Case Law – Page 2 – Swanson Reed | Specialist R&D Tax Advisors

GeneCure, LLC v. Comm’r: A Case in Biotechnology

Genecure, LLC v. Comm’r, T.C. Memo 2022-52 | May 23, 2022 | Jones, J. | Dkt. No. 14916-15.

Summary:

GeneCure, LLC is a biotechnology company focused on developing gene therapy based technologies to treat genetic and acquired human diseases. The company developed a patented lentiviral delivery platform which they use to further develop novel human vaccines. The company claimed R&D tax credits for this research and were met with adjustments made by the IRS for the 2009-2012 taxable years.

The opinion set out to address numerous issues including taxation of settlement proceeds received in contract dispute, deductibility of item-by-item categories of business expenses, recapture tax for an Affordable Care Act-Qualified Therapeutic Discovery Project (QTDP) grant received by Genecure, characterization of amounts received from an LLC owned by Frank Tung’s wife (i.e., is it a loan, or not a loan), and possible capital contributions from the LLC owned by Frank Tung’s wife.

Key Points of Law:

This is a TEFRA partnership-level case with GeneCure organized as a member-managed LLC. As such, it is treated as a partnership for federal income tax purposes (Treas. Reg. § 301.7701-3(b)(1)).

The IRS first examined the tax returns for 2009-2012, providing a Form 11661, Fraud Development Recommendation-Examination. They then issued Frank Tung, in his capacity as tax matters partner, a separate Notices of Final Partnership Administrative Adjustment (FPAA) for each of the years in issue, as well as a section 6663 civil fraud penalty for underpayment of tax for each year.

Frank Tung gathered and attempted to admit evidence and documentation including emails and letters from GeneCure’s day-to-day business. Most of this documentation the Tax Court refused to admit or consider. This was due to the irrelevance of the evidence. Tax Court evidentiary rulings are determined under the Federal Rules of Evidence (7453; Rule 143(a)).

The Court’s Decision And Learnings:

Frank Tung, acting as tax matters partner for GeneCure, failed to provide acceptable evidence following evidentiary standards. He also failed to provide available exceptions to the rules and therefore the evidence was not submitted.

GeneCure failed to document and substantiate most of the claimed business expenses it sought to deduct. They further failed to report taxable income including the amounts received in a settlement from a business contract dispute. Deductions and other tax benefits were claimed but could not be substantiated. They further could not prove that a $200,000 payment from Frank Tung’s wife was a loan for rent.

Because of these failures, the Tax Court ruled in favor of the IRS on all tax issues. They found Frank Tung’s testimony to be self-serving, evasive, conflicted, and improbable. The court’s conclusions were as follows:

That Genecure had unreported income of $6,000; $21,578; and $7,000 in taxable years 2009-11, respectively;
That Mr. Tung largely failed to establish Genecure’s entitlement to deductions for various business expenses reported for each of the taxable years at issue;
That Genecure is subject to a $230, 979 recapture tax with respect to its taxable year 2010 for excess amounts received as a QTDP grant;
That Mr. Tung failed to substantiate a $200,000 loan to Genecure from Mrs. Tung in taxable year 2009;
That Mr. Tung failed to substantiate a $100,000 capital contribution to Genecure from Mrs. Tung in taxable year 2011.

As for the fraud-related penalties, the IRS Civil Penalty Approval Form and its Form 11661 did not satisfy the written supervisory approval requirements for purposes of assessing section 6663 civil fraud penalties; therefore, such penalties were inapplicable against Genecure at the partnership level.

This court case serves as an example of the absolute importance of documentation and substantiation. There are stringent evidentiary requirements which must be considered and having a paper trail to back up any claim is crucial to the vitality of said claim.

Click here to read the full case.

Are you conducting research and development activities? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.

Navigating a Software R&D Tax Credit Claim

Alaska Patent of the Month - September 2021

Software development is a broad range of activities – from functional enhancements to app development. It becomes easy to confuse which aspects of software development are considered R&D in the eyes of the IRS, since all forms of it are referred to as development. But the IRS indeed has some pretty strict thoughts on what software activities are truly research and development.

As with any industry, the IRS follows the rules outlined in I.R.C. § 41. To summarize these rules, qualifying R&D refers to activities must:

Fundamentally rely on the principles of hard sciences (eg. physical or biological sciences, engineering, or computer science)
Involves the identification of technical uncertainties concerning the development or improvement of the business component
Use a process of experimentation to evaluate alternative solutions to overcome these uncertainties
- This process may involve modeling, simulation, systematic process methodologies etc

There is a very helpful guideline to follow to see if your activities will qualify for the R&D tax credit. This guideline has been curated based on the precedence set out in other cases and audits, so following this will surely help guide you in the right direction, and may help you understand what the IRS is really looking for.

The IRS splits software activities into three risk categories:

High risk means that these activities usually fail to constitute qualified research under I.R.C. § 41(d).
- Activities that don’t advance or create new system architectures and, instead, apply slight modifications or integrations with existing architectures and systems are often high risk.
- Quality control, bug detection, and minor updates do not have sufficient technical uncertainty, and often involve routine or standard modifications/updates.
- These maintenance activities involve work that is well known in the industry and does not contribute new knowledge or require a process of experimentation.
Moderate risk means that these activities often fail to constitute qualified research under I.R.C. § 41(d).
- These activities are split down the middle and it often comes down to the details of the project. Many of these categories could effectively describe projects that have no uncertainty, or much technical uncertainty
Low risk means that these activities rarely fail to constitute qualified research under I.R.C. § 41(d).
- These activities are often new developments, creating novel architectures and involve high technical uncertainty.

We have collated this audit guide into an easy to follow Risk Matrix, though you can browse the expanded version of the guideline for examples of each point.

Likely Eligible	Likely Ineligible
Initial development and release of a new software product Development of new system softwares Development of specialized technologies (eg. AI, speech recognition, image processing) Software developed as part of a hardware product, interacting directly with that hardware	Maintenance of existing software applications/products Software Application Configuration Reverse engineering Detecting Flaws and bugs in software Modifying existing software to make use of new or existing standards or devices, or to be compliant (i.e., certified, validated, etc.) with another product or platform. Developing a business component that is substantially similar in technology, functionality and features to the capabilities already in existence at other companies. Upgrading to newer versions of hardware/software, or installing vendor fix releases. Re-hosting or porting an application to a new hardware/software platform or rewriting an existing application in a new language Writing hardware device drivers to support new hardware (e.g., disks, scanners, printers, modems, etc.). Data quality, data cleansing, and data consistency activities. Bundling existing individual software products into product “suites” Expanding product lines by purchasing other products. Interfaces, Graphical User Interfaces Y2K Program Changes. Vendor Product Extensions.
Possibly Eligible
Functional enhancements to existing software applications/products. Software developed as an embedded application (eg in cell phones, automobiles, airplanes. Development of software utility programs, such as debuggers, backup systems, performance analyzers, data recovery, etc. Changing from a product based on one technology to a product based on a different or newer technology (e.g., switching from a hierarchical database technology to a relational database technology). Adaptation and commercialization of a technology developed by a consortium or an open software group.

Are you developing new software for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Leon Max v. Comm’r: A Case in Fashion and R&D

Leon Max v. Comm’r. T.C. Memo. 2021-37 (3.29.2021)

Leon Max Inc. (Leon Max) is a clothing designer who specializes in women’s apparel. They submitted an R&D tax credit claim for the 2009 to 2012 tax years. The claims are based on projects that show development of garments. The claims were denied on the premise that the projects did not qualify as eligible R&D under section 41. They more specifically asserted that the process did not qualify for the research credit because the process “was nontechnical, typical of the industry, and [was] concerned more with style, taste, and seasonality.”

Leon Max explained that their development processes began with the design team creating concepts for each collection. Following concept design, they would choose textiles and determine design elements that would suit it best. Uncertainty regarding incorporating design elements were solved through trial and error. Following store approval of these samples, Leon Max then fabricated prototypes to be sent to third-party manufacturers.

Law and the Court’s Decision

The Tax Court approached this analysis as they normally do -with the four-part test.

The four-part test under IRC Section 41 is made of the following

- IRC Section 174 Test

Requires research expenditures to be eligible for treatment as expenses – so those costs that are directly linked to the experimental components

- - The court found that Leon Max’s outlined uncertainties (eg. how to drape fabric, proper thread size) are not qualified uncertainties.
  - They further found that the tests applied (eg. test fabric shrinkage by washing it) were not investigative in nature.
- Technological Information Test

Qualifying projects are undertaken in order to discover information that is technological in nature. So the application of hard sciences to further the industry

- - The court found that Leon Max’ testing (eg. fit testing of cloth) does not fall under engineering as they claimed, and therefore they did not utilize any principles of engineering in their process.
  - The court further found that their method of testing draping fabric did not rely on any material science
- Process of Experimentation Test

All of the research activities must constitute the three elements of a process of experimentation for a qualified purpose.

- - - “Substantially all” element
    - “Process of experimentation” element
    - “Qualified purpose” element
  - The court asserted that Leon Max did not meet the qualified purpose element, as a “ “purpose is not qualified if it relates to style, taste, cosmetic, or seasonal design factors.”
  - The court further asserted they did not meet the process of experimentation element, as a process of experimentation inherently requires uncertainty to try and overcome. Without true technical uncertainty, they could not follow a scientific process of experimentation.
  - Finally, the court also asserted Leon Max did not prove that at least 80% of their activities were a part of a process of experimentation, as many of their activities were simply not qualified.
- Business Component Test

The application of this research must result in the development of a new or improved business component of the company/taxpayer

- The court did not continue it’s evaluation with this test as they had asserted a failure to meet requirements for all other tests already.

Overall, the court ruled in favor of denying these tax credits stating that the activities were “common solutions to common problems.”

Learnings

While the IRC section 41 does have some historical precedence in relation to the textile and apparel industries, IRC Section 41(d)(3)(B) outlines an exclusion of style, taste, cosmetic or seasonal design factors from the definition of “qualified purpose’. This exclusion absolutely proves to be a hurdle for apparel companies – but it should be evaluated carefully before claiming the tax credit.

Something to consider – there is a repetitive use of the scientific method as a means to deny a credit claim. The scientific method, however, does not always conform directly into industrial and commercial practices. A systematic process of experimentation does not always follow a scientific process but might still reflect an effective and comprehensive experimentation process. The Tax Court should consider addressing how this terminology may no longer accurately reflect the variety of innovation processes across industries.

Click here to read the full case.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.

Swat-Fame v. OTA: A Case in Fashion and R&D

Swat-Fame, Inc. OTA Case Nos. 1801072, 1812114, & 18012115

Swat-Fame Inc. an S-corp apparel designer for women and girls clothes also develops and refines new and improved garments. Because of this design development, they have claimed R&D tax credits under section 41. These claims were made through amended tax returns for the years 2008 through 2011. These claims were denied and promptly appealed by the company.

Swat-Fame claimed the research activities involved product design and development through a design team, focusing on new and improved silhouettes and fabrics for their upcoming seasonal line. Substantive documentation was provided through feedback from designer departments, hand sketches and drafts in computer aided modeling programs (CAD), and a narrative outlining the concept phase and fabrication phases (eg. Different materials, cuts etc).

The projects specifically pertained to development of bermuda shorts, dresses with adjustable straps, two-piece set of leggings and skirts, and a two-piece set with sundress and shrugs.

Basic Facts

The claims were denied as the Franchise Tax Board (FTB) did not agree that the activities were qualified research under R&TC section 23609.

FTB claimed the company failed to demonstrate that substantially all of the activities related to each of the sample projects reviewed by the OTA (Office of Tax Appeals) constituted a “process of experimentation” for a qualified purpose.
FTB claimed the company failed to demonstrate that 80% or more of Swat-Fame’s activities for any of the four projects reviewed constituted elements of a process of experimentation for a qualified purpose.
FTB claimed the company failed to show their activities were more than simple trial and error, or proving they engaged in a scientific method
FTB claimed the company’s activities pertained to the style or aesthetics of the garment as opposed to a qualified purpose relating to the function, performance, quality, or reliability.

Specifically, the FTB claimed that each solution used to overcome any development issues were achieved through known methods and nothing new or innovative was created for the industry. They were further unconvinced that the company successfully substantiated their claims. The FTB denied a total of $2.4M in claims spread over the 4 years.

Court’s Decision

In review of the appeal, the OTA found that the original FTB claims were upheld, with no new methods or designs being produced. For instance, one garment faced issues wherein pockets were ripped during stonewashing. The solution eventually used was using extra bar tack stitching – the application of a known solution. The OTA confirmed the denial of tax credits.

Learnings

Documentation is the key component to substantiating your claims. Even when your research might be questioned, the supporting documentation is the key to making your argument. In this case, Swat-Fame failed to accurately document its systematic process of experimentation, showing no trail of methods tested in temperature wash trials. They could not differentiate between developments that contributed to functional enhancement over aesthetics and style. In addition, they lacked documentation showing that multiple and iterative testing methodologies were used and therefore could not support a process of experimentation.

In addition, it’s important to understand the types of projects that the R&D tax credit considers qualifying. These research components must be rooted in hard sciences – think: engineering, chemistry, physical sciences. So aesthetics and style modifications often do not qualify. But that’s not to say apparel companies should count themselves out – in fact clothing and apparel companies often have R&D that they don’t even recognize. For instance: integrating prototype machinery or equipment, enhancing manufacturing processes, designing new fabric blends for strength or durability etc.

The IRS has historically acknowledged (See SOI Tax Stats – Corporation Research Credit, Table 2: Corporations Claiming a Credit, by Manufacturing Subsector) the eligibility of apparel and textile companies and manufacturers in claiming the R&D tax credit – but it still comes down to substantiating your claims.

Click here to read the full case.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Little Sandy Coal Co. Inc. v. Commissioner

Background

Little Sandy Coal Co. Inc. v. Commissioner, T.C. Memo. 2021-15

Corn Island Shipyard, Inc. (CIS) operates as a shipbuilding subsidiary of Little Sandy Coal Co. They developed 11 vessels in 2014, using 2 as representatives for the others in their R&D study. The IRS disallowed the credits claimed for this research, contending that CIS failed to meet the “substantially all” requirement with respect to the “process of experimentation” test under Internal Revenue Code (IRC) Section 41.

Basic Facts

The IRS took the position that CIS did not meet the “substantially all” requirement, i.e., that substantially all of the activities involved in the research constitute elements of a process of experimentation, which according to the relevant regulations means that 80% or more of the taxpayer’s research activities constitute elements of a process of experimentation for the costs related to the business component to be qualified.

For R&D that does not meet the 80% threshold, there exists a sub-business component for the “Shrink Back” provision of Treas. Reg. §1.41-4(b)(2) to apply. This allows a taxpayer to claim certain improvement costs where the improvements made to an existing product account for less than 80% of the total product costs.

CIS argued that substantially all of the development activities constituted elements of a process of experimentation as definied in sec. 41(d)(1)(C) and sec. 1.41-4(a)(6). Their case in point was that more than 80% of the elements of each vessel differed from previous vessels. For instance, they argued that the hull, which comprises 90% of the vessel, was completely redesigned.

CIS also argued that the work of the production employees directly supported research and constitued elements of a process of experimentation as such. Their argument specified that the work done by production workers on novel elements made up at least 87% of their work on the vessel and so they met the “substantially all” test requirements.

Court’s Decision

The court ruled in favor of the IRS and stated the following:

The “substantially all” test must be applied in reference to activities, not physical elements of the business component being developed or improved.
- The hull of a ship corresponds to 90% of the product, but does not guarantee that the activities involved would meet the “substantially all” requirements.
Only employees directly involved in the process of experimentation are qualified expenditures.
- The court further specified that if there had been detailed records outlining the production workers contribution to the R&D, an argument could be made to include them. However, without any evidence they could not be included.
The novelty of an element of a business component does not establish that the work involved in developing that element involves a process of experimentation.
- The court further specified that developing novel components only guarantees uncertainty at the beginning of development but does not guarantee that a process of experimentation was undertaken.

Although the court had no doubt that the vessels required iterative and detailed processes of experimentation, they remained unconvinced that CIS had proved their development activities constituted 80% of a process of experimentation. They further ruled that they could not apply the Shrink Back provision as they had chosen an “all or nothing strategy” rather than looking at a subcomponent level. The final ruling resulted in all activities related to the projects being disqualified.

Learnings

This case highlights the importance of maintaining detailed records of employee contribution to R&D projects and ensuring you have the evidence to support your research tax credit claims. Identifying a detailed approach to analyzing business components and outlining methodologies is key to providing a reasonable basis which will quantify whether the “substantially all” test is met. Without sufficient substantiation to support claims, an entire research tax credit could be subject to disqualification.

Click here to read the full case.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

Who We Are:

Swanson Reed is one of the U.S.’s largest Specialist R&D tax advisory firms, offering tax credibility assessments, claim preparation, and advisory services. We manage all facets of the R&D tax credit program, from claim preparation & audit compliance to claim disputes.

Audio Technica, Inc V Commissioner (2020)

Background

Audio Technica vs. Comm’r., Case: 5:16-cv-02052-JRA; (Fed. Dist. Ct. Northern OH)

Audio Technica, Inc. makes high-end audio equipment and contends that it was entitled to a tax credit for increasing research and development activities under section 41 for the 2002-2005, 2006-2010, and 2011 tax years. The IRS issued a notice of deficiency stating that Audio Technica was not entitled to the credit amounts it claimed. In response, Audio Technica filed a petition for review with the United States Tax Court. This was ruled on and then appealed at the District Court of Appeals.

Basic Facts

Under Section 41(c)(3)(A), the R&D tax credit is available when taxpayers increase certain research expenses overtime. This increase is measured against research costs from a previous 5-year period and taken as a percentage of gross receipts during those years. This fixed-based percentage is multiplied across the average gross receipts for the most recent 4 years to obtain a base amount. A taxpayer is entitled to a credit equal to twenty percent of the amount that its qualified research expenses for the year exceeding this base amount.

Court’s Decision

Original Dispute

Audio Technica reached a settlement with the court with the following outcomes:

2002-2005: listed the dollar amounts of an agreed-upon deficiency by tax year
2011: stated the total dollar amount of Audio Technica’s research credit

With respect to the 2006-2010 tax years, Audio Technica paid the amount owed to the IRS and subsequently sued the Northern District of Ohio for a refund. They filed a motion which stopped the government from claiming that the .92% fixed-base percentage did not apply in this case, as they had already previously agreed to it’s accuracy in the 2002-2005 and 2011 rulings. The court eventually ruled in favor of Audio Technica and directed them to propose a supplemental judgement, which was later agreed to. As requested, Audio Technica filed a proposed final judgment, which noted that the fixed-base percentage from the Tax Court proceedings was .92% and calculated the total amounts for R&D tax credits it was owed in certain of the tax years at issue

Appeal

The government appealed the ruling stating that Audio Technica had improperly filed to stop the government regarding the 0.92% fixed-base percentage. The court ruled in favor of Audio Technica again, as the government still failed to provide any proof that would have shown a different fixed-base percentage.

Learnings

The calculations involved with research tax credits can be convoluted, and so it is important to accurately track the values used to determine percentages and credit amounts. Having a sufficient history of evidence is the best way to ensure you receive the credits you are entitled to.

Click here to read the full case.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

Who We Are:

Tangel V Commissioner (2021)

Background

Tangel v. Comm’r, Docket No. 27309-13 (U.S.T.C. Jan. 11, 2021)

Enercon Engineering, Inc. claimed R&D tax credits for research performed through 2008-2010. Enercon was hired by Vericor to develop a new enclosure for turbine power generation. The IRS filed a motion for partial summary judgment with respect to the expenses incurred by Enercon while providing services to Vericor. The IRS brought this forth as the research expenses were funded and are therefore not eligible for research tax credits.

Specifically, this case looked at how substantial rights apply to a taxpayer working on behalf of another company.

Basic Facts

Under Section 41(d)(4)(H), qualified research expenses are defined to exclude any research that is funded by a grant, contract, or other person or entity. Exceptions to this apply when the taxpayer retains substantial rights to the research. Enercon and Vericor negotiated a detailed set of contract terms which restricted Enercon’s use or disclosure of technical information, except in the case of the performance of work for Vericor. Paragraph 15 had expansive definitions for research rights that ranged from rights to technical information to the tooling created to develop the products for Vericor. The paragraph further prohibited Enercon from using the research for any purpose other than Vericor’s project without prior consent.

The IRS disallowed research credits of approximately $930,000 claimed during 2008 – 2010 by Enercon. The IRS’ stance was that the contract removed any substantial rights from Enercon to the research performed. Enercon petitioned this, arguing that paragraph 15 was a standard non-disclosure agreement and so they retained the right to use institutional knowledge gathered during the project for future uses.

Court’s Decision

Following thorough examination of the contract, the court ruled in favor of the IRS. Their decision was based on the unequivocal nature of the language of the Terms and Conditions. While the petitioner’s argued that the substantial rights were not specifically written in and could be “read-in”, the court ruled that such a right in this case is more properly characterized as an “incidental benefit to the taxpayer” and thus does not meet the substantial rights requirement. They maintained that the results of all research performed to fulfill the contract were retained by Vericor and were therefore not qualified research expenditures for Enercor. Further, Enercor would be held to the conditions of the contract and would be unable to re-use the results of its research without getting Vericor’s prior written consent.

Learnings

It has been well established that a taxpayer is only entitled to research tax credits under Section 41 if they retain substantial rights in their research. With this in mind, it is crucial for taxpayers to evaluate the extent in which their company retains the substantial right to the research performed when funded through a third party. Taxpayers should carefully consider the rights they are explicitly granted in contracts prior to claiming R&D tax credits. Further, careful consideration of the rights explicitly granted during contract drawing could lead to favorable outcomes for the taxpayer.

Click here to read the full case.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

Who We Are:

Sun Microsystems Inc v Commissioner (1995)

BACKGROUND

Sun Microsystems Inc. (“Sun Microsystems”) v. Commissioner, T.C. Memo 1995-69

Sun Microsystems was a computer company that sold computers, computer components, software, and IT services. It was founded in 1982 in California.

At Sun Microsystems, an incentive stock option (ISO) plan was given to employees who engaged in R&D work from April 1983 to July 1986. They were allowed to be exercise this (i.e. buy and sell stock) from August 1985 to June 1987. Then, in 1987, the plan ended and any ISO shares that employees held were sold back to the company. These sales were referred to as ‘disqualifying dispositions’. Employees, in 1987, therefore may have had income from these sales (i.e. the sales price minus the market value when they were bought). This income was called ‘spread income’ and was reported on the employees’ W-2 forms.

BASIC FACTS

When Sun Microsystems filed its 1987 return, it claimed the R&D Tax Credit, and included wages as Qualified Research Expenses (QREs). Within these wage expenses was $1,025,918 from spread income from the disqualifying dispositions. The IRS disallowed the claim. The company and the IRS disagreed about whether ‘wages’ (for R&D purposes) include income from disqualifying dispositions of stock purchased through the company’s ISO plan.

When claiming the R&D Tax Credit, “in-house research expenses” count as QREs. They’re defined as “any wages paid or incurred to an employee for qualified services performed by such employee”, and often just referred to as ‘wages’. It’s also specified that ‘wages’ refers to all remuneration for services performed by an employee for their employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash. By this logic, Sun Microsystems argued that spread income is classed as wages.

COURT’S DECISION

The court referenced Apple Computer, Inc v Commissioner, in which spread income was found to constitute wages. It also acknowledged that there was no language in legislative history that excluded spread income from the definition of wages. As such, the court agreed with Sun Microsystems, and held that spread income constituted wages, and QREs.

LEARNINGS

QREs include wages, supplies and computer rentals, but, within these groupings, it’s important to understand what can and can’t be claimed. Many companies utilize different pay structures, and must take these into account when claiming wages for their R&D Tax Credit refund. Or, get professional assistance when making the claim.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

WHO WE ARE:

Deere & Co v Commissioner (2009)

BACKGROUND

Deere & Co. v. Commissioner, 133 T.C. 11 (2009)

Deere & Co manufactured and distributed agricultural equipment, commercial and consumer equipment, and a broad range of equipment for construction and forestry. Although its principal office was in Illinois, it had branches in Germany, Italy and Switzerland. These European branches were involved in the development of numerous products.

In the company’s 2001 R&D Tax Credit claim, it calculated its average annual gross receipts (averaged from the last four years’ gross receipts) totalled as $11,737,809,783. This total included only the U.S branch’s gross receipts. This average annual gross receipts amount is used to calculate the company’s base amount; qualifying research expenses over this amount can be claimed.

In response, the IRS issued a notice of deficiency, saying that Deere & Co should be disallowed the credits. It argued that the company should have included gross receipts from the foreign branches. This average would have been $13,373,420,885.

BASIC FACTS

It’s important to note that in 1996, a new section of the R&D tax credit was enacted that allowed taxpayers to use an alternative, three-tiered formula calculation method. And, in 1999, Congress changed the definition of foreign research to “any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States”. It said, “in the case of a foreign corporation, there shall be taken into account only gross receipts which are effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico, or any possession of the United States”.

So, in 2001, when Deere & Co calculaed its R&D tax credit claim, it used this method and did not include its foreign gross receipts. It argued that it didn’t include these because there was no clear definition of gross receipts, and the structure of the statute and legislative history demonstrate that the R&D credit has an historic domestic focus. To simplify, it argued that the R&D credit allowance is for work undertaken within the U.S., so only U.S. gross receipts are relevant, and because there is no clear definition the company shouldn’t be disallowed the credits.

COURT’S DECISION

The court disagreed with Deere & Co. Congress has excluded research from outside the U.S. as qualifying research, to ensure foreign research was not claimed. But, as above, foreign gross receipts are to be taken into account if they are connected with the business/trade. The court therefore found that the company should have included these foreign gross receipts. Deere & Co was disallowed the credits, because of its calculation error.

Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

WHO WE ARE:

Ekman v. Commissioner (1999)

BACKGROUND

Ekman v. Commissioner, 184 F.3d 522 (6th Cir. 1999)

Leonard and Kaye Ekman, in their 1991 joint income tax return, claimed the cost of a Porsche engine that Leonard performed R&D work on. However, the tax court found that this was not a deductible research and development expense, because it was an asset. The Ekmans appealed this decision.

The Commissioner found that expenses claimed for cam development, piston development, engine block development, cylinder head development, and the damaged Porsche engine were not deductible because they were capital expenditures which must be depreciated when placed in service. Before trial, the Commissioner agreed to allow all of the disputed expenses, except for the $7,000 claimed for the cost of the engine.

BASIC FACTS

The Porsche 928 S4 engine was designed to run comfortably at speeds of 130 to 150 miles per hour. However, Leonard Ekman felt there was a niche market for a racing vehicle with this engine, and as such he began work on this. He started development work on a Porsche 928 S4 two-valve engine in 1984. In late 1991 he sought to intensify his efforts, and purchased a damaged Porsche 928 S4 four-valve engine for $7,000. Ekman also enlisted other people to help with his developments; he developed the engine while they developed other parts to enhance the engine. During the process he also bought two used Porsche automobiles that provided the parts and body for the enhanced engine.

The objective of Ekman’s projects was not to sell the modified engine, but just to make the modifications, and if successful they would be implemented on other 928 S4 engines. He was successful in increasing the engine’s horsepower.

COURT’S DECISION

Supplies are deductible if they are used in the project and can’t be used again, but there is a certain amount of allowance for natural ‘wear and tear’. For example, metal bent/manipulated during a project is claimable (because it can’t be used again), but if the company buys a new wrench this can’t be claimed. The wrench, in this scenario, is an asset that might have natural damage, but it was not bought solely for use in this project. The tax court concluded that the expenditure for the engine was not deductible, because the engine was subject to this wear and tear, rather than damage during the R&D process.

Ekman argued that the asset to be depreciated was used in producing final goods to be sold (i.e. the engine was a depreciable asset, but could be claimed because it was used for R&D). The court disagreed. An expense being deductible or only depreciable refers only to the character of the property, not the use of the property.

Ekman also argued that the cost of the engine wasn’t depreciable because the engine was “not subject to wear and tear, but is intentionally being destroyed as part of the on-going research”. He said that the engine was bought for the purpose of “blowing it up”, but his testimony made it clear that the engine was repaired, modified, and still running after five years. He explained that by “blowing” the engine, he meant some internal damage. The engine would then be taken apart and examined for wear and repaired.

The court decided that the property was subject to wear and tear, even excessive wear and tear, and therefore a depreciable rather than deductible research or experimentation expense.

LEARNINGS

Qualified Research Expenses (QREs) are split into categories: in-house wages, contractor costs, supplies and computer rental. Supplies can be claimed if they’re used in the R&D projects, and are likely to be fully used, or destroyed, during the experimentation. For example, computers, wrenches, and test tubes are all supplies that may be used in the R&D activities, but they’re considered assets because they can be used multiple times and are likely to last a number of years. They will eventually need to be replaced because of general wear and tear, but are not considered deductibles. Comparatively, supplies like metal, wood, and chemicals are likely to be used in only this experimentation, and cannot be used again. Therefore, they’re a supply, rather than an asset, and can be claimed in the R&D tax claim. The line between these two is not often so obvious, so it’s a good idea to get advice from industry experts.

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