The R&D tax credit is accessible to more small businesses, and it can be a valuable way to manage expenses for innovative research. However, US Tax Court cases in recent years have revealed some weaknesses in corporate due diligence to support eligibility for the credit.
Companies should not be afraid to claim the credit for qualifying activities when they meet the four-part test as laid out in IRS code Section 41. But the question, “Will it stand up in court?” is also important to answer when reviewing contract language and properly documenting eligible activities.
Review contract language carefully
Contract language can be nuanced. The matter of payment and the terms of payment are key aspects of due diligence to support R&D credit eligibility.
In the case of Populous Holdings Inc. v. Commissioner of Internal Revenue Service, the IRS concluded that the research by Populous was funded and therefore ineligible for the R&D credit. IRC section 41(d)(4)(H) provides that qualified research excludes “[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).”
However, in this case the U.S. Tax Court granted summary judgment to Populous, concluding that payment was actually contingent upon the success of the research, which put Populous at risk for nonpayment. The court also agreed that Populous retained substantial rights to the research. This case is consistent with court precedent that “risks and rights” play heavily into considerations for claiming the R&D credit.
If contract terms with a client stipulate that the taxpayer is required to succeed or return the client’s funds, or incur additional costs beyond what the client is paying, the research could be considered unfunded and the taxpayer is viewed as at financial risk. In addition, the taxpayer must retain substantial rights to the results of the research to support eligibility for the R&D credit. Contracts in which the client assumes all rights to the research should be reviewed carefully in light of the contractor’s total costs and approach to research.
Inadequate documentation derails credit eligibility
In Siemer Milling Company v. Commissioner of Internal Revenue Service, the IRS claimed that Siemer was not eligible for the R&D credit over two tax years in which it was claimed.
Although the U.S. Tax Court agreed that the business components met the requirements of Section 41, inadequate documentation did not allow the Tax Court to confirm the nature of the company’s scientific principles or its process of experimentation. This lack of documentation led the Tax Court to rule in favor of the IRS.
If the credit study had more detailed descriptions of scientific principles used and the process of experimentation, this company may have met the four-part test for qualifying R&D activities. This documentation cannot be completed retroactively, so we’ll never know. However, the case does reveal the importance of detailed documentation to satisfy the IRS and potentially the court.
Staying informed about tax court proceedings helps our team at Anglin use best practices in R&D due diligence — reviewing contract terms, properly documenting activities and expenses and applying the tax credit rules. Contact Jeremy Mosteller, CPA, CGMA or Christopher Cook, CPA with your questions.
Read our article about applying the R&D credit in government contracts.