision in McFerrin, the Tax Court weighed in on the research tax credit in Union Carbide Corp. The taxpayer filed claims for refund based on additional expenses that it believed now qualified for the research tax credit. On its originally filed return, Union Carbide (UCC) claimed research tax credits that the IRS accepted. Later UCC filed amended returns to claim additional research tax credits based on additional research expenses incurred in process improvements in UCC’s production runs. The additional credits were at issue before the Tax Court.

Although the government prevailed with respect to the amount of the additional qualified research expenses eligible for the credit, several rulings were favorable to UCC. Union Carbide, like many taxpayers, did not keep detailed time records for employees engaged in research and development. To determine the amount of wages of those engaged in research at UCC, employees made estimates of hours spent on various projects and later testified as to the time allocation. The Tax Court found that the testimony of employees of the estimated time spent on research was “credible and sufficiently substantiated the wages paid to these employees.” The Tax Court accepted the oral testimony of those performing research in order to substantiate qualified wages for the research tax credit.

McFerrin and Union Carbide are significant both in the application of the law and in the type of evidence needed to support a credit claim. For taxpayers without detailed time records, McFerrin and Union Carbide allow reasonable estimates based on the longstanding rule in Cohan, 39 F.2d 540 (2d Cir. 1930).

Substantiation of research activities and expenses is a contentious issue for taxpayers and the IRS. The Service argues that it is unable to audit research credit claims without detailed records that tie specific expenses to defined research activities. Taxpayers are understandably upset that the IRS applies such elevated documentation standards during examinations without providing guidance in the final regulations or other forms of official guidance. Typical documentation standards, vaguely described in Sec. 6001, are aimed at reasonable substantiation of income and expenses as accepted by the Tax Court and not the higher standard required by the IRS.

The General Accounting Office (GAO) addressed this issue in a comprehensive report on the research tax credit (GAO, The Research Tax Credit’s Design and Administration Can Be Improved, GAO10-136 (November 2009)). The GAO’s report reviews the design of the research tax credit, tax policy issues, and administrative problems and contains recommendations for both congressional and administrative action to make the credit more effective. The GAO report thoughtfully addresses problems in the enforcement of the research tax credit, focusing on examination issues between the IRS and taxpayers claiming the credit.

A significant issue identified in the report is substantiating the validity of a research tax credit claim. As the report notes, “The burden of substantiating research credit claims represents a significant discouragement to potential credit users; however, the flexibility in substantiation methods that many practitioners seek could help some taxpayers claim larger credits than those to which they are entitled.”

The report recommends that Treasury organize a working group that includes IRS and taxpayer representatives to develop standards for the substantiation of qualified research expenses. A comment letter from Treasury attached to the GAO report at Appendix VIII acknowledges the GAO recommendation.

Court cases and the analysis by the GAO have put Treasury and Congress on notice that substantiation of the research credit is a significant hurdle to the effectiveness of the credit as a tax incentive. The research credit has again lapsed, and Congress is now considering bills to extend and modify the credit. A bipartisan bill sponsored by Senators Max Baucus and Orrin Hatch would strengthen the credit’s effective rate. Commenting on the GAO report and proposed legislation, Senator Chuck Grassley pointed out, “The IRS should offer administrative simplification and education and outreach to maximize the number of businesses using this credit towards job creation.” This would be an opportune time for the IRS to take up the GAO’s recommendation and collaborate with industry representatives to develop substantiation standards for qualified research expenses that make the research tax credit more widely available to qualified taxpayers.

EditorNotes

Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or rick.klahsen@rsmi.com.