IRS Enhances Focus on R&D Tax Credit Substantiation 

The credit for increasing research activities, better known as the R&D tax credit, encourages businesses to pursue exploratory, innovative research in the United States. Determining qualifying research activities (QRA) and computing qualified research expenses (QRE) is technical and complex, as are the requirements for contemporaneous documentation to support them.  Two active U.S. Tax Court cases show a change in how the IRS expects taxpayers to support their R&D tax credit claims.

Taxpayers often seek experienced advisors to conduct R&D tax credit studies that help ensure compliance. As part of these studies, advisors evaluate the taxpayer’s contemporaneous documentation — records created as qualified research activities are conducted — and interview the subject matter experts (SMEs) who were involved in the research activities. The result is a comprehensive report designed to substantiate the taxpayer’s R&D tax credit claim.

According to these court cases, the IRS is placing less value on SME testimony than it used to, underscoring the importance of contemporaneous documentation. Although after-the-fact supporting documentation can still enhance a taxpayer’s position, it is alone insufficient to meet the IRS’s heightened bar for credit substantiation.

Proactive conversations with a tax advisor can help ensure businesses prepare the documentation they need to claim the R&D tax credit.

Kyocera v. Commissioner

Kyocera Corporation is a Japan-based, multinational company that manufactures industrial ceramics and electronics. On its 2018 U.S. tax return, it claimed an R&D tax credit of nearly $400,000. In 2021, Kyocera amended its 2018 return and increased its R&D tax credit to about $1.7 million.

What happened between the original and amended filings? Kyocera had its 2018 research activities re-evaluated.  

More than 16 months after the company’s 2018 tax year ended, the company’s accounting firm conducted an R&D tax credit study, interviewing 36 Kyocera employees identified as subject matter experts (SMEs). It appears that Kyocera employees didn’t keep timecards or any other type of contemporaneous records. Instead, their outside public accounting firm relied on SMEs to estimate how more than 1,200 employees spent their working hours.  

Upon audit, the IRS denied Kyocera’s entire $1.7 million claim. The IRS stated in a court document, “… because Kyocera did not retain any supporting documents and the study is based on mere guesstimates from interviews, the [U.S. Tax Court] should decline any invitation to estimate the amount of the credit.”

The case is still pending with the U.S. Tax Court.

George v. Commissioner

George’s of Missouri, Inc. (GOMI), is a large poultry processing company in the United States. From 2012 to 2014, the company conducted seven research trials related to broiler chickens. Later, in 2014, the company signed an agreement with a consulting firm to conduct an R&D tax credit study.

The study found that GOMI had nearly $63 million in qualifying supplies expenses over the three-year period, resulting in an R&D tax credit of more than $4.5 million. The company did not claim any credit for wages or contracted R&D activities.

Upon audit, the IRS disallowed the credits in full and tacked on accuracy-related penalties. The IRS argued that the company shouldn’t qualify for an R&D tax credit based on supplies expenses if it didn’t also claim qualifying wages. The U.S. Tax Court disagreed with the IRS, resulting in a taxpayer-favorable ruling.

In the end, the U.S. Tax Court allowed R&D tax credits that could be substantiated with a mix of contemporaneous records and supporting documentation from the R&D tax credit study. It also waived the accuracy-related penalties. Here’s an excerpt from the court memo:  

GOMI’s research credits were a mixed basket of eggs: some good eggs supported by contemporaneous records and some rotten eggs that petitioners could not substantiate. GOMI is a highly data-driven business that collects substantial data as part of its standard production processes. However, despite extensive contemporaneous documentation, we were unable to identify sufficient evidence that certain research trials occurred or the information necessary to apply the four-part statutory test.

3 Takeaways From Recent U.S. Tax Court Cases on R&D Tax Credits  

Kyocera and George both show us that the IRS and U.S. Tax Court value contemporaneous records over documentation compiled after the fact. Here are three takeaways from these two consequential cases:

1. Be Proactive About R&D Tax Credit Planning

In both Kyocera and George, the taxpayers did not conduct their research activities with a potential R&D tax credit claim in mind. It’s during the planning phase that specialty tax advisors can support taxpayers in proactively planning and advising on proper documentation to help bolster an R&D claim.  

It helps to start an R&D tax credit study in the year the credit is claimed. SME testimony is more likely to be accurate and, therefore, reliable. Plus, it shows that the company took the proper steps to ensure compliance.

2. Consult With an Advisor on Gathering the Optimal Contemporaneous Documentation

It is not advised to claim an R&D tax credit without proof that you conducted qualified research. Insufficient contemporaneous documentation, including timecards, technical documentation, and research data that connect qualified research with qualified expenses, can lead the IRS to disallow an R&D tax credit.

3. Fill in the Gaps with SME Interviews

Contemporaneous documentation is paramount, but SME testimony still has value. In George, the U.S. Tax Court permitted R&D tax credits based on information from SME interviews that helped contextualize primary records. That’s the best use of SME interviews: Fill in gaps left by documentation. A proactive advisor can help taxpayers identify areas in which SME testimony can shore up an R&D tax credit claim.

U.S. Tax Court case law teaches us that SME interviews can only take a taxpayer so far. For example, it says that estimates from SMEs are permissible only when they are reasonable and supported by data.

Smith + Howard: R&D Tax Credit Experts

The Smith + Howard Specialty Tax Services team works with you to optimize tax credits and other incentives, including more than just the R&D tax credit. Contact Jackson Moore, a manager in the Smith + Howard Specialty Tax Services team and this article’s author, to start a conversation.