United States

Apparel company’s R&D credit claim fails in court

TAX ALERT  | 

In a recent decision, Halpern v. United States, the U.S. District Court of the Central Division of California held that apparel company owners were not entitled their claimed research and development tax credit.

Facts

The taxpayers were S-corporations shareholders of 4 What It’s Worth (“4WIW”) a clothing apparel company. The company manufactured women’s jeans and other clothing items. 4WIW hired a boutique tax consulting company to calculate and document its research credit for the company’s 2008 tax year. The tax consulting company relied on estimates from employees familiar with 4WIW’s R&D activities to estimate the percentage of time each employee spent on qualified research. That information was used to calculate the 4WIW’s qualified research expenses.  4WIW then filed an amended 2008 tax return in 2010 to claim the additional credit. The IRS accepted 4WIW’s amended return. The company sent taxpayers an amended schedule K-1, and the taxpayers amended their personal return. The IRS ultimately denied the claim, and the taxpayer’s filed suit for refund.

R&D Credit Qualifications

The court determined that the taxpayers failed to satisfy their burden of proof by demonstrating that they met the four-part test1 for qualified research under section 41(d). The court stated that the taxpayers parroted the statutory requirements without explaining how their activities actually satisfied them. The court added that the taxpayers made “conclusory assertions that the company’s ’R&D employees’ impart ‘a unique combination of qualities affecting function, performance, reliability and aesthetic’ without specifying how the employees improved each ‘business component.’”

The court required a showing that a research credit claimant provide evidence and detailed analysis showing how a taxpayer qualifies for the credit. It compared the taxpayers’ conclusory statements to the level of support the taxpayer provided in Suder v. Comm’r and Siemer Milling Company v. Comm’r. In Suder, the taxpayer methodically explained how each business component complied with the four-part test. In comparison, the taxpayer in Siemer Milling Company made conclusory statements about how its projects satisfied the four-part test. Here, the taxpayers “did not apply the statutory test to their work to determine whether and what amount of, that work constituted qualified research, and they did not meet their initial burden to show that they qualified for the research credit.”

Adjustment at the Corporate Level

Additionally, the taxpayers’ argued that the government could not deny the claimed credit because the taxpayer argued that a regulation required that an adjustment of an S-corporation could only occur at the corporation level. The government disagreed because the statute under which the regulation was promulgated was repealed by congress several years ago. The court agreed with the government and found that the government was not required to make an adjustment at the corporate level because the regulation was no longer in effect because congress repealed the underlying statute. 

Conclusion

As this case and Siemer Milling Company show, it is important for any research credit study methodically to apply the four-part test to each business component that the taxpayer engaged in to determine whether that business component qualifies for the credit. Without that necessary step, a taxpayer is likely to be unsuccessful during an IRS audit of the claimed credit.

 

  1The research must have a permitted purpose that relates to a new or improved function performance, reliability or quality of a business component. The research activity must be technological in nature and rely on principles of science, such as physical science, biological science, computer science or engineering. The research activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing the business component. Lastly, substantially all of the research activities must be elements of a process of experimentation.

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