By: Paige Riordon, R&D Tax Credit Leader
Like most years, as 2023 came to an end we saw a lot of discussion around picking a “Word of the Year”. These discussions were from individuals as they try to set a focus for the new year as well as from dictionary publishers as they look for what word was searched the most in the current year. After reflecting on the discussion around R&D tax credits from last year, and the conversations happening this year, we decided to jump on the bandwagon and choose a word of the year for R&D tax credits. As we look back at court cases over the past year and think through where taxpayers should focus for future R&D tax credit claims, the choice was easy – SUBSTANTIATION. Taxpayer’s substantiation requirements are defined in Treas. Reg. Section 1.41-4(d) “Taxpayer must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” Throughout 2023 we saw several court cases where the courts disallowed R&D tax credits emphasizing inadequate substantiation.
Little Sand Coal, Inc. v. Commissioner 62 F.4th 287 (7th Cir. 2023): The US Court of Appeals 7th Circuit affirmed the Tax Court’s disallowance of Little Sandy Coal, Inc.’s R&D tax credit stating the “Taxpayer asks us to take on faith that the percentage allocations of each nonproduction employee’s wages were only for research activities that involved a process of experimentation. But Section 41(d) requires us to walk by sight, not by faith. Taxpayer has the burden to document that the activities accounted for by the nonproduction wages were elements of a process of experimentation…Something more, such as documentation of time spent on such activities, is necessary.”
Moore v Commissioner, T.C. Memo 2023-20: The Tax Court disallowed Nevco, Inc.’s R&D tax credit based on “[t]he record provides no estimate of the time spent on qualified research as distinguished from the broader category of new product development.”
Betz v. Commissioner, T.C. Memo 2023-84: The Tax Court disallowed Catalytic Products International, Inc.’s (“CPI”) R&D tax credit due to CPI not providing evidence to establish that products were pilot models, that employees’ activities constituted research and development within the meaning of Section 174, or evidence for a reasonable basis for estimating the amount of corresponding qualified wage research expenses. Within its findings, the Tax Court noted “Merely identifying a project difficulty and the eventual design solution, without bridging the gap with evidence as to what investigative activities were performed, does not satisfy petitioners’ burden.”
U.S. v. Grigsby, 635 F. Supp. 3d 467 (M.D. La. 2022): The US Court of Appeals 5th Circuit agreed with the District Court’s findings rejecting Cajun Industries Inc.’s R&D tax credit claim because “the asserted products and processes did not satisfy the business components test because the taxpayers put forth no evidence of the alleged product”.
As we proceed through 2024, companies should review their R&D tax credit methodology to ensure they are adequately substantiating the research activities and expenses being claimed as part of their credit. In the US Court of Appeals 7th Circuit findings in Little Sandy, the Court summarized how taxpayers should focus on substantiation going forward:
“The lesson for taxpayers seeking to avail themselves of the research tax credit is to adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation. Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough.”
If you have questions around how to substantiate your R&D tax credit claim, give BRC a call. We would love to help.
The information contained in this article is for informative purposes only and should not be relied on when making any business, legal, or other decisions. This information may be updated without notice and/or may not contain the most current information that is available related to this topic. Please consult with your advisor to determine how this information applies to your specific facts and circumstances.