It appears that the study was prepared using a cost-center approach, which is a perfectly legitimate method for preparing research tax credit studies. The court noted that of the several entities that the taxpayer owned, the taxpayer was not able to demonstrate what entity or employees worked on what projects. The court also took issue with the taxpayer’s use of reasonable estimates. The court seemed to be expecting project-based records, even though project-based records are not required (as has been admitted by the IRS).

The court, perhaps because it is a general district court and not a court with any particular knowledge of taxes or tax law, cited to the (old) IRS Audit Techniques Guide in support of its position (although the guide is not the law and cannot be cited in court), cited only one of the court case that addresses documentation requirements (i.e., Eustice and not Fudim), and cites to the heightened documentation standards in the Norwest and Research cases even though those cases are not generally appropriate for the issues that they were cited for.

After the taxpayer spent six days in court to introduce documents in support of its research tax credit claims, the court concluded that the taxpayer did not retain sufficient records to support its claims. This is surprising given that he court opinion even cites (in a footnote) the fact that Congress has made it clear (repeatedly) that there is no higher documentation standard for research tax credits.

The taxpayer has appealed the decision.

Research and Development Credit. The law provides a research tax credit equal to 20 percent of the amount by which a taxpayer’s qualified research expenses for a taxable year exceed its base amount for that year. The provision expired 12/31/07. The proposal would extend current law to the end of 2009, with the following changes: 1) repeal the alternative incremental research credit in 2008; 2) increase the alternative simplified credit to 14% for 2008, and 3) increase the alternative simplified credit to 16% for 2009.

• Enacting the Largest Expansion of Tax Benefits for Research and Job Growth in a Generation: Increase the existing R&D credit by 50% and create a new 40% R&D credit for basic research. These steps will reward high-wage job growth in the U.S. and help make U.S. manufacturers and research companies more globally competitive.
• Creating New High Tech Jobs With at Least 15 New Innovation and Research Clusters Across the U.S.
• Launching a New Insourcing Markets Tax Credit to Spur Business Investment in Communities Facing Global Competition.
• Catalyzing a 21st Century Manufacturing Sector with a New MARPA-Research Program, a Green-Manufacturing Extension Program and Made Green in America Fund: These initiatives will help small- and medium-sized manufacturers prosper, including in new renewable and clean energy markets.

This ruling is important because the election to take a reduced R&E tax credit must be made on an original tax return.  If a taxpayer fails to claim a Sec. 174 R&E tax deduction on an original tax return and then later submits an amended tax return to claim a R&E tax credit, the taxpayer cannot elect to apportion its R&E expenses between the R&E tax credit and deduction on the amended tax return.  Taxpayers often make this election if they have an alternative minimum tax liability or net operating loss that precludes the taxpayer from taking full advantage of the R&E income tax credit. 

This decision is important becuase it helps taxpayers understand how the IRS may view their design and manufacturing process.  It is very difficult to determine when research stops and the preparation for manufacturing begins.  The R&E tax credit excludes expenses for manufacturing.  As the decision explains, research stops when the product meets “the basic functional and economic requirements for the taxpayer for the component’s sale or use.”