The research credit: Documenting qualified services

Editor: Alexander J. Brosseau, CPA

A recent Tax Court case illustrates the importance of documenting and substantiating employee wages that are being included in the research credit under Sec. 41. In Moore, T.C. Memo. 2023-20, the IRS challenged an S corporation’s substantiation of qualified time performed by the company’s president and COO. This item discusses guidance regarding qualified services, observations from Moore and other case law, other recent developments, and considerations that taxpayers may need to make when claiming and defending research credits.

Code and regulations

Sec. 41 allows taxpayers to claim a research credit on the incremental amount of qualified research expenditures (QREs) that they pay or incur during a tax year. QREs include inhouse research expenses, such as wages, supplies, and computer rental costs, as well as contract research expenses. In many instances, the largest portion of QREs claimed by a taxpayer relate to wages for individuals performing qualified services. Sec. 41(b)(2)(B) defines qualified services as “(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.”

Regs. Sec. 1.41-2(c) further defines engaging in qualified research as “the actual conduct of qualified research (as in the case of a scientist conducting laboratory experiments).” In addition, “direct supervision” is defined as “immediate supervision” but excludes supervision by a higher-level manager to whom first-line managers report, even if the manager is a qualified research scientist. Lastly, “direct support” is defined as either conducting actual qualified research or directly supervising the actual conduct of qualified research.

The regulations provide examples of what does and does not constitute direct support; for example, “general administrative services, or other services only indirectly of benefit to research activities” do not qualify as direct support. It appears that the IRS has been successful in recent cases in contesting taxpayers’ application of direct support. As with other tax issues, taxpayers bear the burden of proof, and in cases where taxpayers are not able to provide proof regarding the direct support or direct supervision of qualified research, the IRS has been prevailing on these issues.

Additionally, Regs. Sec. 1.41-2(d)(2) provides the “substantially all” test, which states that “if substantially all of the services performed by an employee for the taxpayer during the taxable year consist of services meeting the requirements of [Sec.] 41(b)(2)(B)(i) or (ii), then the term ‘qualified services’ means all of the services performed by the employee for the taxpayer during the taxable year.” Under this provision, if at least 80% of an employee’s activity was for qualified research or direct supervision or direct support of qualified research, then all the employee’s wages are eligible as QREs.

Moore and substantiating engagement in qualified research

In Moore, the IRS challenged the taxpayer’s substantiation of qualified time regarding the company’s president and COO, identified in the Tax Court’s opinion only as “Mr. Robert.” Court documents showed Robert devoted much of his attention to new product development. This was supported by the fact that Robert was an engineer by trade and left most administrative aspects of his job to other executive leaders. The opinion describes Robert’s participation in four sample projects for which he defined and specified requirements for new and improved products and developed them with the company’s engineers.

Despite Robert’s testimony at trial that the court considered corroborated by others, detailing his roles and responsibilities, the court ultimately disallowed the inclusion of a portion of his wages and time in computing the taxpayer’s QREs, based on two key points: First, the record provided “no estimates of the amount of time Mr. Robert spent on qualified research as distinguished from the broader category of new product development.” For example, the court noted that specifying and developing requirements for a product is not qualified research, yet the amounts were included within the represented time. The court had no means to segregate that time from that of other, potentially qualifying activities. Second, the court reasoned Robert’s time could not be captured under the “supervisory” definition, as Robert was not the engineers’ first-line manager. Additionally, the court ruled that Robert did not provide direct support as that term is defined in the regulations.

Ultimately, the Moore case is a reminder to taxpayers that, although time estimates may be used when determining the portion of an employee’s wages to be treated as QREs, those estimates should be carefully tied to specific qualified (and nonqualified) activities. Taxpayers may also need to consider documenting wage QREs for each category of qualified services.

Other case law

Time spent on qualified services: A foundational case when it comes to the substantiation of time allocations is Fudim, T.C. Memo. 1994-235, which revolved around the substantiation of qualified time claimed by Efrem and Margarita Fudim and their daughter, Natalie. Mr. and Mrs. Fudim were heavily involved in the development of new rapid modeling processes using ultraviolet light and light-sensitive liquid polymers to fabricate plastic objects. Court documents showed that both Mr. and Mrs. Fudim had an extensive technical background in the field. With no time-tracking systems used by the company, the Fudims estimated they spent at least 80% of their time engaging in qualified services.

Despite the couple’s lack of formal time tracking or documentation regarding time spent, the court applied the Cohan rule (Cohan, 39 F.2d 540 (2d Cir. 1930)), under which the court agreed with the time allocations claimed by the Fudims. The court based its decision on the corroborating evidence presented at trial, including employee testimony, scientific articles Mr. Fudim had published, and patents he had filed, as well as both spouses’ technical backgrounds. However, the court removed the time of their daughter, for whom no contemporaneous documentation was provided to support the allocation. This case illustrates that companies without time-tracking systems or other timekeeping records can use estimates of time to compute research credits; however, those estimates must be supported through corroborating evidence.

Process of experimentation and “substantially all” test: In Little Sandy Coal Co., T.C. Memo. 2021-15, aff ’d, 62 F.4th 287 (7th Cir. 2023), the IRS challenged whether the taxpayer’s shipbuilding activities were qualified research activities. The majority of the substantiation the taxpayer provided was oral testimony; the Tax Court found this mostly lacking. For example, the taxpayer provided estimated wage expenses that were not based on specific projects. Although the taxpayer could identify the individuals contributing to the estimated wages, i.e., engineers and managers of the company’s subsidiary, Corn Island Shipyard Inc. (CIS), the oral testimony merely indicated that they contributed to the wage research expenses instead of describing the specific activities that the wages were related to.

Some of the oral testimony was intended to support the taxpayer’s assertion that its ship design activities constituted a process of experimentation as defined in Sec. 41(d)(3)(A), such as the statement by Brian Varner, CIS’s engineering technician: “We have to feel pretty comfortable with a design before we start cutting steel. Any repairs or modifications become very costly very quickly.” Varner’s statement was confirmed by the IRS’s expert’s report, which also concluded that the uncertainty of the appropriate design was basically resolved prior to assembly.

However, the Tax Court held, and the Seventh Circuit ultimately agreed (although disagreeing with some aspects of the Tax Court’s reasoning), that the taxpayer did not substantiate that substantially all of the claimed activities constituted elements of a process of experimentation. Uncertainty with respect to some of the claimed activities, such as determining the appropriate design of a new dry dock model, was not resolved until the design was finally tested and thus not eliminated by experimentation, the Tax Court stated. The Seventh Circuit agreed, stating that in developing the dry dock, the taxpayer “did not document whether hypotheses and alternatives were tested and refined in a scientific manner.”

With respect to the use of estimates, the Seventh Circuit stated, “Only after a taxpayer establishes that qualified research has occurred under Section 41(d) may we estimate, if needed, the amount of qualified research expenses under Section 41(b).”

A takeaway from Little Sandy Coal is that oral testimony alone is insufficient to substantiate that substantially all of the activities constitute elements of a process of experimentation for qualified research activities, especially when a taxpayer’s research credit claim relies on estimates.

In Betz, T.C. Memo. 2023-84, the Tax Court reached varying conclusions of whether the taxpayer had substantiated qualified research in each of a sampling of projects. The court echoed other cases by stating that the Cohan rule will not apply to estimating wages paid or incurred if the taxpayer fails to make a threshold showing that a particular employee performed activities that constituted qualified services with respect to a business component. Further, the Tax Court clarified that the Seventh Circuit in Little Sandy Coal addressed the substantiation burden that taxpayers claiming the research credit bear and determined that shortcut estimates of experimentation that rely merely on trial testimony that basically asks courts to “take on faith” their allocations are insufficient without further documentation to support the testimony.

For example, in Betz, the taxpayer failed to substantiate technical uncertainty through an employee’s testimony that the final design of components as a whole in a proposal delivered to a customer were “significantly different” than the initial design. Therefore, the majority of the uncertainty had been resolved prior to incurring or paying the subsequent wages.

In contrast, a project related to the design of an oxidizer was concluded to establish that uncertainty existed regarding the design of a gas train component, based on email correspondence that fleshed out the specifications and alternatives related to the uncertainty. However, the Tax Court went on to state that allocating a de minimis estimated amount of wages to the email activity, pursuant to the Cohan rule, would be futile because the activities were not part of a structured process of experimentation.

A key lesson learned from Betz is that trial testimony is not only insufficient to substantiate qualified research activity without further contemporaneous documentation, but it is also insufficient to dispute contrary evidence in contemporaneous documentation, such as a final proposal delivered to customers or clients. The court stated several times that a contract supporting the trial testimony would have sufficed to substantiate the taxpayer’s testimony.

In Suder, T.C. Memo. 2014-201, the IRS challenged the taxpayer’s substantiation of qualified research expenditures, particularly wages, to compute the research credit. Allocations of qualified time were estimated by the company’s senior vice president of product operations, Harvey Wende. The IRS challenged Wende’s prepared time allocations, arguing he lacked the tax or accounting educational background to make reliable estimates. The court disagreed, citing Wende’s knowledge on the subject, having worked with a research credit consulting firm previously to claim the company’s research credit. Additionally, the court placed heavy emphasis on Wende’s credible testimony regarding the roles and responsibilities of the qualified individuals.

Suder demonstrates that time estimates can and should be employed in instances where time-tracking data does not exist, so long as those estimates are made by individuals who have the institutional knowledge and the educational background to reliably make them and other documentary evidence exists in the record. It is also important to note that the court did not challenge Wende’s practice of first leveraging the prior-year R&D percentage as a starting point, then considering whether the employee’s role had changed since the prior year, as well as allocating small percentages of time to employees outside product development (i.e., quality assurance or shipping and handling) to the extent they assisted product development. This point supports the notion that it is the individual’s yearly activities, not their job title, that should be assessed when determining qualification.

In Shami, T.C. Memo. 2012-78, the IRS challenged the taxpayer’s substantiation of wage qualified research expenditures for the company’s CEO and a vice president. Similar to the other cases discussed here, the company used estimates of time to compute qualified wage spending. However, unlike in Suder, the employee testimony presented in the case was inadequate, as several witnesses contradicted each other when discussing the engagement of the CEO and vice president in qualified research activities. Additionally, neither executive had any sort of training or extensive technical background in science or engineering. Despite these facts, the taxpayer argued the court was bound to apply the Cohan rule and estimate the amount of time the executives engaged in qualified research. However, with noncredible and conflicting testimony, along with no other corroborating evidence, the court disagreed, citing the lack of evidence established to make the estimate.

The Shami case is an important reminder that, although estimates can be used, there must be some level of contemporaneous documentation and credible corroborating testimony with which the court can make the estimate. Courts are not bound to apply the Cohan rule in instances where sufficient evidence is not produced.

Other recent developments

On Sept. 15, 2023, the IRS issued a news release (IR-2023-173) requesting feedback on a preview of proposed changes to Form 6765, Credit for Increasing Research Activities, for the 2024 tax year. The proposed Form 6765 included several new reporting requirements for taxpayers to claim the research credit. One of these proposed requirements is for taxpayers to show, for each business component, the breakout of wage QREs to qualified research, direct support of qualified research, and direct supervision of qualified research. The inclusion of this reporting requirement illustrates the IRS’s continued focus on substantiation of qualified services.

On Sept. 29, 2023, Treasury and the IRS issued their 2023–2024 Priority Guidance Plan, which contains a list of projects that they will prioritize from July 1, 2023, through June 30, 2024. The second priority under the General Tax Issues section of the Priority Guidance Plan is the need for regulations under Sec. 41 that address research credit substantiation. Taxpayers should be aware that research credit substantiation continues to be a priority for Treasury and the IRS and that further guidance may be issued.

Readiness to adapt

Given that the burden of proof is on the taxpayer to substantiate research credit claims, it would be prudent for taxpayers to consider recent events and case law when evaluating their methodology for determining and documenting qualified services. This may include analyzing how employee time and expenditures are captured and tied to the appropriate categories of qualified services and business components and, in particular, what documentation supports that substantially all of the activities are a process of experimentation. This may better position taxpayers to implement any potential changes in reporting requirements and technical guidance that may be on the horizon.

Editor Notes

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. For additional information about these items, contact Brosseau at abrosseau@deloitte.com. Unless otherwise noted, contributors are associated with Deloitte Tax LLP.

This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.