Last year, President Obama made research & development tax credits permanent in his FY2014 budget. Businesses now have another tool to increase cash flow and spawn innovation. Like all tax credits, certain tests must be met to qualify. With Estech Systems (TC Memo 2014-201), the IRS did not believe some were met. The Tax Court took a different view and sided with the taxpayer on most of the tests. The Tax Warriors® give the rundown on this decision.
For amounts incurred before 2015, Internal Revenue Code (IRC) Section 41(a) provides a research credit, equal to 20% of the excess of qualified research expenses (QREs) for the tax year over the base amount.
An expense qualifies for the IRC Section 41 research credit if:
(1) it is incurred with the taxpayer's trade or business, which represents research and development costs in the experimental or laboratory sense;
(2) it relates to research undertaken to discover information that is technological;
(3) the application of such research is intended to be useful in developing a new or improved business component of the taxpayer; and
(4) substantially all (i.e., 80%) of the activities of the research constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality.
Estech Systems, Inc. (ESI), was a designer of telephone systems. Its founder, Mr. Suder, spent most of his time brainstorming ideas for new products and ways to improve existing products. ESI's product development process began with concept development in senior product strategy meetings where they discussed high-level ideas for new products and selected the major components to be used in the new products. The hardware and software went through extensive alpha and beta testing.
The IRS contended that ESI failed to meet the first and fourth test for qualifying as a QRE. The IRS argued that ESI failed to show uncertainty regarding the capability, method, or appropriate design as of the beginning of the product-development activities. The IRS also challenged the reasonableness of Mr. Suder's wages as QREs under IRC Section 174(e). Regarding the fourth test, the IRS argued that ESI chose among design alternatives by applying engineering know-how, publicly available knowledge, or by-committee methods that were not processes of experimentation.
Mr. Suder argued that testimonial and documentary evidence showed the numerous technical uncertainties it faced in building the phone systems, adding innovative and improved software features, and incorporating the new and different technological hardware components to stay competitive. Regarding the fourth test, Mr. Suder argued that ESI 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 develop new and improved phone systems; (2) testing these alternatives in a scientific manner; (3) analyzing the results; (4) refining the initial hypothesis or discarding it for another.
The Court determined that for the first test, "uncertainties" on capability, method, or appropriate design were present in all projects. Each project began as an idea to develop a new product. The ideas were vetted in the product strategy and follow-up meetings. ESI's product managers, engineers and technicians then transformed the ideas into commercially ready products. No one at ESI had information detailing the exact steps to create the products or their ultimate design. The products were all proprietary, publicly available information did not previously exist.
The Court found that regarding the fourth test, IRS had raised no persuasive distinction between principles of engineering and "engineering know-how." ESI's engineers combined their knowledge from prior work experience and the institutional knowledge of ESI in the design of new products. Neither IRC Section 41 nor the related regulations required taxpayers to "reinvent the wheel." The vast planning, testing, and bug fixing documentation in the record established that ESI did not know the appropriate design of the products at the outset.
The Tax Court reasoned that the most important factor in evaluating the reasonableness of Mr. Suder's compensation was how it compared to the compensation paid by similar company’s CEOs performing similar services as Mr. Suder. The Court agreed with the taxpayer's expert that a reasonable compensation package for Mr. Suder should include a base salary, an annual incentive, and a long-term incentive. However, the Court found it wasn't appropriate to include a royalty component in Mr. Suder's wages as QREs. His compensation was found to be unreasonable.
Tax Warrior Perspective
The wages ESI included for Mr. Suder in their QREs should not have included the royalty component because IRC Section 41(b)(2) defines in-house research expenses as any “wages” paid or incurred to an employee for “qualified services” performed by such employee. IRC Section 41(b)(2)(B) goes further to indentify three types of qualified services: 1) engaging in qualified research, 2) directly supervising qualified research, or 3) directly supporting qualified research. Since the royalty component of Mr. Suder’s wages could not be categorized as qualified services, the Court disallowed that portion of his wages as unreasonable. If ESI would have considered the three qualified services in their compensation structure, they may have been able to restructure Mr. Suder’s wages to result in a larger R&D credit.
The highly skilled tax advisors at Drucker & Scaccetti have extensive experience with R&D credits. We’ve been helping companies devise sound tax strategies for 25 years. Tech companies, software developers, biotechnology companies, and anyone providing cloud-based technology or services probably have QREs. Contact us if you need assistance in determining if your company qualifies for R&D tax credits. We are always prepared to help you with this or any other tax-related matter.