Tax Court disallows R&D credit for insufficient evidence
Flour company failed sect 41 four-part test for every project claimed
TAX ALERT |
Recently, the United States Tax Court, in Siemer Milling Company v. Commissioner (T.C. Memo 2019-37), held that the taxpayer had not properly supported the R&D credit under section 41, and disallowed the taxpayer’s R&D credit claim for the tax years ended May 31, 2011 and 2012. The R&D credit study that resulted in the claim was prepared by the taxpayer’s accounting firm, and the disallowance amounted to $122,424 for 2011 and $116,246 for 2012.
Facts of the case
The taxpayer is an Illinois-based company engaged in the business of milling and selling wheat flour. The taxpayer claimed the research credit for research activities for seven projects, some spanning both tax years at issue. The taxpayer’s credit claim included employee activities from employees with titles including miller, maintenance personnel, lab technicians, lab supervisors, a research and development manager and research and development staff.
Grounds for the Tax Court’s decision
The court applied the section 41 research credit rules to each project independently. To qualify, for the R&D credit each project must pass the four-part test. Generally, this requires:
- A permitted purpose (which includes a new or improved function, performance, reliability or quality) related to a product or process.
- An intent to discover information that is technological in nature by relying on principles of a hard science: engineering, computer science, biological or physical science.
- Technical uncertainty at the project’s outset regarding capability, method or appropriate design.
- A systematic, trial and error process of experimentation to attempt to resolve technical uncertainties.
Successful taxpayer arguments
While the court ultimately determined that the taxpayer failed to support its R&D credit claim, the taxpayer was successful on several important issues. The tax court agreed with the taxpayer’s position regarding whether its projects were business components in accordance with section 41. In doing so, the court found that the development or improvement of a single business component can span multiple years. Relatedly, the court agreed that a project could face the same uncertainty in more than one year because, “not all uncertainties are neatly resolved within the confines of a single taxable year.” Additionally, the court also determined that the taxpayer was not required to “employ or contract with someone with a specialized degree to prove that research relied on the physical or biological sciences, engineering, or computer science.”
Successful IRS arguments
However, the Tax Court sided with the IRS on issues that ultimately doomed the taxpayer’s entire R&D credit claim. The court applied the 4-part test to each project, and the taxpayer failed to provide evidence to show that each project met each part of the 4-part test. The ruling established that the taxpayer failed to provide adequate documentation as evidence to support its credit claim.
The Tax Court focused on the process of experimentation test of section 41, and repeatedly cited to Union Carbide v. Commissioner on this issue. The court found that the record did not establish the taxpayer had a, “methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.”
The Tax Court also disallowed the credit for several projects based on the technological in nature test because even though the taxpayer argued that they relied on principles of engineering and the physical and biological sciences, Seimer failed to establish the principles on which the research activities relied.
The Tax Court also determined that the taxpayer was not subject to the section 6662 accuracy related penalties due to the credit disallowance. In doing so, the court continued its application of Neonatology Assoc. v. Commissioner.
Neonatology provides that a taxpayer is not subject to accuracy related penalties where a taxpayer acted with reasonable cause and good faith by relying on a competent tax professional. Under the reasoning of Neonatology, reliance is reasonable where the advisor was a competent profession with sufficient expertise to justify reliance, the taxpayer provided all necessary and accurate information to the advisor, and the taxpayer actually relied in good faith on the advisor’s judgement. The court concluded that the taxpayer’s advisor was competent and sufficiently an expert, the taxpayer gave its advisor open access to all information, and the taxpayer actually relied in good faith on its advisor. Therefore, it met the reasonable cause standard of 6664(c) and therefore the accuracy related penalties should not apply.
Taxpayers claiming the R&D credit should ensure not only that their claims meets all requirements under section 41, but taxpayers should carefully scrutinize whether they have sufficient documentation to support their claim in the event of an examination or litigation. The court’s focus on the process of experimentation aspect of the 4-part test highlights the importance of maintaining the necessary documentation to support all aspects of an R&D credit claim, particularly the process of experimentation requirement. Taxpayers should also recognize that consulting with a profession who is experienced with and knowledgeable of the research credit may mitigate potential penalties when a credit claim is denied.