The US Tax Court (the Court) recently issued a decision, holding that the Petitioners were not entitled to a research and development (R&D) credit under Internal Revenue Code (I.R.C.) § 41. Petitioners in the consolidated cases are shareholders in an S-Corporation, Catalytic Products International, Inc. (“CPI” or “the Company”), that designs and supplies air pollution control systems. CPI claimed a research credit under I.R.C. § 41 in connection with 19 projects, based on both employee wage expenses and supply expenses incurred in connection with the projects and systems the Company supplied. The Internal Revenue Service (IRS) issued a notice of deficiency related to the credit claim, and the Petitioners subsequently filed a timely petition with the Tax Court.

Background

CPI was founded in 1969 and operated as a manufacturer. However, beginning in 1987, CPI transitioned its business away from manufacturing, and instead began operating as a designer and supplier of custom-built air pollution control systems, primarily catalytic and thermal oxidizers. During 2014, the tax year at issue, CPI supplied both catalytic and thermal oxidizers used for eliminating certain environmentally hazardous airborne manufacturing byproducts, including volatile organic compounds (VOCs).

What Was At Issue?

The Court analyzed many issues related to the Petitioners’ R&D credit claim, including the threshold issue of whether the research met the foundational I.R.C. § 174 requirements. Specifically, to be qualified for purposes of the R&D credit, research expenditures must satisfy the requirements of section 174. § 41(d)(1)(A). Treas. Reg. § 1.174-2(a)(1) provides that to be “research or experimental expenditures” under 174, the expenditures must be for “activities intended to discover information that would eliminate uncertainty.” Uncertainty exists “if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.” In other words, the Court provided, the Petitioners were required to show that “(1) information was not available to CPI establishing the appropriate design of the oxidizers and (2) CPI undertook investigative activities intended to discover such information.”

The IRS contended that Petitioners failed to meet this requirement. Specifically, the IRS argued that CPI’s employees’ activities were not intended to discover information that would eliminate uncertainty regarding the development of the systems. Petitioners countered that CPI faced uncertainty as to the appropriate design of each system because the appropriate design of each system could not be established until after that system cleared various onsite tests. Petitioners further argued that uncertainty existed because “the prospect of revising or altering the design of the overall system existed” in each of its projects.

The Court rejected the Petitioners’ blanket argument, providing that “postproduction testing on a product does not establish that its appropriate design as a whole remained uncertain.” The Court also determined that this issue required a more in-depth examination of the employee activities on each of the 19 projects. Throughout its analysis of each project, the Court highlighted various items at issue. However, the common theme was that CPI failed to establish “investigative” activities for nearly every project. Further, CPI relied on “vague testimony” and lacked the requisite substantiation to prove even the threshold 174 standards to be eligible for section 41 qualification. The Court cited the Seventh Circuit’s opinion in Little Sandy Coal Co. v. Commissioner 62 F.4th at 298:

“‘Uncertainty’ in Section 174 means something more…Expenses incurred merely to determine whether a product is built to satisfy a client’s desired specifications—without any indication that the expenses were incurred to improve or develop the concept of the product—do not qualify.”

For example, on one of the 19 projects, CPI performed basic calculations to determine the required duct size based on revised airflow specifications provided by the customer. The Court provided that these basic calculations were not investigative activities under the meaning of 174. Rather, CPI already had the information needed to address the unknown and did not produce any credible evidence as to what investigative activities were performed.

Supplies

Further, the Court also evaluated whether the supply of Qualified Research Expenditures (QREs) for all 19 projects would be eligible under section 174, and therefore potentially qualified under section 41 for the credit. For many of the reasons related to establishing and resolving uncertainty related to the product, the Court found that the Petitioners failed to meet their burden of proof. Further, the Court also pointed out that the supply QREs claimed as part of the credit corresponded to payments made by CPI to various subcontractors and suppliers for the costs of fabricating, assembling, and supplying components of the oxidizers. However, the Court noted that CPI did not itself fabricate, assemble, or manufacture any components. The Court also noted that the “supply” label used by petitioners was partially a misnomer, since the claimed supply QREs appear to encompass supply expenses, but also payments made to subcontractors for services.

Credibility and Substantiation

As part of the Court’s analysis of the wage QREs, the Court addressed whether the wages of certain employees were incurred in connection with the performance of qualified services, and whether the wage QREs were credible. The Court noted that Petitioners largely relied on the trial testimony of two employees to carry their substantiation burden. The Court found the testimony to be credible “with respect to the basic facts of CPI’s business process and the technical background of oxidizers,” but also “vague, in conflict with the record, and lacking in credibility with respect to their self-serving characterizations of some of the work performed by CPI on specific projects.”

The Court also quoted the Seventh Circuit in Little Sandy Coal, noting that “shortcut estimates of experimentation-related activities will not suffice…something more, such as documentation of time spent on such activities, is necessary.”

Takeaways Moving Forward

This case highlights the continued emphasis on many issues consistently before the court – qualified activities, substantiation, and funded research. However, this case also serves as a cautious reminder not to forget the foundational requirements necessary for a successful R&D claim. To qualify expenditures for purposes of the R&D credit, research expenditures must first satisfy the threshold requirements of section 174. Companies that perform qualified activities must also be able to demonstrate and substantiate these activities for a successful R&D credit claim. Lack of documentation, credible testimony, and expertise can result in credit denial and disallowance. In the words of the Seventh Circuit, no shortcuts.

As the courts continue to emphasize the importance of proper documentation, it is critical to partner with a firm that understands the process by industry and what is necessary to best support a taxpayer’s R&D tax credit claim. Contact CTI today and let our team of R&D experts work to maximize your credit and help you gather, produce, and maintain a package tailored to satisfy the latest case law and regulatory changes.