The decision in this case, issued as a Memorandum decision by the Court, J. Vasquez, reflects the analytical complexity of the Section 41 tax credit rules for qualified research and development costs and further highlights the taxpayer’s burden to prove that it properly claimed the tax credits based on the evidence presented on the record at trial or by stipulation prior to trial, and including the submission of expert reports. The research tax credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.
General Rules Under Section 41
Section 41(a)(1) allows a taxpayer a tax credit up to an amount equal to 20% of the excess, if any, of the taxpayer’s qualified research expenses (QREs) for the taxable year (credit year) over the base amount. QREs are defined as the sum of a taxpayer’s in-house research expenses and contract research expenses paid or incurred by the taxpayer during the credit year in carrying on a trade or business. §41(b)(1). The base amount is the product of the fixed-base percentage and the ave. annual gross receipts of the taxpayer for the four years preceding the credit year. §41(c)(1). The base amount still may not be less than 50% of the QREs for the credit year. §41(c)(2). The fixed-base percentage is generally the lesser of 16% or the percentage that the aggregate QREs of the taxpayer for certain years (base period) is of the aggregate gross receipts of the taxpayer for those years. §§41(c)(3)(A) and (C).
The Taxpayer In Suder v. Commissioner
The taxpayer company, ESI, computed its research tax credit using a fixed-base percentage of 16%, the maximum allowable under the statute, for each of the years at issue. A taxpayer must determine its QREs in computing its fixed-base percentage “on a basis consistent with” its determination of QREs for the credit year (the consistency requirement). § 41(c)(6). Chief Counsel, in its pretrial memorandum, raised the consistency requirement, contending that petitioners must provide evidence as to the correct amount of ESI’s base period QREs to substantiate the research tax credits claimed. Neither petitioners nor respondent addressed the consistency requirement or ESI’s base period QREs in the opening or reply briefs. The court found that both parties conceded any arguments they might have otherwise had on the consistency requirement. See Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989); Money v. Commissioner, 89 T.C. 46, 48 (1987).
Accordingly, the taxpayer’s entitlement to the research tax credits turns on whether ESI incurred QREs during the years at issue. As previously stated, QREs are defined as the sum of a taxpayer’s in-house research expenses and contract research expenses. This consists of in-house expenses for wages paid to employees for “qualified services” and amounts paid or incurred for supplies used for qualified research. §§ 41(b)(2)(A)(i) and (ii). Qualified services consist of engaging in qualified research or engaging in the direct supervision or direct support of research activities which constitute qualified research. §41(b)(2)(B). Contract research expenses are equal to 65% of the amounts paid or incurred by the taxpayer in relation to a person other than an employee of the taxpayer for qualified research. §41(b)(3).
Therefore, to be eligible for a credit under section 41(a)(1), petitioners had to prove that ESI performed qualified research, or paid someone else to perform qualified research, during the years at issue.
The Four Tests for Qualified Research.
Qualified research is research that satisfies four tests. First, expenditures connected with the research must be eligible for treatment as expenses under section 174 (the section 174 test). Second, the research must be undertaken for the purpose of discovering technological information (the technological information test). Third, the taxpayer must intend that the information to be discovered be useful in the development of a new or improved business component of the taxpayer (the business component test). Fourth, substantially all of the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality (the process of experimentation test). A fifth test, in effect, is the limitation under section 174(e).
The tests are applied separately with respect to each business component. A “business component” is defined as a product, process, computer software, technique, formula, or invention that the taxpayer holds for sale, lease, or license or uses in its trade or business. If a business component as a whole fails the qualified research tests, the “shrinking-back rule” applies, which allows the court to apply the qualified research tests to a subset of the business component if doing so will allow the subset to satisfy those tests. See Treas. Reg. §1.41-4(b)(2). The shrinking-back rule provides that if the qualified research tests are not satisfied at the level of the discrete business component, they are then applied to the most significant subset of elements of the business component. The shrinking-back continues until either a subset of the business component satisfies the tests or the most basic element of the business component is reached and fails to satisfy the tests.
Certain types of research are specifically excluded from the definition of qualified research. They include research conducted after the beginning of the commercial production of a business component, research related to the adaption of an existing business component to a particular customer’s requirement or need, foreign research, research in the social sciences, arts, or humanities, and funded research. §41(d)(4). Furthermore, research relating to style, taste, cosmetic, or seasonal design factors is not a qualified purpose under the process of experimentation test and is thus not qualified research. §41(d)(3)(B).
A. The Section 174 Test.
The section 174 test requires that expenditures connected with the research activities be eligible for treatment as expenses under section 174. Section 174 provides alternative methods of accounting for “research or experimental expenditures” that taxpayers would otherwise capitalize. Sec. Treas. Reg. §1.174-1. The regulations define “research or experimental expenditures” as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” Treas. Reg. §1.174-2(a)(1).
At issue in the case were 12 projects undertaken incurred in connection with ESI’s trade or business. The Service contended, in challenging the claimed tax credits, that the petitioners introduced “very little evidence that showed uncertainty regarding the capability, method, or appropriate design of the 12 projects as of the beginning of ESI’s product-development activities.” The government’s expert report set forth that “[h]alf of the projects created products that merely matched products already available from other vendors. The expert opined that there was no technical challenge in those projects that would require resolving uncertainty through experimentation.” He further states that “ESI’s strength is building low-cost, easy-to-use telephone systems that match products introduced earlier by industry leaders such as Avaya and Cisco.”
The Court was not persuaded by the government’s expert and found that many statements in his report are contradicted by credible evidence in the record. Accordingly, the Court found that government’s expert’s testimony “unreliable”. That essentially left the record open for the taxpayer to prevail based on its expert testimony provided it was credible.
The taxpayers argued that “ESI provided the Court testimonial and documentary evidence of the numerous technical uncertainties it faced in building exponentially larger phone systems than it had ever attempted, adding innovative and improved software features, and incorporating the new and different technological hardware components needed to stay competitive.” Petitioners further argued that “[e]very single one of these identified uncertainties was of a type specifically contemplated by Section 41 of the Internal Revenue Code and thus eligible for consideration in ESI’s credit calculation.”
The Court agreed with the taxpayers that uncertainties as to capability, method, or appropriate design were present in all 12 projects. Each of the 12 projects began as an idea to develop a new hardware product, software product, or both. Senior management vetted the ideas in the senior product strategy meetings and followup meetings. ESI’s product managers, engineers, technicians, and other employees then transformed the ideas into commercially ready products. On the basis of the foregoing, Judge Vasquez concluded that all 12 projects satisfy the section 174 test.
B. The Technological Information Test.
The technological information test requires that the research be undertaken for the purpose of discovering information that is “technological in nature”. §41(d)(1)(B)(i). Information is “technological in nature” if it “fundamentally relies on principles of the physical or biological sciences, engineering, or computer science”. H.R. Conf. Rept. No. 99-841 (Vol. II), at II-71 through II-72 (1986), 1986-3 C.B. (Vol. 4) 1, 71-72. The government conceded that this test was met by the taxpayer.
C. The Business Component Test.
The business component test requires the taxpayer intend the information to be discovered will be useful in the development of a new or improved business component of the taxpayer. § 41(d)(1)(B)(ii). To be useful for this purpose, the research need only provide some level of functional improvement to the taxpayer. Norwest Corp. & Subs. v. Commissioner, 110 T.C. 454, 495 (1998). Again, the IRS conceded the taxpayer’s meeting this test at trial.
D. The Process of Experimentation Test.
The process of experimentation test has three elements: (1) substantially all of the research activities must constitute (2) elements of a process of experimentation (3) for a qualified purpose. §41(d)(1)(C). The “substantially all” element means that 80% or more of the taxpayer’s research activities for each business component, measured on a cost or other consistently applied reasonable basis, must constitute a process of experimentation for a qualified purpose. Norwest Corp. & Subs. v. Commissioner, 110 T.C. at 497; Treas. Reg. §1.41-4(a)(6).A taxpayer does not fail this requirement even if the remaining 20% (or less) of its research activities with respect to the business component do not constitute elements of a process of experimentation for a purpose described in section 41(d)(3) as long as the remaining research activities satisfy the requirements of section 41(d)(1)(A) (the section 174 test) and are not otherwise excluded under section 41(d)(4). Treas. Reg. §1.41-4(a)(6).
Where a business component fails the process of experimentation test because of the “substantially all “requirement, again, as mentioned above, the Court may apply the shrinking-back rule, until an element that satisfies the test is reached. Norwest Corp. & Subs. v. Commissioner, 110 T.C. at 497. A process of experimentation is “a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.” A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).
On this test the government argued that “design alternatives” of information already of public knowledge is not a process of experimentation as required. The taxpayers argued, to the contrary. Their argument was that ESI clearly had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved 1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, 2) testing these alternative in a scientific manner, 3) analyzing the results, 4) refining the initial hypothesis or discarding it for another if necessary, and 5) repeating the same, if necessary.
The Court, as per Judge Vasquez’s opinion, agreed that ESI used a process of experimentation to resolve uncertainties in all 12 projects. Contrary to respondent’s argument, publicly available knowledge describing the appropriate design of the products being designed in the 12 projects did not exist. ESI’s hardware engineers consulted data sheets, design manuals, application notes, field service engineers, and online materials for general information on components. ESI’s software engineers, researched general code design. The hardware and software engineers then applied their knowledge of engineering and computer science, respectively, to create an appropriate design for the products. On the basis of the record, the Court found that of the 12 projects 80% or more of the activities with respect to each constituted elements of a process of experimentation and found that the experimentation undertaken with respect to 11 of the 12 projects was for a qualified purpose. The Court held, therefore, that 11 of the 12 projects satisfy the four-part test for qualified research and that 91.67% (eleven-twelfths) of the 76 projects constitute qualified research.
The next issue was that of substantiation of ESI’s QREs.
IV. Substantiation of ESI’s QREs.
Where an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense. Treas. Reg.§1.41-2(d)(1). If substantially all of the services performed by an employee during the taxable year consist of engaging in qualified research or engaging in the direct supervision or direct support of research activities which constitute qualified research, the term “qualified services” means all of the services performed by the employee during the taxable year. §41(b)(2)(B)(flush language). The “substantially all” threshold is satisfied with respect to an employee if the wages appropriately apportioned to qualified research services constitute at least 80% of the wages paid to or incurred by the taxpayer for the employee during the taxable year. Treas. Reg. §1.41-2(d)(2).
The amount of wages properly allocable to qualified services is determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the employer to the total time spent by the employee in the performance of all services for the employer during the taxable year. Another allocation method may be used if the taxpayer demonstrates the alternative method is more appropriate.
A taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.. A taxpayer is not required to keep records in a particular manner so long as the records maintained substantiate his or her entitlement to the credit. Shami v. Commissioner, 741 F.3d 560, 567 (5th Cir. 2014), aff’g in part, vacating in part, and remanding T.C. Memo. 2012-78; see also T.D. 9104, 2004-1 C.B. 406, 408 (“[T]he 2001 proposed regulations do not contain a specific recordkeeping requirement beyond the requirements set out in section 6001 and the regulations thereunder.”).
Under the often-called “Cohan Rule”, where a taxpayer can prove that its employees engaged in qualified services, the Court may estimate the expenses associated with those activities. See United States v. McFerrin, 570 F.3d 672, 679 (5th Cir. 2009); see also Shami v. Commissioner, 741 F.3d at 568 (stating that the rule of Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), applies in the context of the section 41 research tax credit). The Court “should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.” McFerrin, 570 F.3d at 679 (citing Fudim v. Commissioner, T.C. Memo. 1994-235). For the Cohan rule to apply, however, a reasonable basis must exist on which the Court can make an estimate. Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); see also Shami v. Commissioner, 741 F.3d at 568-569.
The government argued that “petitioners neither substantiated the QREs claimed nor produced sufficient evidence for this Court to make reasonable estimates for QREs.” Respondent contends, specifically, that “[p]etitioners failed to provide any nexus between the expenses claimed and qualified research activities, if any, performed.”
The taxpayers argued that they did in fact introduce “sufficient and credible documentary and testimonial evidence to support the estimated percentages of time ESI’s employees spent performing qualified services during the tax years at issue.” The Court agreed.
V. A Reasonableness Test for Qualified Research Credits? Yes, in Section 174(e).
In Driggs v. United States, 706 F. Supp. 20 [63 AFTR 2d 89-804] (N.D. Tex. 1989), the District Court held that section 174 did not impose a reasonableness requirement as to the deductibility of research and development expenditures. Less than a year later, Congress added section 174(e) to the Code in the Omnibus Budget Reconciliation Act of 1989 (OBRA), Pub. L. No. 101-239, sec. 7110(d), 103 Stat. at 2325. The House report accompanying OBRA, H.R. Rept. No. 101-247, at 1203 n.12 (1989), explains that the bill provides for a rule contrary to the holding in Driggs v. United States, 706 F. Supp. 20 (N.D. Tex. 1989).
Under section 174(e) a taxpayer may deduct a research and development expenditure only to the extent that “the amount thereof is reasonable under the circumstances.” The amount of an expenditure is reasonable if the amount would ordinarily be paid for like activities by like enterprises under like circumstances. Treas. Reg. §1.174-2(a)(6). So the government challenged the reasonableness of Mr. Suder’s wages as QREs under section 174(e).
The question of reasonableness is one of fact that must be resolved on the basis of all of the facts and circumstances. Citing the multi-factor test in Mayson Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949), for determining the reasonableness of compensation the opinion listed the factors to be applied: (1) the employee’s qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with gross income and net income; (5) the prevailing general economic conditions; (6) comparison of salaries with distributions to stockholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; and (8) the salary policy of the taxpayer as to all employees. The Court found that a portion of Mr. Suder’s wages was in fact unreasonable and excessive.
VI. Accuracy-Related Penalties. When the Taxpayer Carries 11/12ths of the Case?
Pursuant to section 6662(a) and (b)(1) and (2), a taxpayer may be liable for a penalty of 20% on the portion of an underpayment of tax due to: (1) negligence or disregard of rules or regulations or (2) a substantial understatement of income tax. “Negligence” is defined as any failure to make a reasonable attempt to comply with the provisions of the Code; this includes a failure to keep adequate books and records or to substantiate items properly. Negligence has also been defined as the failure to exercise due care or the failure to do what a reasonable person would do under the circumstances. “Disregard” means any careless, reckless, or intentional disregard. §6662(c). “Understatement” means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed which is shown on the return, reduced by any rebate. §6662(d)(2)(A). A “substantial understatement” of income tax is defined as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. §6662(d)(1)(A).
The Commissioner bears the initial burden of production. Where the Commissioner satisfies his burden, the taxpayer then bears the ultimate burden of persuasion. The accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer shows that he or she acted with reasonable cause and in good faith. § 6664(c)(1).
The Court would find for the Petitioners here. It opined that regardless of whether respondent has met his burden of production, petitioners are not liable for accuracy-related penalties for 2004-07 because they meet the reasonable cause and good faith exception. While a portion of the wages were excessive the taxpayers made a honest understanding of the tax law that was reasonable in the light of all the facts and circumstances. See Treas. Reg. §1.6664-4(b). Accordingly, we find that petitioners acted with reasonable cause and good faith in claiming excessive research tax credits for 2004-07. Therefore, the Tax Court held that the petitioners are not liable for accuracy-related penalties for 2004-07.