BACKGROUND

Wicor, Inc. (“Wicor”) v. United States, 263 F.3d 659 (7th Cir. 2001)

Wisconsin gas company Wicor sought to integrate a computer system, so that it could perform a number of tasks (e.g. process service orders, record meter readings, bill customers, record transactions, etc).  It hired a third party, Anderson Consulting, to assist. Most of the software previously existed, but Wicor and Anderson Consulting jointly developed an integration program.

Wicor claimed R&D Tax Credit for this integration work, which was denied. The U.S. stated that the company didn’t satisfy four requirements, that the research:

1. wasn’t for the purpose of discovering technological information,
2. wasn’t experimental,
3. wasn’t innovative, and
4. didn’t involve significant financial risk.

BASIC FACTS

Discovery of Technological Information

Wicor responded that it ‘discovered technical information’ by determining the best mix of algorithms, data and rules needed. To this, the court found that the project was technological in nature, but was not undertaken to discover information. Instead, it was done to install a system that would integrate company information functions.

Experimental in Character

Wicor argued that it tested solutions and/or hypotheses, and then made improvements based on the results, until no more development was needed. Its software engineers tested a variety of hypotheses, which were later used as case studies for customers, management and consultants. However, the court stated that the development of the new software design didn’t have any uncertainty at the project’s outset. It’s the company’s burden to provide evidence of uncertainty, which it didn’t.

Innovative

The contract between Wicor and Anderson Consulting said that Anderson Consulting owned the integrated computer system, but it didn’t take a copy of the source code when the project was complete. It was apparent that Anderson Consulting didn’t think the program had any other uses. This makes it seem as though the project involved adapting software for a specific use, not developing innovative software.

The company’s argument was that the innovation was its streamlined functionalities. Although it improved efficiency, Wicor failed to prove how this contributed to technological advancement.

Significant Financial Risk

Through government experts opinions, the court found that the project involved business risk (i.e. will it be done on time?). But, it didn’t have financial risk; Anderson Consulting and Wicor had both undertaken similar projects, and so were sure they could achieve this.

COURT’S DECISION

It’s the burden of the taxpayer (Wicor) to provide evidence that its work meets the R&D tax credit requirements. The company didn’t successfully do this. The court found that Wicor didn’t meet any of the four requirements outlined above, and so wasn’t eligible for the tax refund it had claimed.

LEARNINGS

The R&D Tax Credit is for, as stated, research and development. This means that significant development and/or innovation needs to be achieved, or at the least attempted. The four-part-test asks:

1. Is the work technological in nature?
2. Is there a permitted purpose?
3. Is there elimination of uncertainty?
4. Is there a process of experimentation?

If a company’s project doesn’t meet these requirement AND provide adequate evidence, it’s not entitled to claim the refund. 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. 

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.

BACKGROUND

United States v. Beltecno Inc. & Subs. (“Beltecno”), 104 AFTR 2d 2009-5929 (WD WA 2009)

Cabinet manufacturer Beltecno filed amended tax returns in 2005 and 2006, and claimed $12,117 in R&D tax credit for 2001, and $124,772 for 2002. Both were paid by the IRS, without it performing any investigations. The IRS also refunded Beltecno another $37,231, as it determined the company has miscalculated its uniform capitalization reserves for 2001, and was therefore owed this extra amount.

However, in 2007, the IRS audited the company, and found that the tax refunds issued to Beltecno were in error. So, it demanded a return of funds (totaling $174,120, plus interest). The reasoning was that Beltecno did not record its research expenses, and therefore there was no correlation between its projects and QREs.

BASIC FACTS

The IRS sent Beltecno an explanation (Form 866-A) and requested the funds, but the company didn’t pay. In 2009, the IRS therefore took the company to court over this $174,120.

It’s allowed two years after making an erroneous refund to bring suit, and must establish:

• that the refund was paid to the taxpayer (i.e. Beltecno),
• what the amount was,
• a timely recovery action, and
• that Beltecno isn’t entitled the refund.

Here, the first two points were easily assessed. The payments were made to Beltecno in 2007, and the case was in 2009, so the two year window was also sufficient. Because the company failed to keep records of its R&D expenditure, the final requirement was also met.

Beltecno argued that the IRS’ claims should be dismissed because the IRS failed to provide sufficient evidence. The company argued that without evidence from the IRS, it’d have to undertake an expensive and time consuming discovery. It referred to Mahoney v U.S. and McLennan v U.S., where the United States was the defendant in both cases, and as such had to provide “concrete and positive evidence” as to why the taxpayer could/should not receive a tax refund. However, in this case the IRS is seeking to return funds, not refusing them in the first place. So, the ultimate burden of evidence is on the taxpayer (Beltecno).

COURT’S DECISION

The court referred to Ahmanson Foundation v. United States, where it found that the IRS only needs to prove its claim has substance and was made in good faith. It’s Beltecno’s burden to prove the amount it’s entitled to. Similarly, as seen in Tax & Accounting Software Corp v United States, the tax credits are a privilege granted by the government, and the taxpayer should maintain adequate records. The court was satisfied that the IRS’ Form 866-A proves that its claim has substance, and that it’s acting in good faith. The case was therefore not dismissed, and Beltecno was to return the funds.

LEARNINGS

Regardless of whether companies are claiming the tax year just ended, or filing amended returns, they should keep adequate documentation of the R&D projects and allocation of QREs. It’s their burden to provide evidence, should the IRS audit, deny claims, or request a return of funds.

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.

Wo 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. 

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.

BACKGROUND

Geosyntec Consultants, Inc. (“Geosyntec”) v. United States, 776 F.3d 1330 (11th Cir. 2015)

Geosyntec is an engineering consultancy, specializing in environmental studies, restoration and resource assessment. The company claimed a R&D tax refund of $1,677,432 for 2002, 2003, 2004 and 2005 tax years. During these years, it entered into a number of contracts with clients. The IRS disallowed the tax credit refund because it claimed the work was funded, from these contracts.

BASIC FACTS

Six contracts were brought to the court for review: three fixed-price contracts; and, three cost-plus contracts (also known as ‘capped contracts’, where it was paid for labor and expenses, plus a mark-up, subject to an agreed upon maximum amount). The court initially said that the three capped contracts were funded, and therefore any expenses that occurred were ineligible. But, Geosyntec challenged this ruling; it claimed it held risk in two of the three.

According to Fairchild Industries Inc v U.S., the entity or person who can claim (i.e. the company or its client), is whoever holds the financial risk. This means that the client can claim the R&D credit if they are required to pay, regardless of whether the research is successful or unsuccessful. Conversely, if the client is only paying for a finished product, the company can claim, because it’s taking the risk.

In both contracts, Geosyntec was given several tasks, each with subtasks that were priced separately, with a capped total on the project. Clients had the authority to request additional tasks or alter tasks. And, additional compensation was available in certain circumstances, such as if statutory, administrative or state authority requirements meant more work was needed. Invoices were created by Geosyntec and approved or denied by the clients. The company claimed that it held financial risk because it would only be paid for expenses incurred and tasks completed, not for research. It said that if it were to go over budget it would not be reimbursed for this, and that it would not be able to profit from the research performed.

COURT’S DECISION

Firstly, the court found that Geosyntec’s risk arguments were moot. The court was only looking at whether payments were contingent on the success of the research; the cost of performance and profitability were irrelevant. And, compensation was available in certain circumstances. Also, neither contract stated that tasks had to be successful, just that they had to be performed. For example, one task was to run laboratory tests and provide the client with a report, but nothing was said about the test results having to be successful. As another example, one task was to design a landfill expansion and provide services during construction (both which required R&D work). But, Geosyntec didn’t have to install or implement this design, and it wasn’t subject to testing or inspection before acceptance.

Because no payments were contingent on project success, the court decided that Geosyntec did not have the necessary risk needed to claim the R&D Tax Credit refund.

LEARNINGS

Any company claiming this credit should look closely at who holds financial risk, specifically, whether payment is contingent on success. While it’s not always black and white, this question helps to confirm, or deny, eligibility.

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. 

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.

BACKGROUND

Populous Holdings, Inc (“Populous”) v. Commissioner of Internal Revenue (Docket No. 405-17) (2019)

Populous is an architecture firm, claimed R&D tax credit for activities in 2010 and 2011. The IRS denied the claim of $132,539 for the 2011 tax year and $151,494 in carryforward credits from 2010. The basis for this denial was that the research was funded.

BASIC FACTS

Under Section 41(d)(1)(H), companies conducting research and development must hold the burden of financial risk, to claim the tax credits. Typically, the company – in this case Populous – holds the financial risk when two conditions are met: (1) payment is contingent on the success of the research and (2) the company retains substantial rights in the research. To simplify, this means that Populous could NOT claim if a third party was paying for its research. It could claim only if the payment was for a final product (i.e. payment was not guaranteed if the product was not made to requirements), AND, Populous held substantial research rights.

In this instance, the IRS claimed that the research was funded: Populous did not have enough financial risk and lacked sufficient rights.

COURT’S DECISION

Risk

The court thoroughly examined the contract between Populous and the third party involved (the companies paying for the final products). Previous cases Fairchild Industries, Inc. v. United States and Geosyntec Consultants, Inc. v. United States were used as reference. Both these cases help to explain that they key point is “who bears the cost of the research if [the research] is unsuccessful”. And, these cases also helped to specify clauses to look for in the contract, including:

• payment procedures,
• quality and performance standards,
• termination clauses, and,
• warrant and default provisions,
• the right to review and approve design documents,
• invoice dispute provisions, and
• revision obligations and covering related costs.

No contracts stated that research was required, which the court clarified means Populous was not being paid for its research. Instead, the companies were paying fixed prices for final products. As such, payments were contingent on Populous’ successful research, it it therefore held the financial risk.

Rights

The court looked to Lockheed Martin Corp. v. United States and found that the contracts held no provisions that

• restricted Populous from using the research it performed,
• Populous needed to pay for the use of research, and
• the right to use the research was exclusive.

So, again, the court found that Populous retained sufficient rights to its research and results.

LEARNINGS

Many companies engage in R&D activities with third party contracts in place. This case is a huge win for those companies. It is, however, an example of how to scrutinize those contracts to ensure all Qualified Reasearch Expenditure eligibility requirements are met.

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. 

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.

BACKGROUND

Quebe v U.S. (2019)

Quebe Holdings, Inc (“QHI”) operates as three separate electrical companies: Chapel Electric, Romanoff Electric, and CRT Technologies. In 2013, QHI filed an amended tax return for the 2009 and 2010 financial years. For both claims, QHI used the “start-up” method to calculate its base amount, and the subsequent R&D tax credit.

BASE AMOUNT

The amount of R&D credit a company can claim is dependent on a “base amount” spent during a “base period”. This base period is 1984-1988, unless the company meets certain criteria, in which case it can claim an alternative period for “start-up” companies.

Traditionally, to calculate the base amount, a taxpayer (i.e. a company) calculates the percentage of gross receipts they spent on research from 1984-88. This percentage X the average gross annual income for the four years preceding the year being claimed = base amount. For example, if during that time a company spent 5% on R&D, and then in 2006 – 2009 its average gross annual income was $150,000, then the base amount for 2010 would be $7,500. This base amount represents what would have been spent on research, so the company can claim any qualified research expenses (QREs) above this amount (i.e. if the company spent $8,000 on R&D QREs it could claim $500).

When using the start-up calculation method, the base percentage automatically starts at 3%. In the example above, the company could claim anything more than $4,500 on QREs, if it met the criteria. Taxpayers can use the start-up period if:

(1)The first taxable year in which a taxpayer had both gross receipts and qualified research expenses begins after December 31, 1983, or

(2)There are fewer than 3 taxable years beginning after December 31, 1983, and before January 1, 1989, in which the taxpayer had both gross receipts and qualified research expenses.

BASIC FACTS

In Court in August 2015, the Government argued that QHI was not permitted to use the start-up method for claiming R&D. Two of QHI’s companies, Chapel Electric and Romanoff Electric, had gross receipts both before 1984 and during the 1984-88 period. And, some of the company’s research activities in 2009 and 2010 were also being performed in the 1980s. 

The Government also argued that QHI failed to substantiate, or prove, its claim.

QHI returned, saying that Chapel Electric was mostly engaged in ‘Time and Materials’ based contracts. These contracts are routinely found to not qualify. It also stated that Chapel Electric did not have on offsite space for engineers to perform these activities (i.e. a prefabrication unit) in 1941-1988. Therefore, it argued that the same activities could not have been performed. Although QHI did not own Chapel Electric at that time, it was still claiming for the company and, as such, must provide evidence. However, the company provided no proof to support either of these claims. Instead, it argued that there needed to be evidence against the claims (i.e. the Government must provide proof).

Although it wasn’t the Government’s duty, the Government had actioned this case, and as such, came forward with proof. It provided evidence that the same activities were being performed in 1984-1988, as were performed in 2009 and 2010. These activities included: developing new means and methods, issuing requests for information (RFIs), implementing change orders, value engineering, determining pathways for conduit and wiring, coordination among trades and estimation.

COURT’S DECISION

The Court sided in the Government’s favor, and told QHI it was not entitled to its R&D tax refund. This was because QHI had failed to provide proof. And, it was wrong in implying that it was the Government’s duty to provide proof. The Court quoted 26 C.F.R. § 1.6001-1(a), saying a taxpayer “shall keep such permanent books of account or records . . . as are sufficient to establish” the amount of a credit claimed. Also, it “must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”

LEARNINGS

Establishing base periods can be complicated, especially if ownership has changed hands or the company has had years where no R&D occurred. Companies using the start-up calculation method need to provide credible evidence that they were not performing qualified research in the 1980s. Although, this reasoning is somewhat counterintuitive; providing evidence that something didn’t happen is not always easy to produce. If there’s no clear evidence from that time, taxpayers may be able to make an estimate about those years. For example, a Court may accept a credible testimony which provides the number of R&D staff, and labor statistics to determine salary. However, this is not a certain method.

As with all R&D claims, companies should consider the documentation it has, and discuss with an R&D expert. Want to know more about claiming R&D tax credits? Connect with our R&D tax experts today.

Click here to read the full case.

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. 

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.

BACKGROUND

Siemer Milling Company (Siemer Milling) v. Commissioner of Internal Revenue, T.C. no 37 (2019)

Illinois based company Siemer Milling mills and sells wheat flour. In the tax years ending May 31, 2011 and 2012, it claimed R&D tax credit for seven projects, some spanning both years. The company claimed expenses involved in new product development projects. These included staff wages for projects such as flour heat treatment, wheat hybrids and whole wheat flour.

BASIC FACTS

To qualify for the R&D tax credit, a company must prove that its projects pass the four part test, which requires answers to the following questions:

• Is the work technological in nature? (i.e. does it rely on principles of hard science: chemistry, engineering or computer science?)
• Is there a permitted purpose? (i.e. is there intent to develop a new or improved product or process?)
• Is there elimination of uncertainty? (i.e. at the offset of this project, was there uncertainty about its design, capability or method?)
• Is there a process of experimentation? (i.e. did the company systematically trial and experiment?)

Siemer Milling provided no evidence of a methodical experimentation. The company recited the steps it took in the technical process, but did not back this up with documentation.

COURT’S DECISION

The court ruled that Siemer Milling was disallowed $235,000 it had claimed. This was because it failed to retain and provide adequate documentation to demonstrate that its activities met the IRS’ four part test. The court paid particular attention to the experimentation aspect, and found that the company did not have 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 court also disallowed credit because it could not see evidence of all the work being ‘technological in nature’.

LEARNINGS

This case is a reminder of being thorough, both in undertaking the R&D activities, and documenting them. The court’s focus on the experimentation aspect of the four past test shows the importance of documenting the testing method (i.e. steps taken, failed iterations, changes made, variables monitored).

But, there are some positive takeaways from the case. The court disagreed with the IRS on some points and found that:

1. “The development or improvement of a business component can span more than one tax year”.
2. Project could have the same uncertainties in both years because “not all uncertainties are neatly resolved within the confines of a single taxable year”.
3. The company was not required to employ staff with degrees in hard sciences, or staff with hard science titles (i.e. engineers), in order to be utilizing hard sciences in its projects.

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. 

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.