Two recent court opinions – Moore v. Commissioner and Little Sandy Coal v. Commissioner – reiterate the pitfalls of claiming the Research & Development (R&D) Tax Credit without sufficient documentation. In both cases, the courts completely disallowed the taxpayers’ R&D tax credit despite recognition that the taxpayers undertook R&D activities and had some level of R&D expenses. The issue was that the taxpayers did not meet their burden of proof to show that all of the activities and associated expenses qualified, and the taxpayers did not provide a reasonable basis for estimating what portion could be properly included.
In Moore, the taxpayer and sole owner recognized pass-through credits on her personal return from credits claimed on Nevco’s corporate returns. The only issue before the court was whether the taxpayer was entitled to claim the R&D Tax Credit expenses under section 41 for compensation paid to Mr. Robert, who was the President and Chief Operating Officer during the relevant tax years. The qualification of the projects and inclusion of the other wage expenses was previously settled.
In its analysis, the Court took the time to detail several new or improved products developed by Nevco, a manufacturer, during the relevant tax years as well as Mr. Robert’s participation in each project. The court heard credible testimony that Mr. Robert spent 50% to 65% of his time on new product development. Additionally, the court conceded that many of the activities detailed through the testimony of Mr. Robert’s activities may have constituted qualified research. One example of such work was his contribution to the Scorbitz project, which resulted in Mr. Robert being named on the resulting patent. However, the court explained that the same testimony included activities categorized as product development that were not qualified research, such as second-level oversight of the engineering team.
Ultimately, the court determined that Nevco and Moore could not claim any of Mr. Robert’s wages towards the R&D tax credit. Although testimony supported that a significant portion of his time was spent on “new product development,” not all of that time was qualified under the requirements of section 41, and the taxpayer provided no documentation to parse Mr. Robert’s time between qualified and non-qualified new product development activities.
Learn More: Seventh Circuit Weighs in on Little Sandy Coal
Little Sandy Coal
The taxpayer in Little Sandy Coal experienced a similar outcome to Moore. The US Court of Appeals for the Seventh Circuit recently affirmed the US Tax Court’s decision disallowing the taxpayer’s credit based on its failure to establish that the projects claimed met the statutory threshold that 80% or more of the activities must constitute elements of a process of experimentation. In its opinion, the court accepted that portions of the projects were likely qualified:
We recognize also that the Tanker’s stern notch and towing bridle, as well as the Dry Dock’s outboard side plate, among other elements, went through several design iterations. The research activities to develop these parts may very well constitute elements of a process of experimentation. But… the taxpayer’s documentation lacks the necessary detail to prove that.
While the court acknowledged that the tax code does not define the exact documentation necessary to support the credits, the taxpayer must produce sufficient information to support the qualification of the identified business component, in this case, first-in-class vessels. The court cautioned that “other taxpayers seeking to avail themselves of the research tax credit would be well-advised to document research activities for subcomponents if they cannot demonstrate a process of experimentation at the business component level.” Further, the court explained that in the absence of documentation related to the activities performed, no estimation of qualified expenses can be performed.
Whether the challenged issue is the allocation of an individual’s time or qualification of projects, if the court cannot identify a reasonable basis for estimating the qualified expenses, the taxpayer will receive no benefit. The Seventh Circuit summed up its decision by saying:
Taxpayer claimed more tax credit than it could prove. Taxpayer did not offer a principled way to determine what portion of the employee activities … constituted elements of a process of experimentation, much less research activities.
With the most recent guidance from the courts, it is more important than ever to have an established R&D team to guide your company through identifying and quantifying the proper R&D activity and expenses. Get advice from one of our Tax Professionals today! CTI can help navigate you through these changes and how they apply to your specific business to maximize your tax savings.