Originally published in The Cooperative Accountant, Spring 2022 Issue
Research Credit Update
The federal Section 41 Credit for Increasing Research Activities (“R&D Credit”) is an intriguing opportunity for cooperatives to claim a dollar-for-dollar tax credit against their tax liability for the year based on their qualified research expenses and a 20-year carryforward of any unused credit to offset tax liabilities in future tax years.
However, the IRS and U.S. Tax Court have recently indicated heightened requirements for taxpayers to provide supporting information to substantiate their R&D Credit claims. On October 15, 2021, the IRS released IR-2021-203 (October 15, 2021) and Chief Counsel Memorandum 20214101F (September 17, 2021) (the “Memorandum”), providing detail regarding what information taxpayers must provide to the IRS to substantiate a refund claim for the R&D Credit, how the information must be formatted, and specified the statute of limitations period for such a refund claim. Subsequently, the IRS has issued interim guidance in LB&I-04-0122-0001 and released a set of FAQs describing the new requirements and how R&D Credit claims will be processed by the IRS in the future. The FAQs are available at: https://www.irs.gov/businesses/corporations/research-credit-claims-section-41-on-amended-returns-frequently-asked-questions.
This Memorandum comes after two important memorandum opinions were issued by the U.S. Tax Court on the issue, Siemer Milling Company v. Commissioner, T.C. Memo 2019-37, in 2019 and Little Sandy Coal Company v. Commissioner, T.C. Memo 2021-15, in 2021.
What is the Research Credit?
The federal R&D Credit, as set forth in IRC section 41, is a credit available to taxpayers for increasing their qualified research expenses (“QREs”) during the applicable tax year. QREs include wages paid for performing qualified research activities, expenses for supplies used in conducting qualified research activities, and contract research expenses for qualified research activities performed on behalf of the taxpayer by a non-employee of the taxpayer. Qualified research activities include engaging in qualified research as well as engaging in the direct supervision or direct support of qualified research. Generally, the R&D Credit equals a percentage of the taxpayer’s QREs that exceed a base period calculation based upon the taxpayer’s prior year gross receipts or research expenses.
Qualified research must satisfy a “four-part test” – 1) the research is related to a new or improved business component’s function, performance, reliability, quality, or composition; 2) the research fundamentally relies on principles of physical sciences, biological sciences, computer science, or engineering; 3) the research is intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process; and 4) substantially all of the activities of the research must constitute the process of experimentation involving simulation, evaluation of alternatives, confirmation of hypotheses through trial and error, testing or modeling, or refining or discarding of hypotheses.
The R&D Credit was first established in 1981 as an incentive for taxpayers to invest in research and development to drive long-term technical change and innovation. Although the R&D Credit has gone through some iterations since its inception, the R&D Credit still provides a valuable benefit to taxpayers.
Cooperatives may claim the R&D Credit, but in order to receive a current year benefit the cooperative must have sufficient taxable income during the year to apply all or a portion of the R&D Credit against. Without sufficient taxable income, the cooperative may carry any unused R&D Credit forward up to 20 taxable years. Note, however, that the portion of R&D Credits exceeding taxable income cannot be transferred to members of the cooperative generating sufficient income.
The Siemer Milling Company Case
On April 15, 2019, the U.S. Tax Court issued its memorandum opinion in Siemer Milling Company.
Siemer Milling Company (“Siemer”) was a wheat milling company that operated two mills in the United States. It consulted with an accounting firm to file an R&D Credit for tax years 2011 and 2012, based on its various research projects during those years. The projects included a flour heat-treatment project, a project involving a Pulsewave machine that reduces the particle size of materials, a wheat hybrids project, an ozone project, a toasting production project, and a whole wheat flour project.
After Siemer filed its tax returns claiming R&D Credit for 2011 and 2012, the IRS audited the returns and issued a notice of deficiency disallowing the R&D Credits claimed for both years. The Commissioner raised a number of arguments as to why Siemer’s projects did not meet one or more prong of the four-part test to substantiate its notice of deficiency, many of which were rejected by the Tax Court, but one of which was accepted.
The Tax Court rejected the following arguments:
- First, the Commissioner unsuccessfully argued that Siemer’s projects did not face uncertainty because the projects spanned several years, and the same uncertainty could not exist for more than one year. The court held that there is no requirement that the taxpayer face different uncertainties each year.
- Second, the Commissioner unsuccessfully argued that Siemer’s activities did not rely on principles of engineering, computer science, or physical and biological sciences because Siemer did not employ anyone with the title of engineer or anyone with an engineering degree. The court held that the taxpayer does not need to employee or contract with someone with a specialized degree to prove a reliance on sciences.
- Third, the Commissioner unsuccessfully argued that Siemer did not establish what business components the projects related to because Siemer was inconsistent in describing the business components of each project, at alternate points stating the projects were to improve processes or to improve products, or a combination of the two. The court held that ultimately the different phrasing in Siemer’s statements was inconsequential and not at odds with one another.
- Finally, the Commissioner argued that a business component must be a new issue during the tax year for research related to that business component to qualify. As was also the case with technical uncertainties, the court ruled there was no requirement business components could not span more than one year.
While these arguments were unsuccessful, the Tax Court did rule on several projects that Siemer failed to establish the technical uncertainty, business component, and technological information qualifications on a basis of a lack of evidence provided by Siemer.
After presenting those failed arguments, the Commissioner successfully argued that Siemer had not shown that it engaged in a process of experimentation with respect to its projects, thereby failing the four-part test. The Court held that Siemer failed to prove that its various projects had “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.” Siemer raised various arguments against the Commissioner’s assertion. It argued summarily for all projects that it engaged in a process of experimentation, that it engaged in a process designed to evaluate alternatives, and that it “ran tests.” However, for each project, the court stated that it required the description of a scientific process where a hypothesis was formed, tested, and retested. In one instance, Siemer presented the steps in a project’s process but did not demonstrate that it engaged in the testing of a hypothesis.
The Siemer case is an important barometer for the level of detail the IRS, and ultimately the judicial system, requires for a taxpayer’s R&D Credit claim. It is important to note that the court did not conclude that Siemer had not engaged in qualified research activities, but rather concluded that Siemer had not met the four-part test in demonstrating that it had conducted a scientific process. The Tax Court would continue to provide its input on how R&D Credit claims must be substantiated in the Little Sandy Coal Company case.
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