Evolving Tax Credits
California CPA October 2009
Keeping up with the ever-changing R&D tax credits.By Randy Crabtree, CPA
The research and development tax credit has seen important developments over the past few years stemming from case law, IRS pronouncements and legislative action. Indeed, the Emergency Economic Stabilization Act of 2008 most recently extended the credit through Dec. 31.
The credit is designed to stimulate increased company spending on R&D activities over time by reducing taxes. In general, a qualifying company is eligible to deduct from corporate income taxes an amount equal to 20 percent of qualified research expenses above a base amount.
The base amount is a calculation of a company’s ratio of qualified research expenses to gross receipts during a given time period multiplied by current gross receipts, dependent on the year the business was founded.
Qualified research expenses include wages, supplies and contract research expenditures. Qualified activities for the research credit must pass a four-part test:
- Permitted purpose.
- Technological in nature.
- Elimination of uncertainty.
- Process of experimentation.
Recent Case Law: U.S. v. McFerrin
A June ruling by the Fifth Circuit Court of Appeals in U.S. v. McFerrin established new guidance and precedence for the examination of R&D tax credit claims and will likely be heavily relied upon by taxpayers in future examinations.
In its decision, the original district court cited several issues that indicated it was not persuaded that qualified research for the purposes of the research tax credit took place.
First, the court took issue with the fact that the evaluation of qualified activities and the calculation of the credit were not conducted by engineers or anyone with meaningful scientific experience. Second, the company was unable to produce any records of the hours worked on any given project or the hours worked or supplies used that involved research. Third, and most significantly, the court held that research only qualified if it expanded or refined the existing principles in a technical field and had a high threshold of innovation (known as the “discovery test”). Finally, the court held that qualified research only applied if a process of experimentation occurred that involved the forming and testing of a hypothesis, rather than “trial and error” testing.
The appellate court found that the:
- District court had used incorrect applications of the discovery test and process of experimentation by applying the wrong legal standards and failing
- to consider all the relevant evidence of the taxpayer;
- “Cohan Doctrine” allows a taxpayer to use estimates of qualified research expenses when it can be proved that qualified research activities have occurred; and
- Oral testimony and the institutional knowledge of employees are acceptable in determining estimates.
Based on this, the appellate court vacated the district court’s original ruling and sent it back for further proceedings consistent with the appellate court’s findings.
Given these issues, it is recommended that a client’s facts be aligned with those identified in the McFerrin decisions: utilize engineers or technical experts to evaluate and document the qualified nature of projects, and ensure there is sufficient documentation to support the existence and facts of each qualified project and the array of employees involved.
IRS Pronouncements
As a result of the significant increase in recent years in R&D credit claims, the credit was designated as an LMSB Tier 1 Audit Issue as of April 4, 2007. Tier 1 Audit Issues are those that, if present in an audited tax return, must be reviewed. Due to this, tax practitioners should expect to see an increased level of scrutiny relating to R&D credit claims.
In May 2008, the IRS published a revised version of “Research Credit Claims Audit Techniques Guide (RCCATG): Credit for Increasing Research Activities Sec. 41.” Though this is not an official law pronouncement or IRS position, and thus cannot be used, cited or relied upon as such, it does provide practitioners with an understanding of how the IRS views the R&D credit and further insight into the main issues the IRS focuses on in examination.
Legislative Action
Other changes implemented by the Emergency Economic Stabilization Act of 2008 include:
- The Alternative Simplified Credit was increased from 12 percent to 14 percent for taxable years ending after Jan. 1, 2009;
- The Alternative Incremental Credit was no longer electable after Dec. 31, 2008; and
- A technical correction was made to modify the computation of the research credit’s base amount for a tax year in which the credit was not in effect for the entire year.
Randy Crabtree, CPA is a partner with Tri-Merit, LLC.
