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Tax Court Mostly Agrees with Taxpayer on Research Tax Credit.
(Parker Tax Publishing October 14, 2014)

The research tax credit was added to the Code in 1981 as a temporary provision at a time when research and development jobs were significantly declining in the United States. It has proved extremely popular and is generally included in the annual "Tax Extenders" bill that is often signed into law by the President near the end of the calendar year. It was most recently extended for a two-year period by The American Taxpayer Relief Act of 2012, resulting in it being retroactively reinstated to cover calendar year 2012 and prospectively extended to cover calendar year 2013. However, as a result of Congressional gridlock, it has yet to be extended to 2014, although most experts expect that it will because both political parties view it as a highly valuable business tax incentive. Thus, the recent Tax Court decision in Suder v. Comm'r, T.C. Memo. 2014-201 (10/1/14), is relevant for businesses that are, or may be, engaged in research activities for which they intend to take the research tax credit.

In Suder, the IRS disallowed a company's research tax credits in full, unsuccessfully arguing on numerous fronts that the company did not qualify for the credits. However, in an issue of first impression, the Tax Court did find that part of the CEO's compensation used to calculate the research tax credits was unreasonable under Code Sec. 174(e). This is a departure from most reasonable compensation cases, as the decision on whether compensation is reasonable is generally determined under Code Sec. 162. The Suder case provides a roadmap for taxpayers calculating the research tax credit (RTC) by showing what the Tax Court will look for in deciding if a taxpayer's activities qualify for the credit and what the court considers in determining if compensation is reasonable for purposes of calculating qualified research expenditures (QREs).

Practice Tip: In this case, the CEO's wages were based on the company's growth, overall value, and cashflow. In other words, they were based on the success of the company's business. The court in Suder noted that, while the compensation might be reasonable from a business standpoint, the test of reasonableness is different for purposes of Code Sec. 174(e). Thus, a compensation deduction may be reasonable under Code Sec. 162 for calculating a company's taxable income, but practitioners may need to adjust such compensation when calculating that same company's research tax credit.

Facts

Eric Suder worked for Candela Corporation until it went out of business. Eric then started a company out of his garage called Estech Systems, Inc. (ESI), through which he designed telephone systems for small and midsize businesses. ESI was incorporated as an S corporation and Eric owned 90 percent of the corporation. Doug, an ESI employee, owned the other 10 percent. Under Eric's leadership, ESI went into the business of designing telephone systems for small and midsize businesses. By 2004, Eric had grown ESI into a company with approximately 125 employees, including a team of roughly 40 engineers, and gross revenues of approximately $38.5 million.

For tax years 2004 through 2007, ESI filed a Form 1120S in which it claimed a credit for increasing research activities under Code Sec. 41. In addition to owning 90 percent of ESI, Eric was also its CEO and most compensated employee. Eric claimed flow-through research tax credits of approximately $450,000 for each year from 2004 through 2007 on his Forms 1040. In computing the credits, Eric claimed QREs for 76 projects. Most of ESI's QREs were attributable to Eric's wages. In 2009, the IRS issued Eric a notice of deficiency disallowing the research tax credits in full and assessing accuracy-related penalties. Eric took the case to the Tax Court.

The threshold question before the Tax Court was whether the activities for which the credits were taken constituted "qualified research" within the meaning of Code Sec. 41(d). Eric and the IRS stipulated 12 of the 76 projects as being a representative sample for purposes of determining whether ESI's employees performed qualified research during the years at issue.

Calculation of Research Tax Credits

Eric's entitlement to the research tax credits turned on whether ESI incurred QREs during the years at issue. QREs are defined in Code Sec. 41(b)(1) as the sum of a taxpayer's in-house research expenses and contract research expenses. Under Code Sec. 41(b)(2), in-house research expenses include wages paid or incurred in relation to an employee for qualified services performed by the employee and the amounts paid or incurred for supplies used in the conduct of qualified research. Qualified services means services consisting of engaging in qualified research or engaging in the direct supervision or direct support of research activities that constitute qualified research. Under Code Sec. 41(b)(3), contract research expenses are equal to 65 percent of the amounts paid or incurred by the taxpayer to a person other than an employee of the taxpayer for qualified research. Therefore, to be eligible for research tax credits, Eric had to prove that ESI performed qualified research, or paid someone else to perform qualified research, during the years at issue.

Qualified research is research that satisfies four tests listed in Code Sec. 41(d)(1). First, expenditures connected with the research must be eligible for treatment as expenses under Code Sec. 174 (the Section 174 test). Second, the research must be undertaken for the purpose of discovering technological information (the technological information test). Third, the taxpayer must intend that the information to be discovered be useful in the development of a new or improved business component of the taxpayer (the business component test). Fourth, substantially all the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality (the process of experimentation test).

The above tests are applied separately to each business component. A "business component" is defined as a product, process, computer software, technique, formula, or invention that the taxpayer holds for sale, lease, or license or uses in its trade or business.

Under Code Sec. 174(e), a taxpayer may deduct a research and development expenditure only to the extent the amount is reasonable under the circumstances. Under Reg. Sec. 1.174-2(a)(6), the amount of an expenditure is reasonable if it would ordinarily be paid by similar enterprises for similar activities under similar circumstances.

Allocation of Qualified Services

In 2003, ESI hired Alliantgroup, LP, to perform a research and development tax credit study (R&D study) for 1999 to 2002. As part of the R&D study, Alliantgroup created a spreadsheet listing the employees at ESI that performed qualified services, the employees' titles, the percentage of time that each employee spent performing qualified services, and the employees' wages reported on Forms W-2. Alliantgroup looked at the roles and responsibilities of each employee and consulted with senior management in making the percentage allocations.

Alliantgroup worked primarily with Mr. Wende, the senior vice president of product operations and product development. After working with Alliantgroup on the R&D study, Mr. Wende felt that he understood how to compute ESI's research tax credit going forward. For 2004-2007, each of the years at issue, Mr. Wende prepared a spreadsheet listing each employee that received an allocation of time spent on qualified services and his or her allocation. In determining an employee's allocation, Mr. Wende counted the time that the employee spent discussing ideas for new products, researching new products and features, writing specifications, designing new products, building prototypes, testing prototypes, repairing bugs and defects in prototypes, writing software, working on the alpha and beta tests, and doing similar activities. If the employee had worked at ESI in the prior year, Mr. Wende used the prior year's allocation as a starting point and considered whether the employee's role had changed since the prior year.

Mr. Wende believed that 80 percent would have been an appropriate allocation for Eric for 2004-2007 to reflect Eric's role as the creative genius behind product development at ESI. Unlike typical CEOs, Eric spent most of his time steering product development at ESI from the idea generation stage all the way through alpha testing. Eric did spend some time, though, working on the business aspects of ESI. And so, in a measure of conservatism, Mr. Wende decided to allocate 75 percent of Eric's time to qualified services. Mr. Wende gave ESI's engineers, product managers, and product testers 100 percent allocations for the most part. However, Mr. Wende did not count maintenance work as time spent on qualified services, and so he gave lower allocations to those employees that performed maintenance more than sporadically. Mr. Wende gave some employees at ESI small allocations, generally 5 percent or 10 percent, if they spent a small amount of time assisting with new product development. These employees generally had roles that did not directly relate to new product development, such as quality control or shipping and handling.

After Mr. Wende finished making his percentage allocations for ESI's employees, he provided his spreadsheet to ESI's accounting department, who then entered the employees' wages and totaled up the wages for qualified services. ESI reported wages for qualified services of $9,650,761 for 2004, $8,877,903 for 2005, $8,728,067 for 2006, and $11,994,452 for 2007 on Form 6765, Credit for Increasing Research Activities. Wages for qualified services accounted for more than 95 percent of the QREs that ESI reported for the years at issue.

The Parties' Arguments

Eric argued that ESI faced numerous technical uncertainties in building exponentially larger phone systems than it had ever attempted, adding innovative and improved software features, and incorporating the new and different technological hardware components needed to stay competitive. Every single one of these identified uncertainties, Eric said, was of a type specifically contemplated by Code Sec. 41 and thus eligible for the research tax credit.

The IRS argued that there was little evidence showing uncertainty regarding the capability, method, or appropriate design of the projects as of the beginning of ESI's product-development activities. According to the IRS, the evidence introduced by Eric showed ESI encountered uncertainty that was inherent in every large development effort, including uncertainty resulting from deadlines, lack of resources, unexpected delays, and human error.

The IRS did not dispute that the 12 projects satisfied the technological information test and the business component test. However, with respect to the process of experimentation test, the IRS argued that Eric showed that ESI chose among design alternatives by applying engineering know-how, publicly available knowledge, or by committee. These methods, the IRS said, are not processes of experimentation as required by Code Sec. 41.

Eric argued that ESI clearly had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved (1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, (2) testing these alternative in a scientific manner, (3) analyzing the results, (4) refining the initial hypothesis or discarding it for another if necessary, and (5) repeating the same, if necessary.

The IRS also argued that Mr. Wende lacked the tax or accounting educational background and experience to make accurate wage QRE percentage allocations and challenged Eric's salary as being unreasonable under Code Sec. 174(e).

Tax Court's Analysis

The Tax Court held that 11 of the 12 projects satisfied the four-part test for qualified research. With respect to the first test (i.e., the Section 174 test), the court agreed with Eric that uncertainties as to capability, method, or appropriate design were present in all 12 projects. Each of the 12 projects began as an idea to develop a new hardware product, software product, or both. Senior management vetted the ideas in the senior product strategy meetings and follow-up meetings and ESI's product managers, engineers, technicians, and other employees then transformed the ideas into commercially ready products. Neither senior management nor anyone else at ESI, the court noted, had information detailing the exact steps to create the products or their ultimate design. Moreover, the Tax Court observed, because the products were all proprietary, publicly available information of that type did not exist.

With respect to the process of experimentation test, the Tax Court rejected the IRS's argument that publicly available knowledge describing the appropriate design of the products existed. Many of ESI's engineers came from well respected companies, the court noted, and brought with them a great deal of knowledge which they applied, along with their institutional knowledge of ESI, in the design of new products. According to the court, neither Code Sec. 41 nor the regulations require taxpayers to "reinvent the wheel." The court concluded that 80 percent or more of the activities with respect to each of the 12 projects constituted elements of a process of experimentation. However, the court concluded that only 11 of the 12 projects were undertaken for a qualified purpose. The court noted one of the projects was undertaken to change the look and feel of the user interface, and thus did not qualify for the research tax credit.

The court also found Mr. Wende's percentage allocations were a reasonable estimate of the percentages of time ESI's employees spent performing qualified services for 2004-07. The court found that because Mr. Wende worked closely with Alliantgroup on the R&D study, he had learned a great deal from that experience and had sufficient knowledge of the Code Sec. 41 research tax credit to make appropriate percentage allocations.

With respect to evaluating the reasonableness of Eric's compensation for purposes of including it in the QREs for 2004-2007, the court stated the most important factor was how Eric's salary compared to CEOs performing similar services in similar companies. Both Eric and the IRS called experts to testify, but the court found Eric's expert to be more credible and agreed that it was appropriate to compensate Eric in the 90th percentile of CEOs for the years at issue. However, the court also looked at other factors. While Eric continued driving product development during the years at issue, the court noted that he was semiretired by 2004 and worked an average of only 20 to 30 hours per week at ESI. Eric's other time was devoted to nonprofits in the Dallas area that were unaffiliated with ESI. According to the court, Eric's part-time work schedule at ESI raised doubt as to the reasonableness of his compensation. The court looked at Eric's wages in comparison to ESI's ordinary business income and found that Eric's wages were approximately 4 and 1/2 times, 6 times, 5 and 1/2 times, and 5 and 1/2 times ESI's ordinary business income for years 2004-2007, respectively.

According to the court, Eric's high compensation relative to ESI's income suggested that his compensation was, at least in part, unreasonable. In addition, the court observed that Eric's wages were significantly higher in 2004-2007 than they had been in prior years, notwithstanding the fact that he was not named as an inventor on any new patent applications filed from 2004 to 2007. As a result, the court reduced Eric's compensation for purposes of calculating the research tax credit. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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