Taxpayer Prevails With Respect To Claimed Research And Development Tax Credits In Eric G. Suder, Et Al. V. Commissioner, TC Memo 2014-201

The decision in this case, issued as a Memorandum decision by the Court, J. Vasquez, reflects the analytical complexity of the Section 41 tax credit rules for qualified research and development costs and further highlights the taxpayer's burden to prove that it properly claimed the tax credits based on the evidence presented on the record at trial or by stipulation prior to trial, and including the submission of expert reports. The research tax credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.

General Rules Under Section 41

Section 41(a)(1) allows a taxpayer a tax credit up to an amount equal to 20% of the excess, if any, of the taxpayer's qualified research expenses (QREs) for the taxable year (credit year) over the base amount. QREs are defined as the sum of a taxpayer's in-house research expenses and contract research expenses paid or incurred by the taxpayer during the credit year in carrying on a trade or business. §41(b)(1). The base amount is the product of the fixed-base percentage and the ave. annual gross receipts of the taxpayer for the four years preceding the credit year. §41(c)(1). The base amount still may not be less than 50% of the QREs for the credit year. §41(c)(2). The fixed-base percentage is generally the lesser of 16% or the percentage that the aggregate QREs of the taxpayer for certain years (base period) is of the aggregate gross receipts of the taxpayer for those years. §§41(c)(3)(A) and (C).

The Taxpayer In Suder v. Commissioner

The taxpayer company, ESI, computed its research tax credit using a fixed-base percentage of 16%, the maximum allowable under the statute, for each of the years at issue. A taxpayer must determine its QREs in computing its fixed-base percentage "on a basis consistent with" its determination of QREs for the credit year (the consistency requirement). § 41(c)(6). Chief Counsel, in its pretrial memorandum, raised the consistency requirement, contending that petitioners must provide evidence as to the correct amount of ESI's base period QREs to substantiate the research tax credits claimed. Neither petitioners nor respondent addressed the consistency requirement or ESI's base period QREs in the opening or reply briefs. The court found that both parties conceded any arguments they might have otherwise had on the consistency requirement. See Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989); Money v. Commissioner, 89 T.C. 46, 48 (1987). Accordingly, the taxpayer's entitlement to the research tax credits turns on whether ESI incurred QREs during the years at issue. As previously stated, QREs are defined as the sum of a taxpayer's in-house research expenses and contract research expenses. This consists of in-house expenses for wages paid to employees for "qualified services" and amounts paid or incurred for supplies used for qualified research. §§ 41(b)(2)(A)(i) and (ii). Qualified services consist of engaging in qualified research or engaging in the direct supervision or direct support of research activities which constitute qualified research. §41(b)(2)(B). Contract research expenses are equal to 65% of the amounts paid or incurred by the taxpayer in relation to a person other than an employee of the taxpayer for qualified research. §41(b)(3). Therefore, to be eligible for a credit under section 41(a)(1), petitioners had to prove that ESI performed qualified research, or paid someone else to perform qualified research, during the years at issue.

The Four Tests for Qualified Research.

Qualified research is research that satisfies four tests. First, expenditures connected with the research must be eligible for treatment as expenses under section 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 of 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). A fifth test, in effect, is the limitation under section 174(e). The tests are applied separately with respect 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. If a business component as a whole fails the qualified research tests, the "shrinking-back rule" applies, which allows the court to apply the qualified research tests to a subset of the business component if doing so will allow the subset to satisfy those tests. See Treas. Reg. §1.41-4(b)(2). The shrinking-back rule provides that if the qualified research tests are not satisfied at the level of the discrete business...