Technological innovations are critical to the future success and growth of our economy. The U.S. and most state governments have recognized this and implemented tax incentives to encourage businesses to invest in Research and Development. The Federal R&D Credit was most recently extended through December 31, 2009, by H.R. 1424, the Emergency Economic Stabilization Act of 2008, passed on October 3, 2008.

The Research and Development Tax Credit is designed to stimulate increased company spending on Research and Development 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. Qualified research expenses include wages, supplies, and contract research expenditures.

Qualified activities for the research credit must pass a four-part test:

1. Permitted Purpose: The project must be intended to be useful in the development of a new or improved business component for the taxpayer. A business component may include a product, process, technique, formula, invention, or software.
    
2. Technological in Nature: The project must be undertaken for the purpose of discovering information that is technical in nature. Thus, the activity must rely on the principles of physical sciences such as engineering, biology, or computer science.
    
3. Elimination of Uncertainty: The project must be intended to eliminate uncertainty related to the development or improvement of a business component. Uncertainty can include the capability, development method, or optimal design of the business component.
    
4. Process of Experimentation: The project must evaluate one or more alternative solutions through the development, refinement, and testing of different options. Further, technical risk must be present, which means that there is a chance the project will not be successful.

The R&D Tax Credit (IRS Code §41) was established by the Economic Recovery Tax Act of 1981, and since that time it has expired and been extended 13 times. During its 28-year history, the credit has frequently undergone significant changes and revisions. The past several years have been no different, with important developments coming from new case law, IRS pronouncements, and legislative action.

Recent Case Law – U.S. v. McFerrin

The recent ruling by the Fifth Circuit Court of Appeals in the case of 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 the original district court decision, several issues were cited in ruling that 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 district 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 also 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.

In the appellate court ruling handed down June 9, 2009, it was 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. Most importantly, the appellate court stated that the “Cohan Doctrine” allows a taxpayer to use estimates of qualified research expenses when it can be proved that qualified research activities have occurred. Further, the appeals court found that oral testimony (through interviews) and the institutional knowledge of employees is 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 the issues identified above, it is recommended that a client’s facts be aligned with those identified in the McFerrin decisions. First, utilize engineers or technical experts to evaluate and document the qualified nature of projects. Second, ensure that sufficient documentation exists to support the existence and facts of each qualified project and the array of employees involved in those qualified projects.

IRS Pronouncements

The volume of R&D Credit claims that have been filed in recent years has significantly increased. As a result, on April 4, 2007, the Research and Development Tax Credit was designated as an LMSB Tier 1 Audit Issue. Tier 1 Audit Issues are issues that, if present in an audited tax return, are required to be reviewed. Due to this, tax practitioners should expect to see an increased level of scrutiny relating to R&D Credit claims.

In May of 2008, the IRS published a revised version of its document titled “Research Credit Claims Audit Techniques Guide (RCCATG): Credit for Increasing Research Activities § 41.” The audit technique guide is not an official pronouncement of law or the position of the Service and thus cannot be used, cited, or relied upon as such. However, for the practitioner it does provide an indispensible view of how the IRS views the R&D Credit and further insight into the main issues the IRS focuses on in examination. As such, it should be considered required reading for anyone preparing an R&D Credit claim.

Legislative Action

With the passage of H.R. 1424, the Emergency Economic Stabilization Act of 2008, the R&D Credit was most recently extended through the end of the 2009 calendar year.

In addition to extending the R&D Credit, H.R. 1424 also implemented changes to the credit. First, the Alternative Simplified Credit (ASC) was increased from 12% to 14% for taxable years ending after January 1, 2009. Second, the Alternative Incremental Credit (AIC) is no longer electable after December 31, 2008. Finally, 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.

Summary

The Research and Development Tax Credit can be extremely valuable in reducing the tax liability of a business engaged in qualifying activities. Due to the heightened scrutiny the credit is receiving, however, it is recommended to proactively prepare the supporting documentation as outlined above, utilizing technical staff with a scientific background, to ensure the substantiation will align with the requirements of the IRS.


About the Author
Randy Crabtree, CPA, is a partner with Tri-Merit, LLC. He has over 20 years of public accounting experience and has focused solely on the R&D Tax Credit for the past three years. He can be contacted at rcrabtree@tri-merit.net.

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