Tax Protest
estudiante
Protest.docxProtest Facts and Requirements
Spring 2026
Your Job: Using the Protest Template I provided to you (its in both Teams and on Canvas) write a winning Tax Protest. You will need to research use CCH Connect and Your favorite AI program.
Your tax protest should contain citations and explanations of minimum of at least three cases 2 Revenue rulings two relevant statues and 3 relevant regulations.
Remember start with secondary research, then go to primary. AI can help with a draft, but it can’t get you there if your plan is to win.
Try to fold in contrary authority to strengthen your argument.
Attached, I have provided an article and part of the IRM discussing audits of Section 41 issues.
FACTS : Your Client, Intrepid Research Concepts, Inc., a Florida corporation designs and manufactures mining and production equipment in the rare earth mineral field. It also does primary research into rare earth use and application in conjunction with several universities. Intrepid engaged a subsidiary using in part the research licensed from the University and one of its subsidiaries to create AI assisted computer software to discover new rare earth applications and processes used in the creation of next generation computer chips.
Intrepid files Form 1120 annually and has a 12/31 year end. The corporation files Forms to report its “qualified research expenses under IRC 41 and Treas. Reg. 1.41-4 in support of deductions on Forms 1120.
IRS Audit
The IRS randomly selected Intrepid Research for audit in 2026 and is auditing Forms 1120 for 2023, 2024 and 2025. The audit division examined the returns filed and disallowed 80% of the research credits taken in each of the three years under audit. The Examination division stated that the research activities of Intrepid were “non-qualifying routine engineering activities” and also found that the Wage allocations were unreliable.
Client’s Position and Argument
Issue 1 — Qualified Research
Client’s position: The projects satisfy the statutory and regulatory tests because they were undertaken to eliminate technological uncertainty through a process of experimentation within the permitted purpose framework.
Application to facts (element-by-element):
· Business component nexus: Each project is mapped to specific SKUs/part numbers and releases.)
· Technological uncertainty: Unknown capability/method/design at project start is documented in engineering charters and change logs
Process of experimentation: Multiple design iterations and test results demonstrate systematic evaluation of alternatives.
Issue 2 — QRE Substantiation and Allocation
Taxpayer position: Wage and supply QREs are supported by contemporaneous records and reasonable allocation methodology, corroborated by payroll and project documentation.
Sample QRE tie-out placeholder (attach as Ex. W-1):
|
Year |
Total W-2 wages (per payroll) |
R&E eligible employees subset |
% time in QRE activities |
Wage QREs |
Supply QREs |
Contract QREs |
Total QREs |
|
2022 |
$[ ] |
$[ ] |
[ ]% |
$[ ] |
$[ ] |
$[ ] |
$[ ] |
|
2023 |
$[ ] |
$[ ] |
[ ]% |
$[ ] |
$[ ] |
$[ ] |
$[ ] |
|
2024 |
$[ ] |
$[ ] |
[ ]% |
$[ ] |
$[ ] |
$[ ] |
$[ ] |
Computation placeholder: The numbers are unimportant to this exercise. Argue that the numbers provided are with the ranges required by the regulations.
Penalties — §6662
Taxpayer acted with reasonable cause and good faith based on documented methodology, internal review, and reliance on outside counsel and accounting professionals who are highly regarded in their fields. . Taxpayer should request penalties to be abated. Penalties should be abated.
Practical Side Note: Arguing reasonable cause based on advisers is normally a losing argument. Leave it to AI to suggest it’s a good idea.
Create an argument that the rules followed are the correct ones and the penalties do not apply because the returns are accurate.
Requested Disposition
You need to provide a persuasive closing argument that your client wins on the merits. Work on your own on this, as this is what will get you a win or a lose. Don’t merely rely on AI>
7) Exhibit List
Not required.
8) Penalties-of-Perjury Declaration
Under penalties of perjury, I declare that I have examined this protest, including accompanying documents, and to the best of my knowledge and belief, the facts stated are true, correct, and complete.
__________________________ [Name], [Title] | [Date]
Additional Materials
From IRS.GOV
Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* - Qualified Research Expenses
Publication Date - June, 2005
* Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 3 | Table of Contents | Chapter 5
4. Qualified research expenses ("QREs")
Section 41(b)(1) defines QREs as the sum of (1) "in-house research expenses" and (2) "contract research expenses”.
Section 41(b)(2) defines in-house research expenses as:
1. any "wages" paid or incurred to an employee for "qualified services" performed by such employee;
2. any amount paid or incurred for "supplies" used in the conduct of "qualified research”;
3. under regulations prescribed by the Secretary, any amount paid or incurred to another person for the right to use computers in the conduct of qualified research.
Section 41(b)(3) defines "contract research expenses" as 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research. If an expense is not set forth in section 41(b), a taxpayer may not claim the expense as a QRE.
a. Wages
The first category of in-house research expenditures eligible for the research credit consists of amounts paid or incurred for wages. Wages paid to an employee constitute in-house research expenses only to the extent the wages were paid or incurred for "qualified services" performed by the employee. For purposes of section 41, the term “wages” means wages as defined in section 3401(a). This means all taxable wages as reported on Form W-2, including bonuses and stock option redemptions. It does not include amounts that are not subject to withholding, such as certain fringe benefits or non-taxed income, even if paid for research services performed by an employee.
Stock options that are exercised and then included in wages subject to withholding, may or may not be included as wages in the research credit computation. 5 The option is generally granted as compensation for work performed and is subject to withholding upon grant. In such situations, the type of work done will determine if the option spread (wage) is included in the computation. For example, if an option is granted in 1997 and exercised in 2003, you would look to see if the work performed in 1997 would qualify as a qualified service. If it would qualify, then the spread is included in wages in the year the option is exercised. In other words, look to the grant year to determine if it is a qualified service but include the spread amount the computation in the year it is exercised.
Section 41(b)(2)(B) identifies three types of qualified services:
1. Engaging in qualified research,
2. Directly supervising qualified research; or
3. Directly supporting qualified research .
Treasury Regulation section 1.41-2(c) provides further guidance.
The term "engaging in qualified research" means the actual conduct of qualified research, as in the case of a scientist conducting laboratory experiments.
The term "direct supervision" 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“. Specific attention should be paid to individuals who do not "directly" supervise qualified research activities (i.e., management levels higher than first line supervisors). In some cases, higher level research managers may perform some qualified research or direct supervision of qualified research due to their technical background and expertise, but this is usually only a minor fraction of their overall work activities. In addition, companies generally have a certain number of employees that work within traditional "research" departments who do not perform qualified services.
The term "direct support" means services in the direct support of either persons engaging in the actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research. This would include the services of a machinist for machining a part of an experimental model used in qualified research. 6 Direct support of research does not include general and administrative services, or other services only indirectly of benefit to research activities. 7 This is true whether general and administrative personnel are part of the research department or in a separate department.
Treasury Regulation section 1.41-2(d)(2) provides that if substantially all 8 of the services performed by an employee during the taxable year consist of qualified services, then the term “qualified services” means all of the services performed by the employee for the taxpayer during the taxable year. The ‘substantially all’ rule for wages is analyzed on an employee-by-employee basis, and, in general, is determined by multiplying total wages by the following fraction: Hours spent in the conduct of qualified services over total hours spent in the conduct of all services (sick leave, for example, would not be included in the fraction). See Treasury Regulation section 1.41-2(d) for the methodology applicable to this rule. If the ratio is less than 80%, the actual amount of qualified services should be used
Identifying the employees whose wages are claimed as QREs and determining the services they perform is perhaps the most important phase of auditing the research credit. Payroll records, employee job descriptions, performance evaluations, calendars and appointment books are good sources of information. The goal is to determine what the employee did and how much time they spent doing it.
If the employee pool is large, and it is impractical to achieve complete coverage, consider using statistical sampling techniques. Audit resources should focus on those employees whose job descriptions suggest they are engaging in administrative, manufacturing, marketing, and other non-qualifying activities. When appropriate, interviews should be considered to supplement and corroborate information obtained from the review of existing records.
An important caveat: Determinations as to whether an employee is (or is not) engaged in qualified services, should not be based solely on job descriptions or titles. Credit eligibility is based solely upon what an employee actually does, or does not, do during a specific time period. It is important to note the technical and educational qualification of a researcher, but this is not conclusive evidence that the individual engaged (or did not engage) in the performance of qualified services.
b. Supplies
A taxpayer may claim the research credit for amounts it paid or incurred for supplies used in the conduct of qualified research. Section 41(b)(2)(C) defines the term "supply" to mean any tangible property other than (1) land or improvements to land, and (2) property of a character subject to the allowance for depreciation. For example, overhead, license fees and costs for leasing assets are not tangible property and, therefore, not supplies. Supplies are used in the conduct of qualified research if they are used in the performance of "qualified services" by an employee of the taxpayer (or person acting in the capacity of an employee). To be a QRE, a supply must be directly related to the performance of "qualified services”. Expenses for property used in general and administrative activities are not QREs. Accordingly, for the purposes of section 41, a "supply" is non depreciable tangible property acquired by the taxpayer that is used in the performance of "qualified services". 9
The examiner should request that the taxpayer produce documents to support its claimed supply expense to ensure that the amount only includes non depreciable tangible property acquired by the taxpayer that was used in the performance of "qualified services".
There has been a trend to include a myriad of non-qualified research related costs in the credit computation by claiming such costs are "supplies”. When reviewing the supplies claimed as qualified, focus on the statutory and regulatory definition of supplies. For example, taxpayers often improperly treat as a supply expense, the general and administrative costs related to "self constructed" supplies. Additionally, the examiner should carefully scrutinize "prototype" 10 expenditures to determine whether the "prototype" is (or contains) property of a character subject to an allowance for depreciation. Other examples of costs that are not supply QREs are:
· travel, meals or entertainment
· telephone expenses of researchers
· relocation or rental/lease expense
· professional dues or royalty/license expenses substantial
Supply QREs, in general, should represent a small portion of total QREs. When supply QREs are substantial, you should be alerted to the possible inclusion of capital or other ineligible expenses being claimed as QREs.
c. Contract research expenses
A contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person, other than an employee of the taxpayer, for the performance on behalf of the taxpayer of qualified research, or services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B). Treas. Reg. § 1.41-2(e)(1). If any contract research expense is attributable to qualified research to be conducted after the close of the taxable year, it shall be treated as paid or incurred when the qualified research is conducted. I.R.C. § 41(b)(3)(B). Thus, prepaid research expenditures are not eligible for the credit until the services are performed.
· Examining contract research expenses is one of the most straightforward, yet most often overlooked, research credit issues. An important audit step is to request a list of all contracts, along with the dollar amount of the claimed contract research expense (by contract). From this list, select the contracts that should be requested and reviewed. When there are only a few material contracts, all the contracts should be requested. The contracts should be reviewed to determine whether all the above legal requirements have been met.
Assistance of local counsel can be helpful in securing these agreements, as well as assisting with their interpretation. If requested contracts are not provided, and the taxpayer fails to represent (preferably in writing) that such contracts do not exist, we recommend the use of summons. This will ensure that the examiner has had the opportunity to review all of the taxpayer’s documentation, and if the case is unagreed, helps to ensure that no new documentation will be provided at an Appeals conference.
Treasury Regulation section 1.41-2(e) provides a three-part test for determining if the payment is for the performance of qualified research where a third party performs the research for the taxpayer. An expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement (usually in writing, but not required) that:
1. is entered into prior to the performance of the qualified research,
2. provides that research be performed on behalf of the taxpayer, and
3. requires the taxpayer to bear the expense even if the research is not successful.
Qualified research is performed on behalf of the taxpayer if the taxpayer has a right to the research results. Qualified research can be performed on behalf of the taxpayer notwithstanding the fact that the taxpayer does not have exclusive rights to the results. Also, if the expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result, rather than the performance of research, and the payment is not a qualified contract research expense.
Under Treasury Regulation section 1.41-2(e), a contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person other than an employee of the taxpayer for the performance on behalf of the taxpayer of (i) qualified research, or (ii) services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B). Where the contract calls for services other than services described above, only 65 percent of the portion of the amount paid or incurred, that is attributable to the services described above is a contract research expense.
Sometimes the activities to be performed by the contractor are more clearly defined in contractually-referenced work orders or statements of work rather than the body of the main contract. Such documents should be secured and reviewed.
A service contract differs from a research contract in calculating what amounts will be allowable contract research expenses. For example, in a service contract, the vendor may be paid by the hour and the research is not specified. In this case, you must look at the work done. Only the amounts paid for qualified research work would be included in QREs (subject to the 65% limitation). In a research contract where there is an agreed fixed price amount to perform qualified research, the entire amount would be subject to the 65% limitation and included as a QRE.
6 Other examples of direct support of research would include the services of (1) a secretary typing reports describing laboratory results derived from qualified research; (2) a laboratory worker for cleaning equipment used in qualified research; and (3) a clerk for compiling research data. Treas. Reg. § 1.41-2(c)(3).
7 Services of payroll personnel in preparing salary checks of laboratory scientists, of an accountant for accounting for research expenses, of a janitor for general cleaning of a research laboratory, or of officers engaged in supervising financial or personnel matters do not qualify as direct support. Treas. Reg. § 1.41-2(c)(3).
8 The “substantially all” for wages differs from the “substantially all rule” for Process of Experimentation.
9 For more information on the definition of a supply, see Lockheed Martin Corp. v. United States, 87 A.F.T.R.2d, ¶ 2001 812 (Ct. Cl. 2001). The only exception to the general rule is for certain "extraordinary utilities" expenditures. See Treas. Reg. § 1.41-2(b)(2).
10 Taxpayer labels are not controlling.
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Businesses given more time to meet requirements. Section G will be optional for all filers for tax year 2025.
IR-2025-99, Oct. 1, 2025
WASHINGTON — The Internal Revenue Service announced today that it is continuing to seek feedback regarding the draft Instructions for Form 6765 and is extending the dates for certain reporting requirements related to the Credit for Increasing Research Activities, also known as the research credit.
After publishing drafts of the Form 6765 and related instructions last year, the IRS received comments in which external stakeholders requested additional time to share feedback. After considering the feedback the agency has decided to extend the comment period for the draft instructions through March 31, 2026, to alleviate taxpayer burden and in the interest of fair and effective tax administration.
Interested parties may submit feedback about the Form 6765 Instructions to [email protected], using the subject line: “ Instructions for Form 6765.” IRS expects to release revised Form 6765 instructions for tax year 2025 (processing year 2026) in January 2026.
While stakeholder engagement continues, Section G of Form 6765 will be optional for all filers for tax year 2025 (processing year 2026).
For tax year 2026 (processing year 2027) and beyond, Section G will be mandatory for all filers with optional reporting for:
· Qualified small business (QSB) taxpayers, defined in section 41(h)(3) of the Internal Revenue Code who check the box to claim a reduced payroll tax credit; or
· Taxpayers with total qualified research expenses (QREs) equal to or less than $1.5 million, determined at the control group level and equal to or less than $50 million of gross receipts, as determined under section 448(c)(3) (without regard to subparagraph (A) thereof), claiming a research credit on an original filed return.
The IRS also is extending the research credit claim transition period, which gives taxpayers 45 days to perfect a research credit claim for refund prior to IRS’s final determination on the claim, through Jan. 10, 2027.
To submit a claim for refund for the research credit postmarked after June 18, 2024, that is sufficient for the IRS to consider taxpayers must:
· Identify all the business components to which the Section 41 research credit claim relates for that year,
· Identify all research activities performed for each business component, and
· Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year. Taxpayers may use Form 6765, Credit for Increasing Research Activities for this purpose.
The IRS previously announced the release of draft Form 6765, Credit for Increasing Research Activities PDF in a news release on June 12, 2024. The IRS released draft Instructions for Form 6765, Credit for Increasing Research Activities PDF and solicited feedback; the new instructions were announced in a news release on Dec. 20, 2024.
Visit IRS.gov to learn more about the Research Credit.
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The research credit: Documenting qualified services
By Jennifer Frost, Esq., J.D., LL.M., Washington, D.C.; Jason Seo, J.D., LL.M., Washington, D.C.; John Andress, CPA, Atlanta; Lauren Mitchell, CPA, Boston; and Kevin Benton, E.A., Dallas, all with Grant Thornton LLP
March 1, 2024
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TOPICS
· C Corporation Income Taxation
· Credits
Editor: Alexander J. Brosseau, CPA
A recent Tax Court case illustrates the importance of documenting and substantiating employee wages that are being included in the research credit under Sec. 41. In Moore, T.C. Memo. 2023-20, the IRS challenged an S corporation’s substantiation of qualified time performed by the company’s president and COO. This item discusses guidance regarding qualified services, observations from Moore and other case law, other recent developments, and considerations that taxpayers may need to make when claiming and defending research credits.
Code and regulations
Sec. 41 allows taxpayers to claim a research credit on the incremental amount of qualified research expenditures (QREs) that they pay or incur during a tax year. QREs include inhouse research expenses, such as wages, supplies, and computer rental costs, as well as contract research expenses. In many instances, the largest portion of QREs claimed by a taxpayer relate to wages for individuals performing qualified services. Sec. 41(b)(2)(B) defines qualified services as “(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.”
Regs. Sec. 1.41-2(c) further defines engaging in qualified research as “the actual conduct of qualified research (as in the case of a scientist conducting laboratory experiments).” In addition, “direct supervision” is defined as “immediate supervision” but excludes supervision by a higher-level manager to whom first-line managers report, even if the manager is a qualified research scientist. Lastly, “direct support” is defined as either conducting actual qualified research or directly supervising the actual conduct of qualified research.
The regulations provide examples of what does and does not constitute direct support; for example, “general administrative services, or other services only indirectly of benefit to research activities” do not qualify as direct support. It appears that the IRS has been successful in recent cases in contesting taxpayers’ application of direct support. As with other tax issues, taxpayers bear the burden of proof, and in cases where taxpayers are not able to provide proof regarding the direct support or direct supervision of qualified research, the IRS has been prevailing on these issues.
Additionally, Regs. Sec. 1.41-2(d)(2) provides the “substantially all” test, which states that “if substantially all of the services performed by an employee for the taxpayer during the taxable year consist of services meeting the requirements of [Sec.] 41(b)(2)(B)(i) or (ii), then the term ‘qualified services’ means all of the services performed by the employee for the taxpayer during the taxable year.” Under this provision, if at least 80% of an employee’s activity was for qualified research or direct supervision or direct support of qualified research, then all the employee’s wages are eligible as QREs.
Moore and substantiating engagement in qualified research
In Moore, the IRS challenged the taxpayer’s substantiation of qualified time regarding the company’s president and COO, identified in the Tax Court’s opinion only as “Mr. Robert.” Court documents showed Robert devoted much of his attention to new product development. This was supported by the fact that Robert was an engineer by trade and left most administrative aspects of his job to other executive leaders. The opinion describes Robert’s participation in four sample projects for which he defined and specified requirements for new and improved products and developed them with the company’s engineers.
Despite Robert’s testimony at trial that the court considered corroborated by others, detailing his roles and responsibilities, the court ultimately disallowed the inclusion of a portion of his wages and time in computing the taxpayer’s QREs, based on two key points: First, the record provided “no estimates of the amount of time Mr. Robert spent on qualified research as distinguished from the broader category of new product development.” For example, the court noted that specifying and developing requirements for a product is not qualified research, yet the amounts were included within the represented time. The court had no means to segregate that time from that of other, potentially qualifying activities. Second, the court reasoned Robert’s time could not be captured under the “supervisory” definition, as Robert was not the engineers’ first-line manager. Additionally, the court ruled that Robert did not provide direct support as that term is defined in the regulations.
Ultimately, the Moore case is a reminder to taxpayers that, although time estimates may be used when determining the portion of an employee’s wages to be treated as QREs, those estimates should be carefully tied to specific qualified (and nonqualified) activities. Taxpayers may also need to consider documenting wage QREs for each category of qualified services.
Other case law
Time spent on qualified services: A foundational case when it comes to the substantiation of time allocations is Fudim, T.C. Memo. 1994-235, which revolved around the substantiation of qualified time claimed by Efrem and Margarita Fudim and their daughter, Natalie. Mr. and Mrs. Fudim were heavily involved in the development of new rapid modeling processes using ultraviolet light and light-sensitive liquid polymers to fabricate plastic objects. Court documents showed that both Mr. and Mrs. Fudim had an extensive technical background in the field. With no time-tracking systems used by the company, the Fudims estimated they spent at least 80% of their time engaging in qualified services.
Despite the couple’s lack of formal time tracking or documentation regarding time spent, the court applied the Cohan rule ( Cohan, 39 F.2d 540 (2d Cir. 1930)), under which the court agreed with the time allocations claimed by the Fudims. The court based its decision on the corroborating evidence presented at trial, including employee testimony, scientific articles Mr. Fudim had published, and patents he had filed, as well as both spouses’ technical backgrounds. However, the court removed the time of their daughter, for whom no contemporaneous documentation was provided to support the allocation. This case illustrates that companies without time-tracking systems or other timekeeping records can use estimates of time to compute research credits; however, those estimates must be supported through corroborating evidence.
Process of experimentation and “substantially all” test: In Little Sandy Coal Co., T.C. Memo. 2021-15, aff ’d, 62 F.4th 287 (7th Cir. 2023), the IRS challenged whether the taxpayer’s shipbuilding activities were qualified research activities. The majority of the substantiation the taxpayer provided was oral testimony; the Tax Court found this mostly lacking. For example, the taxpayer provided estimated wage expenses that were not based on specific projects. Although the taxpayer could identify the individuals contributing to the estimated wages, i.e., engineers and managers of the company’s subsidiary, Corn Island Shipyard Inc. (CIS), the oral testimony merely indicated that they contributed to the wage research expenses instead of describing the specific activities that the wages were related to.
Some of the oral testimony was intended to support the taxpayer’s assertion that its ship design activities constituted a process of experimentation as defined in Sec. 41(d)(3)(A), such as the statement by Brian Varner, CIS’s engineering technician: “We have to feel pretty comfortable with a design before we start cutting steel. Any repairs or modifications become very costly very quickly.” Varner’s statement was confirmed by the IRS’s expert’s report, which also concluded that the uncertainty of the appropriate design was basically resolved prior to assembly.
However, the Tax Court held, and the Seventh Circuit ultimately agreed (although disagreeing with some aspects of the Tax Court’s reasoning), that the taxpayer did not substantiate that substantially all of the claimed activities constituted elements of a process of experimentation. Uncertainty with respect to some of the claimed activities, such as determining the appropriate design of a new dry dock model, was not resolved until the design was finally tested and thus not eliminated by experimentation, the Tax Court stated. The Seventh Circuit agreed, stating that in developing the dry dock, the taxpayer “did not document whether hypotheses and alternatives were tested and refined in a scientific manner.”
With respect to the use of estimates, the Seventh Circuit stated, “Only after a taxpayer establishes that qualified research has occurred under Section 41(d) may we estimate, if needed, the amount of qualified research expenses under Section 41(b).”
A takeaway from Little Sandy Coal is that oral testimony alone is insufficient to substantiate that substantially all of the activities constitute elements of a process of experimentation for qualified research activities, especially when a taxpayer’s research credit claim relies on estimates.
In Betz, T.C. Memo. 2023-84, the Tax Court reached varying conclusions of whether the taxpayer had substantiated qualified research in each of a sampling of projects. The court echoed other cases by stating that the Cohan rule will not apply to estimating wages paid or incurred if the taxpayer fails to make a threshold showing that a particular employee performed activities that constituted qualified services with respect to a business component. Further, the Tax Court clarified that the Seventh Circuit in Little Sandy Coal addressed the substantiation burden that taxpayers claiming the research credit bear and determined that shortcut estimates of experimentation that rely merely on trial testimony that basically asks courts to “take on faith” their allocations are insufficient without further documentation to support the testimony.
For example, in Betz, the taxpayer failed to substantiate technical uncertainty through an employee’s testimony that the final design of components as a whole in a proposal delivered to a customer were “significantly different” than the initial design. Therefore, the majority of the uncertainty had been resolved prior to incurring or paying the subsequent wages.
In contrast, a project related to the design of an oxidizer was concluded to establish that uncertainty existed regarding the design of a gas train component, based on email correspondence that fleshed out the specifications and alternatives related to the uncertainty. However, the Tax Court went on to state that allocating a de minimis estimated amount of wages to the email activity, pursuant to the Cohan rule, would be futile because the activities were not part of a structured process of experimentation.
A key lesson learned from Betz is that trial testimony is not only insufficient to substantiate qualified research activity without further contemporaneous documentation, but it is also insufficient to dispute contrary evidence in contemporaneous documentation, such as a final proposal delivered to customers or clients. The court stated several times that a contract supporting the trial testimony would have sufficed to substantiate the taxpayer’s testimony.
In Suder, T.C. Memo. 2014-201, the IRS challenged the taxpayer’s substantiation of qualified research expenditures, particularly wages, to compute the research credit. Allocations of qualified time were estimated by the company’s senior vice president of product operations, Harvey Wende. The IRS challenged Wende’s prepared time allocations, arguing he lacked the tax or accounting educational background to make reliable estimates. The court disagreed, citing Wende’s knowledge on the subject, having worked with a research credit consulting firm previously to claim the company’s research credit. Additionally, the court placed heavy emphasis on Wende’s credible testimony regarding the roles and responsibilities of the qualified individuals.
Suder demonstrates that time estimates can and should be employed in instances where time-tracking data does not exist, so long as those estimates are made by individuals who have the institutional knowledge and the educational background to reliably make them and other documentary evidence exists in the record. It is also important to note that the court did not challenge Wende’s practice of first leveraging the prior-year R&D percentage as a starting point, then considering whether the employee’s role had changed since the prior year, as well as allocating small percentages of time to employees outside product development (i.e., quality assurance or shipping and handling) to the extent they assisted product development. This point supports the notion that it is the individual’s yearly activities, not their job title, that should be assessed when determining qualification.
In Shami, T.C. Memo. 2012-78, the IRS challenged the taxpayer’s substantiation of wage qualified research expenditures for the company’s CEO and a vice president. Similar to the other cases discussed here, the company used estimates of time to compute qualified wage spending. However, unlike in Suder, the employee testimony presented in the case was inadequate, as several witnesses contradicted each other when discussing the engagement of the CEO and vice president in qualified research activities. Additionally, neither executive had any sort of training or extensive technical background in science or engineering. Despite these facts, the taxpayer argued the court was bound to apply the Cohan rule and estimate the amount of time the executives engaged in qualified research. However, with noncredible and conflicting testimony, along with no other corroborating evidence, the court disagreed, citing the lack of evidence established to make the estimate.
The Shami case is an important reminder that, although estimates can be used, there must be some level of contemporaneous documentation and credible corroborating testimony with which the court can make the estimate. Courts are not bound to apply the Cohan rule in instances where sufficient evidence is not produced.
Other recent developments
On Sept. 15, 2023, the IRS issued a news release ( IR-2023-173) requesting feedback on a preview of proposed changes to Form 6765, Credit for Increasing Research Activities, for the 2024 tax year. The proposed Form 6765 included several new reporting requirements for taxpayers to claim the research credit. One of these proposed requirements is for taxpayers to show, for each business component, the breakout of wage QREs to qualified research, direct support of qualified research, and direct supervision of qualified research. The inclusion of this reporting requirement illustrates the IRS’s continued focus on substantiation of qualified services.
On Sept. 29, 2023, Treasury and the IRS issued their 2023–2024 Priority Guidance Plan, which contains a list of projects that they will prioritize from July 1, 2023, through June 30, 2024. The second priority under the General Tax Issues section of the Priority Guidance Plan is the need for regulations under Sec. 41 that address research credit substantiation. Taxpayers should be aware that research credit substantiation continues to be a priority for Treasury and the IRS and that further guidance may be issued.
Readiness to adapt
Given that the burden of proof is on the taxpayer to substantiate research credit claims, it would be prudent for taxpayers to consider recent events and case law when evaluating their methodology for determining and documenting qualified services. This may include analyzing how employee time and expenditures are captured and tied to the appropriate categories of qualified services and business components and, in particular, what documentation supports that substantially all of the activities are a process of experimentation. This may better position taxpayers to implement any potential changes in reporting requirements and technical guidance that may be on the horizon.
Editor Notes
Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. For additional information about these items, contact Brosseau at [email protected]. Unless otherwise noted, contributors are associated with Deloitte Tax LLP.
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