Executive summary: Tax Court disallows COO’s wages
Specificity and supporting documentation remain tantamount to sustaining research and development (R&D) credits.
R&D continues its losing streak in court
IRS continues to win cases challenging the R&D credit. In Scott Moore et al. v Commissioner, T.C. Memo. 2023-20, the IRS challenged the inclusion of activities from the S corporation’s chief operating officer (COO) as qualifying research expenditures. The taxpayer allocated 65% of the COO’s salary and bonuses to R&D to match the COO’s efforts for the two years under exam. It is worth noting that during the exam, the IRS did allow qualified wages for the engineering department and the engineering supervisor.
The plaintiff asserted that the COO was significantly engaged in new product development and therefore was entitled to include that portion of activities in the R&D credit calculation. The COO testified that he spent “well north of 50%” on product development and his testimony was corroborated by creditable testimony from employees of the taxpayer.
While the court did believe that the COO was engaged in some R&D activity, the court reasoned that not all of the COO’s activities in new product development were qualified R&D activities. The court found that “[t]he record provides no estimates of the amount of time [COO] spent on qualified research as distinguished from the broader category of new product development” therefore none of the COO’s salary or bonus is qualified research. The court went on to conclude that the COO neither provided direct supervision nor direct support to qualified research. While the COO did provide some supervision, it was supervision of the first line supervisors which does not qualify as research activity.
The takeaway is that for highly compensated individuals, taxpayers need to tie the compensation with specific qualified activities (i.e., hours worked on laboratory experiments, etc.). Otherwise, expect the IRS to challenge. And remember, the IRS has been on a winning streak.