Substantiating the research tax credit.

• Author: Klahsen, Rick

Research tax credits present unusual problems of documentation and support. Substantiating activities and expenses to meet the statutory definition of "research" often requires subjective judgments, subject to disparate interpretations. These issues often play out in contentious IRS examinations of the research credit. Fortunately, developments in the past few months may soon give taxpayers some much-needed guidance in this area.

Ever since the IRS designated research tax credit refunds as a Tier I examination issue, IRS examinations of the credit have become increasingly difficult. IRS examiners routinely deny research tax credit claims by requiring taxpayers to adhere to exacting documentation standards. Although specific documentation standards have never been a part of Treasury regulations under Sec. 41 or other guidance to taxpayers, examiners have imposed strict requirements in order to limit research credit claims.

Developments over the past several months may signal some movement on documentation issues. Two significant cases--McFerrin, 570 F.3d 672 (5th Cir. 2009), and Union Carbide Corp., T.C. Memo. 2009-50--have allowed more flexibility in documenting the research tax credit.

In the McFerrin case, the taxpayer filed a claim for refund for the 1999 tax year based on a flowthrough of research tax credits from four subchapter S corporations. Although the IRS paid refund claims to the S corporation shareholders, it later filed suit to recover the refunds as erroneously issued under Sec. 7405. The case ended up in U.S. district court. The government argued that there was insufficient documentation to support the research tax credit because the taxpayer relied on estimates in determining qualified research expenses. The district court ruled in favor of the government and disallowed the tax refunds based on the research tax credit.

On appeal, the Fifth Circuit reversed the district court and reinstated the tax refunds. The court held that taxpayers can use a fair estimate of time and expenses to calculate the credit. "But the court should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate."

Shortly after the Fifth Circuit issued its decision in McFerrin, the Tax Court weighed in on the research tax credit in Union Carbide Corp. The taxpayer filed claims for refund based on additional expenses that it believed now qualified for the research tax credit. On its...