Engineer Looking at Laptop With Robot

While the court order is procedural in nature, it serves as important guidance for taxpayers claiming and defending the research credit.

Tax strategies

Court: Specifics Matter When Pursuing R&D Tax Credit Claims

  • Michael De Prima
  • Mathew Abraham
  • John Kapral
  • 9/25/2018

Businesses often struggle to prove why (and to what extent) projects and activities meet the definition of “qualified research” that is required to claim the research and development (R&D) tax credit (IRC Section 41). What’s more, taxpayers often fall short when trying to properly define and allocate qualified expenses to their business components, a key factor in a successful credit claim.

These issues are at the center of a recent federal court ruling: On August 22, a judge granted the government’s motion to compel CRA Holdings US, Inc. (CRA) to provide satisfactory responses to a formal set of questions regarding its claim for research and development tax credits.

CRA, an environmental remediation consulting firm, filed refund claims for its 2002 and 2003 tax years. But during a lengthy refund litigation process, the government sought details on the employees who performed qualifying services, and on the specific activities they performed.

In its response, CRA provided a list of all employees that worked on the relevant projects, irrespective of whether they performed qualified research. It also provided estimates of time that employees spent performing qualified services on an annual basis, but did not specifically allocate that time to qualifying projects.

The court stated that CRA’s submission of records amounted to a “document dump” that lacked context and would have required the government to scour more than 800,000 pages of material. The court also stated that CRA’s activity descriptions weren’t specific enough. For example, CRA claimed that it had employed new remediation methods on its projects, but did not indicate how or why the experimentation methods represented a new technology or scientific discovery.

CRA’s Cohan argument

CRA further asserted that it was allowed to estimate employee service time under the so-called Cohan rule, which has been used with some degree of success in other research credit claims. Under the rule, taxpayers may estimate qualified expenses if they can first prove that qualified research in fact occurred. The court found that CRA could not meet this threshold inquiry; therefore, the Cohan rule was not applicable and CRA’s use of estimates was misplaced.

Takeaway for claiming the R&D credit

This court order highlights the importance of establishing a clear nexus between qualified research activities and the associated expenses that are being claimed. The IRS and courts are increasingly focusing on this nexus when auditing and ruling on R&D credit claims. And as this case illustrates, the document dump approach is likely to be detrimental to a taxpayer’s claim. Rather, clearly stated responses that address the specific question or request at issue is the preferred approach.

Use of the Cohan rule also must be viewed in its proper context. Many taxpayers and practitioners have interpreted the rule as allowing them to estimate all facets of a credit claim. However, as the IRS and courts have clearly indicated, the Cohan rule does not eliminate the taxpayer’s burden of proving that qualified research has been performed. This requires a careful delineation of the qualified aspects of a project or business component along with meaningful links to the qualifying personnel and expense claims.

How we can help

Engaging a qualified tax provider can help you navigate the many pitfalls and nuances under IRC Section 41. CLA’s national research credit team has prepared thousands of credit claims across a wide range of industries. Our studies are designed to address specific issues that the IRS and states request upon audit in order to sustain maximum credit benefits. We can help you understand how this development may impact your business and R&D claim.

You may qualify for a tax credit if you are designing new products/processes or improving existing ones. Our R&D video shows you how.