Taxpayers rejoice! A recent case decision signals good news for the R&D legal landscape—Audio Technica U.S., Inc. v. U.S. In this case, the taxpayer was a manufacturer of high-quality audio and microphone equipment. After being denied its claimed research credit during audit, the taxpayer sought to litigate the issue through the Northern District of Ohio in June of 2019 in an 8-person jury trial.At trial, the taxpayer presented over 6,000 pages of documentation, additionally offering the testimony of seven witnesses. Interestingly, the government offered no evidence or expert testimony of its own—instead relying on the arguments that the taxpayer had not met its burden in proving and substantiating its entitlement to the credit. Unpersuaded, the jury reached a unanimous verdict in favor of the taxpayer, finding that all 5 business components at issue in the case were qualified. Furthermore, the jury found that the wages, supplies, and contract research expenses claimed to be “reasonable under the circumstances” as required under Internal Revenue Code Section 174.
This may prove to be one of the most impactful consequences of the decision, as it provides valuable numerical information as to what expenses are “reasonable under the circumstances.” Prior to this decision, the only direct R&D guidance available was Suder v. Commissioner, a case involving a telecommunications taxpayer in which the government challenged wages paid to the Company’s founder and CEO as being unreasonable under the circumstances. In reaching its decision, the court identified eight factors to be considered in determining whether a particular expense incurred is reasonable:
- The employee’s qualifications;
- The nature, extent, and scope of the employee’s work;
- The size and complexities of the business;
- A comparison of salaries paid with gross income and net income;
- The prevailing general economic conditions;
- Comparison of salaries with distributions to stockholders;
- The prevailing rates of compensation for comparable positions in comparable concerns; and
- The salary policy of the taxpayer as to all employees.
While Suder has certainly been an illuminating case, its eight-factor analysis made clear that the reasonableness test would always be an intensely fact-specific examination. Consequently, the Audio Technica case provides experts more valuable insight into the factual underpinnings of what makes an expense reasonable under the circumstances. It may also be evident that juries are potentially more sympathetic to the arguments of taxpayers when applying broad multi-factor standards like the Suder analysis than a similarly situated judge in a bench trial.
While still cause for celebration, an appeal to the 6th circuit by the government over the decision is currently active and remains ongoing. While we hope for an encore performance from the appellate court, as always CTI will continue to monitor these critical R&D case developments and provide updates as they occur. For more information on these changes and other tax questions, please consult a tax specialist.