Developing a consistent approach to the sec. 41 research credit.

• Author: Goldbas, Michael

The IRS issued two new research credit audit guides during 2005: one assists examiners in auditing research credits reported by aerospace companies, while the other assists them in applying the "process of experimentation" requirement to cases involving software development. These guidelines have implications beyond their intended scope. They recommend having examiners adopt positions on issues that relate to unsettled areas of the law. As such, they may foretell which positions the IRS will take in formal guidance it intends to issue during 2006. Moreover, they will give taxpayers a sense of the issues likely to be raised during an examination and the type of documentation that will be demanded by examiners to substantiate a credit. The practical implications of the shifts in policy reflected in these audit guidelines will be addressed here.

Aerospace Industry ATG

The "Aerospace Industry-Audit Techniques Guide," dated January 2005, begins by asking a basic question:

Why is there a need for an Aerospace Research Credit Audit Technique Guide (ATG)? ***Because the ATG zeroes in on industry specific matters, it gives background and analysis in addressing research credit issues specific to the Aerospace industry and therefore provides direction to the Aerospace examiner not covered in other audit technique guides. ("Aerospace Industry--Audit Technique Guide--January 2005," p. 1, 2005 TNT 146-147)

While the ATG focuses on research credit issues prevalent in the aerospace industry, it covers many topics that have broad applicability to other business sectors. First, it addresses the Sec. 41(d)(4)(H) exclusion for "funded research." Research performed on behalf of another person is "funded," and thus ineligible for the credit, to the extent the contractor is entitled to payment regardless of whether the research is successful or whether the contractor does not retain substantial rights in the research; see Regs. Sec. 1.41-4A(d); Fairchild Industries, Inc., 71 F3d 868 (Fed. Cir. 1995); and Lockheed Martin Corporation, 210 F3d 1366 (Fed. Cir. 2000).

In Lockheed Martin, the court determined that a defense contractor had substantial rights to the research because the contractor was allowed, subject to certain restrictions, to use the research results to develop future products for sale or license to customers. In some cases, however, the contractor's rights to the research results were limited to future work performed for the same customer that originally paid for the research. The ATG notes that whether the contractor in this instance retains "substantial rights" is unresolved and currently being litigated in a Tax Court case. Also, according to the ATG, contracts often have different payment terms for each of the line-item deliverables due under the contract. Thus, it advises examiners that they need to resolve the "funding" issues based on the terms of each line item--which is consistent with the fact that contractors often perform a mix of funded and unfunded research activities under a single contract; see Regs. Sec. 1.41-4A(d)(3), providing that contracts can be partially funded.

The ATG further addresses the so-called "cascading credit" argument raised in Lockheed Martin, 49 Fed. C1. 241 (2001). The cascading credit potentially occurs when the prime contractor treats a prototype component developed by a subcontractor as a "supply" used in the contractor's research effort, while the subcontractor treats its development of the same component part as qualified research. In the case, the government argued that the prime contractor...