Defending R&D credits: IRS strategies and recent cases.

• Author: Parshall, Gerald H., Jr.

This article highlights and analyzes some recent decisions concerning the research and development (R&D) tax credit and IRS administrative practices when auditing R&D credit claims, most notably the Union Carbide decision in the Tax Court. These recent developments may herald greater reasonableness about R&D credit claims--at least by the courts, and possibly by the IRS as well. For several years, the IRS has been relying on antitaxpayer R&D credit opinions with little precedential value. This article points out how that strategy conflicts with Treasury's public statements about the persuasiveness of court opinions and points practitioners to better authorities with which to counter the IRS's methods in conducting R&D credit audits.

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In 2000, the IRS and Treasury introduced and then dropped a requirement in the regulations that R&D credit claims be supported by "contemporaneous documentation." (1) This requirement demanded that researchers prepare and retain, before or in the early stages of experimentation, a description of the technical problems they faced and what was planned that "exceeds, expands or refines the common knowledge of skilled professionals in the relevant field of science or engineering." (2) The IRS and Treasury also withdrew the "exceeds common knowledge" requirement, often referred to as the "discovery test." Both requirements in the proposed regulations had received substantial public criticism.

However, at least until recently, the news has been more bad than good for taxpayers. The relaxed attitude shown by Treasury in several iterations of R&D regulations has not filtered out to the field. The IRS has been less reasonable in the guidance it is providing its auditors; predictably, this has been reflected in those auditors' examination stances. This guidance relies on questionable case law, primarily Eustace (3) and McFerrin. (4) The IRS has frequently cited these cases for the proposition that the Cohan rule does not apply to R&D credits and that R&D credits cannot be based on estimates of creditable expenses developed through after-the-fact R&D credit studies.

Revenue agents and their managers have been taking this centralized advice to heart, often completely disallowing the credit as their first negotiating point. They are supported in this by the IRS's Large and Mid-Size Business (LMSB) Division, which has designated the R&D credit as a Tier I issue, subject to centralized audit management and now almost mandatory assertion of penalties.

The advice that revenue agents are getting from the LMSB characterizes most R&D credit studies as "prepackaged submissions," often based on oral testimony, estimates, and ad hoc methodologies, which are all very difficult to audit. These criticisms appeared most recently in an audit guide (the RCCATG) (5) and an industry director directive (IDD No. 2). (6)

The newest twist appearing in the IDD is the requirement that in all examinations in which a research credit refund is partially or wholly disallowed, the revenue agent must address the penalty and obtain concurrence from one of a handful of R&D technical advisers for not asserting it. This will make the assertion of the Sec. 6676 penalty for erroneous refund claims much more prevalent, almost mandatory, for R&D credit claims.

Unfortunately for many taxpayers whose businesses are just becoming profitable or who are just becoming aware of the R&D credit, many of the criticisms leveled in those two publications are unavoidable because the traditional method of calculating the R&D credit compares the current credit years with a 1984-1988 base period, and many taxpayers' physical records may no longer exist for such years.

The tax adviser is thus faced with a dilemma: Forfeit the credit (or the greatest part of it) for a given taxpayer, even when it is clear that significant resources have been dedicated to innovation over a long period of time, or find witnesses who can recall what R&D was being conducted in the base period and obtain testimony and R&D documentation for more recent years.

The Good News

Good arguments can be made that the IRS's reliance on Eustace and McFerrin is clearly inconsistent with the regulations. This was so even before the Fifth Circuit reversed the district court's holding in McFerrin on June 9, 2009. While audit guides and IDDs are binding on neither the IRS nor taxpayers, regulations are.

The recent reversal of McFerrin and the opinion by the Tax Court in the Union Carbide case should come as good news. (7) Both of these cases, which are discussed in more detail below, are blows to the hardline stance that the IRS had taken in R&D credit cases.

In addition, in June 2009, in the FedExcase, the IRS was forced to abandon its "whipsaw" argument--that taxpayers wanting to use the IRS's internal use software rules appearing in older proposed regulations were required to submit to those older proposed regulations' adoption of the "exceeds, expands or refines the common knowledge of skilled professionals" discovery test, long since abandoned by the IRS and Treasury and recently criticized in the McFerrin reversal. (8)

Finally, in November 2009 and again in January 2010, the IRS's position on prototypes was substantially challenged by adverse decisions, first in Tax Court and then in a district court opinion. In the first decision, T.G. Missouri, (9) a manufacturer of injection-molded products sought to claim as qualified research expenses (QREs) contract work performed by third parties on molds it sold to customers. The IRS tried to resist this on the basis that the molds were "property of a character subject to the allowance for depreciation" and so were disqualified from the credit. The Tax Court held that the language used in the statute tied credit-ability to the proper financial accounting treatment of the molds in the hands of the taxpayer, not the taxpayer's customers. Because in the taxpayer's hands the molds were not properly depreciable, they were also not disqualified from the credit.

A district court decision (10) held that a shipbuilder's prototypes ("first in class" vessels) qualified as creditable business components and could further qualify as R&D where the evidence of novelty was particularly strong. Where the evidence was less strong, the taxpayer lost because it could not produce evidence allowing the district court to "shrink back" four of six first-in-class ship design projects to their experimental aspects.

What Is a Good Tax Precedent?

Treasury laid out its guidelines for evaluating tax precedents in the regulations for the penalty for substantial understatement of tax. Under Regs. Sec. 1.6662-4(a), such penalties can be reduced by the amount of an understatement attributable to an item for which there is substantial authority. Regs. Sec. 1.6662-4(d)(3)(ii) evaluates authorities as follows:

The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. Therefore, a party generally cannot rely on a case with unique facts unless the subsequent situation's facts closely match it. Similarly, a reversed case has no persuasiveness. Eustace and McFerrin, which the IRS has been relying on, cannot pass muster under Regs. Sec. 1.6662-4.

Eustace

In Eustace the taxpayer sought the R&D credit for software it had developed in house, but the taxpayer's main witness stated that they were not doing any research:

Petitioners' computer expert testified, relating to the expansion of the rating module: "It's hard for me to think about writing each of those programs as constituting...