Moore v. Comm’r, T.C. Memo. 2023-20| February 23, 2023 | Colvin, J. | Dkt. No. 18632-19
Summary:
Nevco, Inc (Nevco) had claimed R&D tax credits for both 2014 and 2015 with a total claim of $68,263 and $141,945 in each year respectively. The company manufactures scoreboards for high school and college athletic events, as well as LED video displays, score tables, and other types of equipment for indoor and outdoor sports venues.
Nevco’s president and chief operating officer (COO) during these years and the claim was calculated with his time included. The IRS held that the wages paid to this COO could not be included in computing the R&D tax credit under Section 41 because the taxpayer failed to adequately substantiate time spent on qualified research and did not engage in direct supervision or support.
The company maintains that the COO spent a significant amount of time — approximately 50-65% — on new product development.
Key Points of Law:
Section 41 outlines that staff must be either engaged directly in qualified services or in direct supervision or support of those performing the qualified services:
- 41(b)(1)(A). A taxpayer’s “in-house research expenses” include “any wages paid or incurred to an employee for qualified services performed by such employee.” § 41(b)(2)(A)(i). Section 41(b)(2)(A) includes as wages “all remuneration . . . for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” See §§ 41(b)(2)(D)(i), 3401(a). An employee performs “qualified services” by either “(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.” § 41(b)(2)(B).
Four Key Criteria
Under section 41(d), four requirements must be met in order for an activity to be “qualified research.”
- Research must be eligible to be treated as expenses under section 174
- Research must be undertaken to discover information which is “technological in nature”
- Application of the research must be intended to be useful in the development of a new or improved business component of the taxpayer
- Substantially all of the activities of the research must constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality.
Details:
The COO had previously been a software engineer, chief information officer at an electronics firm, and vice president at another electronics company. With this history, he had experience with designing and manufacturing various electronics.
The company failed to keep records of the COO’s time including how much time he spent on any individual project. The company could not present any documents that detailed either the COO or any employee’s responsibilities or duties in 2014 and 2015, making it difficult to substantiate the work performed by the COO. The company contended that other senior officers took care of financial, marketing, and sales initiatives, leaving the COO to oversee operations and new product development.
The company followed a structure where the engineering and product development teams reported to Mr. Paslay, a direct supervisor who then reported to the COO. As such, the COO was the second-level supervisor of the engineering team.
The COO testified that he spent two thirds or more of his time working on new product development in 2014 and 2015. His testimony was corroborated by the testimony of other employees, including Mr. Paslay.
The Court’s Decision And Learnings:
The Court agreed with the testimony, as well as the percentage arrived at by the company. Given the company structure leaving operations and product development to the COO while other senior level officers managed the sales and financials, the Court believes a 50-65% estimate of time is reasonable. However, the Court holds that the percentage and time spent are irrelevant as the work conducted by the COO does not meet the definition for qualified services.
An employee’s time must meet four key criteria to be considered eligible. The company’s records provided no proof or detail that distinguished the COO’s time spent on qualified research from the broader category of new product development.
With the example of one claimed project, the testimony only mentioned the COO specified requirements for the product – which is not qualified as they do not apply technology in an experimental process. While they did mention his work in identifying a design that would perform well in high winds, they could not show how much time was spent on this specific activity. The same pattern repeats for all projects claimed wherein the potentially qualified activity could not be substantiated by records.
Regarding the use of direct supervision under 41(b)(2)(B)(ii) (“engaging in the direct supervision or direct support of research activities which constitute qualified research”). The term direct supervision as used in section 41(b)(2)(B) means the immediate supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist. As such, the COO acting as a second-line supervisor negates him from being qualified under this definition.
The Court determined the company could not consider any wages paid to the COO in computing Nevco’s section 41 research credit for 2014 or 2015.
This case highlights the importance of record keeping and maintaining documents or time records to substantiate employee time.
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