Some of you may have spent many nights in the grips of a TV crime series or real-life court case; you speculate on the accused, the innocent…the evidence. Whether fact or fiction, in these dramas, the arrest or verdict always comes down to the evidence. It can prove guilt or innocence. But without compelling evidence, justice is not served, and the appropriate outcome is mislaid.
Crime isn’t the only area where evidence rules critical. Claims for the federal research and development (R&D) tax credit are also bound to appropriate evidence. Without proper documentation and supportive facts, organizations stand to lose great potential savings.
(Lack of) Evidence in Action
A recent R&D ruling handed down by the U.S. Tax Court in Siemer Milling Company v. Commissioner once again highlights the need for taxpayers who claim the research credit to keep and maintain records that sufficiently establish all elements of the credit’s four-part test.
In particular, the court heavily emphasized the lack of evidence that was necessary to prove that the taxpayer engaged in a process of experimentation during the claimed projects.
After receiving a notice of deficiency from the IRS disallowing the claimed research credit, the taxpayer filed suit, arguing that the Commissioner incorrectly denied the organization’s credit.
At trial, the taxpayer presented the expert testimony from one of the company’s employees who described the uncertainties present in each of the seven underlying research projects; the uncertainties that the taxpayer sought to eliminate through research.
After the court’s summarization of section 41 law and its associated treasury regulations, it noted that the process of experimentation element of the research credit required “a more structured method of discovering information than section 174” imposed.
Expanding on this statement, the court recounted its opinion in Union Carbide Corp. & Subs. v. Commissioner, writing:
We have previously explained that “the project must involve a methodical plan
involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis,
and retest the hypothesis so that it constitutes experimentation in the scientific sense.”
For example, the regulations explain that the “evaluation of products available from
vendors is not a process of experimentation.”
The Court Concurs
With the process of experimentation requirement framed this way, the court agreed with the government’s argument that the taxpayer failed to provide any evidence in the record that the organization “formulated or tested hypotheses, or engaged in modeling, simulation, or systematic trial and error.” The court found the study “…included very little evidence of Siemer’s asserted process of experimentation.”
The court ultimately concluded that the taxpayer failed to establish that any of the projects underwent a process of experimentation. It explained that the taxpayer offered very little evidence that it utilized “a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense” in any of the claimed projects.
Failing the Tests
Though the court’s focus on the lack of sufficient evidence mostly centered on the four-part test’s process of experimentation prong, it also found several of the claimed projects failed to establish other elements of the test, including the business component test.
The court determined the evidence provided by the taxpayer merely provided conclusory statements without any detail as to how and why it met the elements of the four-part test.
And the Verdict is…
Siemer v. Commissioner does not create new law or signal a significant departure from the court’s previous interpretations of section 41. Rather, it provides helpful insight into the evidentiary requirements necessary to substantiate the research credit.
It underscores the taxpayer’s necessity to provide detailed information from testimony and records on its research activities – with scrutinizing attention paid to identifying, implementing, and memorializing a methodical plan, which involves a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis at the outset of its research activities.
It also demonstrates that conclusory statements are not sufficient to demonstrate the taxpayer has met an element of the four-part test.
The Siemer decision emphasizes the need to confer with a tax consulting professional who specializes in calculating and substantiating the research credit.
The taxpayer in Siemer relied on a general-purpose accounting firm to perform its research and development tax credit study. The Tax Court previously recognized in Suder v. Commissioner that proper application and substantiation of the research credit is notoriously difficult, writing:
“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.”
Gather Your Evidence
The Siemer decision further substantiates this statement, demonstrating that even sophisticated tax professionals who do not specialize in the research credit can struggle to effectively meet its meticulous requirements. Accordingly, companies should prioritize retaining professional services from firms that focus on this intricate tax incentive.