Credits Against Tax
In theory, the research and development (R&D) tax credit is an excellent incentive for the more than 18,000 taxpayers who claim credits each year. In fact, the R&D credit is one of the few tax breaks that has consistent bipartisan support—President Barack Obama recently joined with congressional leaders in calling for the enactment of a permanent R&D credit. However, in reality, the incentive effect of the R&D credit has been severely dampened by the fact that defending the credit during an IRS audit can be a long and frustrating process for taxpayers. Over the past few years, many taxpayers that develop new products, employ degreed scientists and/or engineers, and conduct laboratory testing have been shocked to hear the IRS exam teams conclude that these activities do not qualify for the R&D credit. How did reality and theory become so different?
There are several vague and subjective terms in the body of the R&D tax credit law that are interpreted very differently by taxpayers, the courts, and the IRS. Perhaps the most prominent current disagreement is over the term “sufficient documentation” and how to properly substantiate the credit.
There are no specific recordkeeping requirements for the R&D credit other than what is found in Regs. Sec. 1.41-4(d)(4): “A taxpayer claiming the credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. For rules governing record retention, see §1.6001-1.” Regs. Sec. 1.6001-1 does not provide much additional detail, other than stating that the taxpayer “shall keep such permanent books of account or records . . . as are sufficient to establish the amount of . . . credits.” Thus, the governing statutory rule, Sec. 6001, and the associated regulations require only that the taxpayer maintain permanent records sufficient to establish the amount of the credit.
Further, when the R&D credit was extended in 1999, Congress made it clear that claiming the credit should not impose unreasonable recordkeeping requirements: “The conferees also are concerned about unnecessary and costly taxpayer record keeping burdens and reaffirm that eligibility for the credit is not intended to be contingent on meeting unreasonable recordkeeping requirements” (see H.R. Conf. Rep’t, No. 106-478 at 132 (1999)). Similarly, in the preamble to December 2001 proposed regulations, Treasury and the IRS concluded that “taxpayers must be provided reasonable flexibility in the manner in which they substantiate their research credits” (REG-112991-01).
Nevertheless, taxpayers in exam often encounter inflexible IRS agents asking for vast amounts of records and documentation; this issue was only magnified when R&D credit claims were designated as a Large Business and International (LB&I) Division Tier I issue in 2007. The Tier I status indicates that the R&D credit is an issue the IRS views as one of its highest strategic priorities. Since the credit’s designation as a Tier I issue, taxpayers have often experienced difficult and drawn-out examinations of their R&D credit claims.
The IRS’s Position: Lack of Nexus
The IRS has made its position on substantiation clear through the release of the standard substantiation write-up included as Exhibit E of its Research Credit Claims Audit Techniques Guide (RCCATG) (LMSB-04-0508-030) released in 2008. This standard write-up, intended to be used as an aid in drafting revenue agent reports (RAR) for disallowing R&D credit claims, provides insight into the IRS’s thinking about substantiation. The argument included in the standard write-up and often seen in actual RARs is that the “[t]axpayer has failed to provide sufficient substantiation to support the amount of its claimed credit.” Often the crux of the IRS’s argument is as follows (as articulated in the standard write-up): “Taxpayer’s estimation methodology faces an insurmountable problem as it lacks a nexus between the ‘amounts’ claimed as qualified research expenses [QRE] pursuant to IRC §41(b) and the ‘activities’ claimed as allegedly qualified. . . . There is no link between the amount of research claimed to have been performed by an employee and the projects which allegedly resulted in alleged research activity.”
This lack of nexus problem is further discussed in the main body of the RCCATG: “The manner in which the information is compiled typically does not support the relationship between the accounting records and the research activities or QREs.” A separate Appeals coordinated issue paper released in April 2007 echoes these same arguments (see Qualified Research, Sec. 41(d) (Research Credit) and Related Penalties, as Expanded, 2007 TNT 69-6 (April 10, 2007)). The IRS takes issue when taxpayers use the Cohan rule to estimate QREs when perfect records do not exist (see Cohan, 39 F.2d 540 (2d Cir. 1930)). When taxpayers attempt to establish the nexus between qualified activities and QREs through the use of appropriate estimation and/or oral testimony, the IRS typically argues that any use of these methods is grounds for disallowing the credit.
Recent Court Guidance
Several recent court cases deal directly with the issue of substantiation and the appropriate use of estimation by taxpayers claiming the R&D credit. In Union Carbide, T.C. Memo. 2009-50, the Tax Court ruled on whether R&D activities and associated QREs claimed for projects performed at the taxpayer’s manufacturing facilities were eligible for the credit. In its ruling, the court found that two of the five projects at issue constituted qualified research; however, it did not allow the supply QREs claimed for these projects. Notably, the court supported the use of the Cohan rule in determining a “close approximation” of QREs through interviews and oral testimony corroborated by documentary evidence. Further, the court found that credible oral testimony “sufficiently substantiated the wages paid” to certain employees—on one project, wages were determined by using estimated hours to compute qualified research percentages.
Another recent court decision, McFerrin, 570 F.3d 672 (5th Cir. 2009), discusses substantiation of the R&D credit. McFerrin dealt with a group of companies that manufactured, stored, and purified chemicals. The original district court case was decided in 2008, when the district court disallowed all credits claimed based on lack of substantiation (McFerrin, No. H-05-3730 (S.D. Tex. 5/25/08)). In June 2009, the Court of Appeals vacated the original decision for several reasons, including the fact that the district court failed to consider all relevant evidence. The Court of Appeals ruled that if the taxpayer incurred qualified expenses, the court should use the Cohan rule to estimate the amount of allowable credit. The Court of Appeals specifically stated that “the court should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.”
In Trinity Industries Inc., 691 F. Supp. 2d 688 (N.D. Tex. 2010), the court considered whether a taxpayer in the business of shipbuilding conducted qualified research and incurred QREs. The qualification of activities in the case was based on testimony and exhibits offered by Trinity. The court found that two of the six projects claimed were qualified; however, as part of its ruling it stated the following: “The Court is aware of case law instructing it to estimate the amount of QRE if it determines that the taxpayer has made some qualified expenditure. . . . In this case, however, Trinity did not offer any evidence from which the Court could make a meaningful estimate.” It is important that taxpayers have enough information and evidence in order to make a reasonable estimate.
These recent court decisions add to the body of case law available to help taxpayers understand how to properly substantiate their R&D credits (see Allen, T.C. Memo. 1988-166; Fudim, T.C. Memo. 1994-235; and Eustace, 312 F.3d 905 (7th Cir. 2002)).
The disagreement between the IRS and taxpayers about how to properly substantiate R&D credits has resulted in a significant backlog of R&D credit cases at both the field exam and Appeals levels. The authors are aware that senior leaders of the LB&I Division are actively working with taxpayers and exam leaders to resolve much of this conflict. The goal of this initiative is to listen to input and find ways to improve the R&D credit substantiation and exam processes. This recent development provides renewed hope that the IRS is committed to working with taxpayers to bridge the current divide about how to properly substantiate the R&D credit.
In order to ensure the highest possible chance of success on exam, taxpayers should rely on the best available documentation to support the QREs included in their R&D credit claims. Since the IRS will challenge any reliance on estimation or oral testimony upon exam, taxpayers should make sure to gather and retain documentary evidence to corroborate any estimates used. Taxpayers claiming the R&D credit should consult with their tax adviser to determine how they can improve their R&D credit documentation.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.