By Long Thai and Saqib Dhanani
The Credit for Increasing Research Activities offers companies engaging in research and development activities the opportunity to lower their tax liability. Following proper procedures, the R&D Tax Credit can be accurately calculated and defended even without formal project accounting. As courts have held that tax credits are a matter of legislative grace, taxpayers bear the burden of proving they qualify for the R&D Tax Credit.
The taxpayer claiming the R&D Tax Credit must retain substantiation records in sufficiently usable form and detail to meet the
burden of proving credit eligibility.
A recent case, Basim Shami and Rania Ardah, et al. v. Commissioner of Internal Revenue, demonstrates the critical importance of proper procedure and methodology when claiming the R&D Tax Credit. In this case, the U.S. Tax Court held that wages paid to a company's shareholders, CEO, and the marketing chief were not qualified expenses under the R&D Tax Credit. The company in question,
Farouk Systems, Inc., is well-known for its hair, skin, and nail products, such as BioSilk, CHI hair coloring systems, and flat irons.
Farouk Systems' research and development staff ranged from 18 to 27 employees during the relevant tax years: 2003, 2004, and 2005. The research and development staff included chemists, technicians, and a vice president of research and development. Generally, a high percentage of wages for these types of employees working for similar companies engaged in product development will be deemed qualified expenses for purposes of the R&D Tax Credit. Indeed, the R&D Tax Credit maintains the 'substantially all' rule, which was designed primarily for engineers, designers, scientists, and programmers.
The rule allows companies to capture 100 percent of an employee's salary if that employee spent 80 percent or more of his/her time performing qualified work. Farouk Systems' R&D study claimed that the company's CEO and marketing chief spent up to 80 percent of their time engaged in qualified work.
Due to the 'substantially all' rule, this captured their entire salaries for certain years, and effectively qualified wages in the amount of: $8,735,727, $7,988,310, and $3,335,373 for the CEO; and $5,722,699 and $1,839,581 for the marketing chief.
While the R&D Tax Credit does not require that the CEO and marketing chief wore lab coats for the majority of the year, there is a requirement of substantiation of time spent performing qualified services.
The court found that the study failed to adequately substantiate the wage allocations for the CEO and marketing chief. The study did not provide any documentation that established how much time these individuals spent performing research and development activities. Mere testimony that was offered to substantiate the time claimed was general, vague, and conclusory, and, therefore, inadequate.
The court ultimately held that the insufficient substantiation prevented any amount of the relevant wages from qualifying for the R&D Tax Credit.
In order to prevent such outcomes such as the aforementioned case example, Paradigm's studies establish a detailed "nexus" of Qualified Research Expenditures to Qualified Research Activities. One of the IRS's biggest concerns is that some "engineering" reports are in fact written by individuals with no engineering or scientific background, and that "no nexus" is established between a company's qualifying expenditures and qualifying activities. Each company's documentation should directly connect the project to the employee and the estimated time spent on that project to each of the years under engagement.
In order to ensure that the requisite statutory requirements are satisfied, there is a series of steps that a company should follow. Start by collaborating internally and with each client to analyze the technical and financial information necessary to qualify relevant projects. Once this is done the company can determine the qualifying R&D activities performed by analyzing the types of operational activities each company performs.
The project identification phase of the study consists of identifying potential projects to be evaluated. Following the initial identification, the projects must be further evaluated to ensure the final list of projects include only the projects that meet each of the requisite elements of qualified research.
During the data collection phase, the company needs to ensure that each study satisfies the substantiation requirements of the R&D Tax Credit. This is accomplished through identification and utilization of various pieces of documentation, both financial and technical. After thoroughly evaluating all the documentation, the next step is to perform an extensive interview process with individuals possessing
direct knowledge of the company's research activities.
These interviews and associated notes are used to supplement the documentary record. Paradigm's Comprehensive Project-by-Project Methodology conducted by our production staff of engineers and IP attorneys is the most thorough methodology accepted by the IRS today.
Long Thai and Saqib Dhanani are Attorneys at Law
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