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The cases of Scott and Gayla Moore and Meyer, Borgman & Johnson, Inc. v. the Commissioner of Internal Revenue underscores the necessity of robust documentation and compliance with regulatory requirements when claiming R&D tax credits under Section 41. Section 41 incentivizes businesses to invest in innovation by offering a credit for qualified research expenses. Despite the broad definition of R&D provided by the IRS, companies miss out on millions of dollars each year by assuming the credit is only meant for specific industries or, in these cases, not fully adhering to the rules of R&D credit election.

Understanding the Cases

Scott and Gayla Moore v. the Commissioner of Internal Revenue

As owners of Nevco, Inc., Scott and Gayla Moore sought to claim a tax credit for the salary and bonus of Gary Robert, the firm’s president and COO, under Section 41. However, the court didn’t find sufficient evidence that his expenses should qualify for the credit.

The Tax Court ultimately disallowed their claim based on several key factors:

  1. Lack of documentation: Gary Robert failed to maintain detailed records of his time spent on qualified research activities, as mandated by regulations. Despite payroll records indicating work hours, the absence of task-specific documentation proved detrimental to the Moores’ case. The lack of written records demonstrating the COO’s time allocation ultimately led to the denial of the R&D tax credit.
  2. Lack of Specificity in Qualified Research Activities: While the COO was involved in product development, not all of the activities qualified as research under Section 41. Gary Robert was unable to provide an approximate estimate of the time dedicated to “qualified” research, a crucial factor in determining eligibility for R&D tax credits.
  3. Insufficient evidence of direct supervision or support: The court noted that Gary Robert didn’t directly supervise or support individuals involved in qualified research, further undermining the claim’s credibility. The court determined that the COO’s role as a “higher-level manager” did not constitute direct supervision, as specified in Treas. Reg. Sec. 1.41-2(c)(2).

Meyer, Borgman & Johnson, Inc. v. the Commissioner of Internal Revenue

Meyer, Borgman & Johnson, Inc. was denied R&D credits because their research activities were considered funded under the law, their payment was based on delivering design services rather than research success, and they lacked specific contractual terms and documentation to prove otherwise.

The Tax Court ultimately disallowed their claim based on several key factors:

  1. Research was “funded”: The court decided that the research was paid for by the clients through contracts. If research expenses are covered by someone else, the firm cannot elect the tax credit.
  2. Payment wasn’t based on research success: The firm was paid to deliver design services, not based on the success of its research. The court found that it was paid for doing the work and not for its research outcomes.
  3. Contracts lacked specifics about research success: The contracts did not explicitly or implicitly tie payment to the success of the research. The court needed to see specific terms in the contracts showing that payment depended on research results, which were missing in this case.

Lessons Learned: The Importance of Understanding R&D Credit Requirements

The Moore and Meyer, Borgman & Johnson, Inc. cases highlight several critical lessons for businesses seeking to claim R&D tax credits:

  1. Maintain detailed records: Accurate documentation of research activities, including time spent and specific tasks performed, is essential for substantiating claims for R&D tax credits.
  2. Understand eligibility criteria: Businesses must familiarize themselves with the requirements outlined in Section 41 of the Internal Revenue Code and ensure that their activities meet the requirements for qualified research expenses.
  3. Identifying Direct Supervision/Support Activities: It’s important to note that the assignment of direct supervision or direct support activities within the context of the R&D tax credit should not be solely based on hierarchical titles. Merely possessing a higher or lower title does not necessarily imply engagement in direct supervision or direct support tasks.
  4. Clarity in Contractual Agreements: Both cases underscore the significance of clarity within contractual agreements regarding the conditions for payment for research activities. Understanding that payments contingent on research success are vital for claiming the R&D tax credit can guide businesses in structuring contracts to align with tax credit requirements.

Moving Forward: Maximizing R&D Tax Credit Opportunities

In light of the recent court cases, businesses must take proactive steps to ensure compliance with regulatory requirements and maximize their opportunities to claim R&D tax credits. This includes implementing robust record-keeping practices, conducting thorough assessments of eligible research activities, and actively engaging in direct oversight and support of qualified research endeavors.

How can you qualify?

First and foremost, R&D activities must meet the following four-part test:

  • Technological in Nature: Activities must be based on sciences, including physics, biology, engineering, and computer science.
  • New or Improved Business Component for a Permitted Purpose: Activities must improve the functionality, performance, reliability, or quality of a new or existing business component, such as a product, process, or software. 
  • Elimination of Uncertainty: The research or experimentation should aim to resolve some uncertainty. This could be uncertainty about how to develop a new product or improve an existing one, the feasibility of a new process, or the design of a new software, for example.
  • Process of Experimentation: All activities must show an evaluation of alternatives through simulation, modeling, or systematic trial and error.

Working closely with your CPAs, Calvetti Ferguson R&D tax consultants will assist you in identifying and capturing federal and state R&D tax credits that can drastically reduce your tax liability. Not only can we review your current tax year, but the R&D tax credit can be taken for all open years, providing a refund on amended returns and instant tax relief on your current year. If a credit cannot be used in the year it is identified, it can be carried forward up to 20 years.

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