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Fudim v. Commissioner, T.C. Memo. 1994-235

Background

T.C. Memo 1994-235

This tax court memo concerns Efrem V. Fudim (Fudim), who in 1988, the Kansas City Service Center informed petitioner that the amount of research credit they claimed exceeded the amount allowable for that year. They disallowed $3,222 of the $6,176 research credit and directed the petitioners to explain why they had not erred in their original amount reported.

Basic Facts

Efrem V. Fudim (Fudim) and Margarita L. Fudim (Mrs. Fudim) formed Light Sculpting Co. in 1985 and engaged in research. The rapid modeling procedure utilized ultraviolet lights to fabricate plastic objects and they attempted to perfect this method by trying other models and alternatives. Sculpting Co. obtained two patents on this process that was developed that improved the forming of three dimensional objects.

The petitioners attached a Credit for Increasing Research Activities form as part of their income tax return however they ignored the explanation of the limitation and they erroneously reduced their tax. The respondent sent a second letter detailed what the petitioner owed and the petitioners denied they owed anything.

The petitioner contend that the Tax Court should shift the burden of proof in this case to the respondent because they improperly reopened the case but there is not authority or truth to t his argument. The petitioner also argues that the respondent’s assessment of the disallowed excess portion was erroneous because no notice was given but the law states that the respondent may not access this information until an issuance of a notice of deficiency to the taxpayer has been put through.

Most importantly, research credits must be decided if they are acceptable for the years 1986 -1988. If accepted, only the wages paid related to the qualifying services constitute in-house research expenses. The Court is satisfied that the petitioner’s subsidiaries spent time engaged in qualified services and that Mrs. Fudim spent at least 80% of her time engaged in qualified services.

Court’s Decision

The Court states that on the basis of these findings, petitioner’s research credits for 1986, 1987 and 1988 and allowable carrybacks must be recomputed accordingly.

Click Here to view the full case: Fudim v. Commissioner, T.C. Memo. 1994-235.

Fairchild Industries Incorporated v. United States, 71 F.3d 868 (Fed. Circ. 1995)

Background

Fairchild Industries Corporation v. United States discusses the regulations in regards to qualified research expenses and the role of “funding”. Qualified Research Expenses (QREs) shall not include the following:

research conducted outside of the United States
research in the humanities or social sciences sectors
research funded by any contract, grant or any other person including a government entity

The research tax credit was established in 1981 to provide incentives to American industries to invest in research. The main issue in this case is the application and implementation of regulations to Fairchild’s contract with the Air Force.

Basic Facts

In 1982, Fairchild Industries Incorporated and the Air Force entered into a fixed-price incentive contract where Fairchild would design and produce a “next generation trainer” aircraft intended to train new pilots. This design included many phases of production, development and testing which also had over 1,000 pages of technical specifications and performance standards that were Fairchild were required to adhere to. For Fairchild’s 1982-1985 federal income tax returns they reported $109.4 million of qualified research expenses related to this project of which the IRS disallowed around $19.6 million not related to this program. Because the Air Force funded 55.8% of Fairchild’s research, the IRS disallowed $5.8 million in research tax credits claimed for those years. The interpretation of the statute and regulation for this case is up for debate and review. The question here is whether Fairchild’s research is considered “funded” by the Air Force in terms of research credits. Fairchild claims that the Air Force “funded” none of its research because their right to pay was considered upon the success of the research project. The government argues that the determination of whether the research is funded or not does not depend on whether the contract reserves the right to pay for unsuccessful research. Fairchild remained at risk throughout this process time until the research was successfully completed. The Regulation places importance on the fact that in order for the researcher to claim credit, accounts payable under the agreement must be contingent upon success.

Court’s Decision

Fairchild’s QREs were not considered “funded” and they are entitled to the research tax credit. The decision of the Court of Federal Claims is reversed and further proceedings will determine how much Fairchild is owed.

Click Here to view the full case: Fairchild Industries Incorporated v. United Sates, 71 F.3d 868 (Fed. Circ. 1995).

Eustace v. Commissioner. 313 F.3d 905 (7th Cir. 2002) aff’g, T.C. Memo 2001-66.

Background

T.C. Memo 2001-66

This tax court memo concerns Applied Systems, a subchapter S corporation that develops and sells software that independent agencies would use to manage their businesses. In the 1990s they improved their software packages and the investors want to take a tax credit for the research and development expenses incurred in these years. The Tax Court concluded that Applied Systems did not pass two tests required to receive the tax credit because the research was not designed to dispel uncertainty about the technological possibility of developing software of this kind. T.C. Memo 2001-66 (2001).

Basic Facts

Applied Systems performed normal software development throughout this time. They made adaptations and changes to several features however none of these were groundbreaking and pioneering and they could be found in other developers’ products. The Tax Court decided that Applied Systems failed the “process of experimentation” and the “discovering information” requirements.

Applied Systems did not argue this in court and supplied no further evidence or documentation that could prove this. Applied Systems asked the Court to use the proposed regulations for the definition of “discovering information” however proposed regulations do not have any legal effect and the proposed regulations refer to taxable years ending on or after December 21, 2001 so Applied Systems would not qualify for this regulation. Applied Systems also asked the court to disregard another court case document that was brought up (Wicor and United Stationers) yet the definitions they are arguing for are not relevant to their case. Applied Systems developed software to sell to customers while the previous two cases, the taxpayer contracted with a consulting firm to develop a program they would use for their own benefit.

Court’s Decision

Regardless of what court case documents have been consulted, simple software development does not qualify for research tax credit. The judgment of the Tax Court is AFFIRMED.

Click Here to view the full case: Eustace v. Commissioner. 313 F.3d 905 (7th Cir. 2002) aff’g, T.C. Memo 2001-66.

Tax & Accounting Software Corporation v. United States, 301 F.3d 1254 (10th Cir. 2002)

Background

U.S. Court of Appeals, 10th circuit. Tax & Accounting Software Corporation v. US 301 F.3d 1254

Tim Kloehr and Sheryl Kloehr own Tax & Accounting Software Corporation which is an Oklahoma corporation that makes and sells computer software for its customers including the four products at issue: EasyACCT, EasyMICR, Professional Tax System, and EasyTEL. They filed a tax refund suit for 1993 and 1994. They acquired research and development credits developing these products and they were denied these credits. Tim Kloehr faced tax deficiencies of $123,764 in 1993 and $192,510 in 1994. The main argument up for debate in this case is what constitutes “qualified research.”

Basic Facts

Qualified research has 5 separate requirements

research much qualify as an expense
the research must be conducted to acquire and discover information
must be technological in nature
the application of information must be used to develop or improve a product
must have a “process of experimentation”

The government conceded that Tax & Accounting Software Corporation’s projects passed the 1st, 2nd and 4th requirements. The “process of experimentation” and “discovering information” requirements are up for debate. The “discovering information” requirement means that the taxpayer must show they discovered new information and must be separate from the product that is actually developed. The evidence presented shows that Tax & Accounting Software Corporation did demonstrate that they passed this “discovering information” test. For the “process of experimentation,” both parties argued in regards to the definitions they thought fit best. The government relied on past legislative history while Tax & Accounting Software Corporation relied on other legislation. The Court found that TAASC could not be allowed this credit because they did not follow all requirements, mainly the feasibility issue, for the “process of experimentation.”

Court’s Decision

The judgment of the district court is REVERSED, and the case REMANDED.

Click Here to view the full case: Tax & Accounting Software Corporation v. United States, 301 F.3d 1254 (10th Cir. 2002).

Nguyen v. Commissioner of Internal Revenue T.C. Memo (2003-313)

Background

Nguyen v. Commissioner T.C. Memo (2003-313)

This is a memorandum from the U.S. Tax Court. Nguyen filed an tax return for the year 2000 and also claimed a tax refund for $4098. In response to a selection for examination, Nguyen sent various documents to the respondent. The respondent stated this information was insufficient and issued another letter to Nguyen for more information.

The issues for decision in this case are as follows:

Whether the IRS’s position in the administrative and court proceedings was substantially justified.
Whether Nguyen unreasonably extended the administrative and court proceedings.
Whether the administrative and litigation costs claimed by Nguyen are reasonable.

Basic Facts

Taxpayers are required to provide information in regards to deductions and claims by maintaining records necessary to establish both the taxpayers’ entitlement to such items and the proper amount. This case dealt with research credits, child tax credit, income credit and The Court holds that respondent’s position in the administrative and court proceedings was substantially justified because failed to substantiate their claims with appropriate information. The Opinion has considered other arguments made by petitioner for a contrary result and found those arguments to be without merit.

Findings

Nguyen is not entitled to administrative and litigation costs.

Click Here to view the full case: Nguyen v. Commissioner of Internal Revenue T.C. Memo (2003-313)

Tyson Foods Incorporated and Subsidairies v. Commissioner T.C. Memo (2007-188)

Background

T.C. Memo 2007-188

This is a case filed in the United States Tax Court. The sole issue in this case is whether Tyson Foods Inc. may depreciate approximately $2 million in expenditures for which complete and correct records were not maintained.

Basic Facts

Tyson Foods is a fully integrated producer, processor and marketer of poultry based foods with offices located in Springdale, Arkansas and Delaware. In 1994, Tyson Foods purchased the stock of Culinary, a manufacturer of frozen food products, in a transaction that was treated as an asset purchase for federal income tax purposes. Tyson Foods did not credit a receivable for accounting for payments the City of Chicago made in connection with the subsidy. The Commissioner of Internal Revenue thinks that Tyson Food’s income should be reduced by $1,800,354 of the $5 million subsidy.

The IRS’ main criticism of the plaintiffs evidence is for the entire calender year of 1995 and cannot be allocated to the fsical years before the Court. Taxpayers are required to keep accounts or records, including inventories in order to establish gross income, credits, deductions and any other information that must be shown. In order for an estimate to made by the Court, there must be sufficient evidence in the record and Tyson Foods failed to provide this. The only evidence the plaintiffs had were recorded in the moving expenses account and no invoices were ever recorded or produced.

Findings

Tyson Foods has failed to satisfy its burden of proof in order to feel entitled to the deductions.

Click Here to view the full case: TG Missouri Corporation v. Commissioner, 133 T.C. 278 ( T.C. 2009).

TG Missouri Corporation v. Commissioner, 133 T.C. 278 ( T.C. 2009)

Background – Case No. 8333-06.

This is a case filed in the United States Tax Court. The sole issue in this case is whether production molds TG Missouri Corporation sold to its customers are assets subject to depreciation for purposes for their tax years. Another issue is whether the amounts paid to third party toolmakers for the molds would count as “cost of supplies” for qualified research expenses when calculating research credits for 1997, 1998 and 1999.

Basic Facts

TG Missouri is in the business of creating and manufacturing products such as steering wheels, air bags and body side molding for the automotive industry. After receiving the contract request, TG Missouri consults with the customer to develop a production mold and they are only entitled to payment if they successfully build a mold and the customers accepts these products to build the mold. TG Missouri would sometimes construct the tool themselves or consult with a third party. The petitioner and third party then work together to design and build the mold. After the third party toolmaker finishes constructing the production mold, the petitioner purchases the mold. This process generally takes around 24 to 36 months to develop, design, construct and test the mold.

TG Missouri filed its 1997-99 Corpartion Income Tax Returns and in the 1998 and 1999 returns, they capitalized and depreciated the costs paid to third party toolmakers but included the costs paid to third party toolmakers as qualified research for research credits. In 1997 they claimed $2,316,601 in research credits and used $48,675 of this amount in 1997 and carried for $2,267,926 in 1998. In 2006, the Commissioner of Internal Revenue mailed a notice of deficiency for 1998 and 1999 because they beclieved the costs incurred in purchasing the prodcution molds from third parties did not count towards research expenses for calculating research credit. In response, TG Missouri filed a petition claiming that the costs incurred in 1997, 1998 and 1999 qualify as research expenditures. When this case was called before the trail court, both parties moved pursuant to Rule 122 to submit this case fully stipulated, which saves time and money for both sides.

Findings

The production molds that the petitioner sold to its customers are not not subject to depreciation allowances because the petitioner does not have any economic interest in production molds it has sold.
TG Missour properly included the costs of production of molds it purchased from third parties as the cost of supplies; therefore, the respondent’s adjustments to TG Missouri’s 1998 and 1999 returns are erroneous and are not sustained.

Click Here to view the full case: TG Missouri Corporation v. Commissioner, 133 T.C. 278 ( T.C. 2009).

What is the R&D Tax Credit?

The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

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Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/

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Lockheed Martin Corporation v. United States, 210 F.3d 1366 (fed. Cir. 2000)

Background

Case no. 99-5039

This is an appeal in the U.S. Federal Court of Appeals where Lockheed Martin Corporation appeals the decisions made denying their attempt to introduce late filed expenses in its tax refund suit and granting the government’s motion for summary judgment in that Lockheed Martin was not entitled to a tax credit refund for research expenses.

Basic Facts

Lockheed Martin Corporation had numerous fixed price contracts during the 1982 to 1988 tax years. In 1991, they filed refund claims for 1984 to 1998 claims. The IRS disallowed these refund claims because the research performed under the contracts was not “qualified research” because it was funded by the government. Lockheed Martin filed an appeal for this decision asking the court to consider evidence regarding these expenses and other expenses uncovered during discovery. The Court of Appeals denied the motion because Lockheed Martin could not verify the legal or factual bases for its refund claim at trial. Both parties agreed to have the issue resolved by referencing four programs that represented 65% of the expenses claimed and they extended the court’s determination whether Lockheed Martin retained substantiation rights under the contracts in the suit. The Court of Federal Claims found that the SICBM, Titan IV and SLAT programs were all under the same contract and LM did not retain substatntial rights in its research for any of these major programs because

the government had an unlimited right to have access and use for this data,
LM had sought prior approval from the State before conducting research
the government had ultimate power over LM and could require them to transfer title to a subject invention if they failed a patent application
LM was required to pay the government for its research results

The appeal covers several issues:

Claim Variance – LM believes the Court erred in denying its motion to order the government to consider additional research expenses not discovered until trial. The Court stated that their decision was correct because LM wrote their claims broadly, they predicated their refund claims on specific expenses which together formed the factual basis for the claims. No other expenses should be allowed to be introduced after the experimentation period of limitation to the filing of a claim. This inclusion of additional expenses would create a variance in expenses from LM’s factual claims.
Substantial Rights – LM believes they are entitled to a research expense tax credit because they meet the “substantial rights” test as they retained the rights to use the research results for their business. The government states that LM does in fact retained the right to use this information but does not believe that this right does not rise to the level of a “substantial” right. This Opinion rejects the government’s argument because they are saying that “substantial rights” only includes scenarios in which the taxpayer is the sole owner of the research and which no other party as the rights to this research, including patented inventions. Under the provision titled “Recovery of Nonrecurring Costs on Commercial Sales” LM was required to pay for that right. LM argues, under this provision, should be entitled to use its research in its business without paying for that right. This provision is a cost recovery provision and it requires the contractor to bear a portion of the government’s costs related to the research or development that is produced and the products relating to the research. This revision only applies when the taxpayer plans on selling the research to third parties which LM did not intend to do.

Findings

In summary, LM retained the right to used its research from the Major Programs contracts without having to pay for the right to use the results of their research. The Court of Federal Claims erred in its decision because “funding” in LM’s case does not fall under the exclusions. The Court correctly denied LM’s motion for pretrial order clarifying the scope of the claim however the court reversed the decision in regards to granting the government’s motion for summary judgment that Lockheed Martin did not full with the funded exclusion for increasing research credit.

Click Here to view the full case: Lockheed Martin Corporation v. United States, 210 F.3d 1366 (fed. Cir. 2000).

Union Carbide Corporation v. Commissioner of Internal Revenue, No. 11-2552 (2d circuit 2012)

Background

This is an appeal from the U.S. Tax Court denying Union Carbide Corporation (UCC) a credit for supplies used in the conduct of qualified research. Judge Pooler agrees with this judgment and files a separate concurrence.

UCC conducted three research projects at two production plants in the 1994 and 1995 tax credit years. UCC requested a research credit for the costs of all supplies used in these projects even though they would have been used if the research and projects hadn’t been carried out. It was argued that UCC only is entitled to credits for the additional supplies that were used in these projects.

Basic Facts

The three projects are as follows:

Amoco anticoking project: UCC conducted research and production on industrial furnaces to diminish the creation of coke in the furnace however they found their project did not result in lower productions of coke and they discontinued the research.
UCAT-J proejct: UCC attempted to lower costs in the production of polyethylene products. They ran this project 19 times and this project was discontinued after it resulted in higher levels of off-grade polyethylene.
Sodium Borohydride: This project was used to find if sodium borohydride would reduce the presence of an unwanted byproduct. The test ran for two weeks and they were successful.

At the bench trial in Tax Court, the costs for supplies used for the anticoking project were not credible as an “amount paid for supplies used in the conduct of qualified research”. They acknowledged that if UCC had not purchased these materials, these woudl have been treated as inventory and costs of goods sold. The sodium borohydride project did not fulfill the “process of experimentation test”.

The main issue in this case is whether the cost for supplies used during these projects would have been used in UCC’s manufacturing process regardless of any research performed and would they qualify as “an amount paid or incurred for supplies used in the conduct of qualified research.”

UCC argues for the dictionary definition of qualified research however this kind of definition does not constitute the beginning and end of statutory construction. The Court and this Opinion agree that these research costs claims are merely indirect research costs excluded from QREs.

Findings

The decision of the Tax Court is affirmed with response to the anticoking project and the UCAT-J project. This Opinion is also in agreeance with the Tax Court’s decision in regards to the sodium borohydride project because it is not considered qualified research.

Click Here to view the full case: Union Carbide Corporation v. Commissioner of Internal Revenue, No. 11-2552 (2d circuit 2012).

FedEx Corporation v. U.S. 03 AFTR 2d 2009-2722 (W.D. Tenn. June 9, 2009)

Background

In 1996, FedEx Corporation found a need for a new computer based system to more easily track their billing records. They carried out this project until 2001 when it was abandoned. In May 2001, they filed research credits for this project which required substantial expenditures for research and development for which the IRS denied.

In 2008, FedEx Corporation filed suit in federal district court in order to receive over $10 million in tax for those years they were not previously granted.

FedEx filed a motion in 2009 for partial summary judgment on the legal standards in regards to the judgment on the legal stand for the “discovery” test and the “internal use software” test.

Basic Facts

The two parties differ over what satisfied the discovery test and the internal use software test. Research on computer or software by or for the benefit of the taxpayer primarily for internal use is not considered qualified research. In 2001, a “discovery” test would be required to be undertaken to “obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.” The “discovery” test in the Proposed Regulations and in the 2003 Final Regulations differed from the 2001 Final Regulations. The 2003 Regulations do not adopt the “internal use software” test and the “discovery” test is satisfied by research that eliminates certain uncertainty and improves business components.

FedEx Corporation seeks summary judgment on the question of the tests the IRS should have applied to determine whether they were eligible for research tax credits in terms of QREs. FedEx Corp argues that the 2001 Final Regulations apply to their project because the tax years in question occurred between 1997 and 2000. Because the IRS has not issued a new “internal use software” test, they should rely on the test from 2001. The IRS tried to amend the 2003 Final Regulations with an announcement when the Treasury could have issued temporary regulations instead. This requirement from the IRS for FedEx to apply to the “discovery” test from 2001 is contrary to what the IRS stated in the 2003 Final Regulations.

Court’s Decision

In June 2009, the U.S. District Court for the Western District of Tennessee granted the plaintiff’s motion for partial summary judgment. The taxpayer may rely on the “internal use software” test from the 2001 Final Regulations.

Click Here to view the full case: FedEx Corporation v. U.S. – 103 AFTR 2d 2009-2722 (W.D. Tenn. June 9, 2009).