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R&D Diagnostics Flashcards
Milestones of an Audit
- Notice of Exam
- KO call
- IDR Phase
- Site Visit
- Agreement/Acknowledgment of Facts (AoF): summary of all the facts in the case without any legal argument
- NOPA: comes with an 886-A
- Protest
- Rebuttal (optional)
- Pre-Appeals Conference
- Appeals
- Post-Appeals Mediation
List 5 IRS employees that participate in an R&D Exam
- Agent
- Agent’s Manager
- Engineer
- Engineer’s Manager
- Computer Audit Specialist (CAS)
What is the role of an IRS engineer–who do they assist?
IRS engineers assist the exam team with understanding R&D–specialists that provide technical or industry-specific guidance.
List four of alliantgroup’s technical advisors
- Kathy Petronchak
- Don Sniezek
- Ron Cerruti
- Dorothy Taylor
- Howard Lewis
- Eric Hylton
- Steve Miller
What steps does the IRS take if the Taxpayer does not sign a Form 872 (SS-10 in ERC)?
- Issues a Notice of Statute Deficiency
- Taxpayer loses their right to appeals
- Only recourse is to file suit
What is the purpose of the IRS appeals conference? Where does it fit in the audit administrative process?
To reach a settlement agreement based on the hazards of litigation. Appeals conference occurs after Exam is closed.
What is the name of the alternative dispute method and when can it be requested?
Fast Track Mediation–can be requested at any time as long as the issues have been narrowed down.
What is the name of the letter prepared as a response to a NOPA–what is the letter’s function?
Protest–to formally request an appeals conference. If a NOPA is not responded to with a formal written protest, the right to appeals is waived and the only recourse for the Taxpayer is litigation.
What are the steps an IRS agent can typically take once they receive a formal protest letter?
- Issue a rebuttal
- Move the case to appeals
List the options available to a Taxpayer if they disagree with the results of the Exam:
- Protest + Request Appeals
- Fast Track Mediation
- Litigation
- Request Manager’s Conference
- Pay the tax
Utilization Formulas
RTL-2 = RTL-1 (credit x tax rate%)
TMT-2 = TMT-1 (credit x AMT rate%)
Spread = RTL-TMT
Refunds = (RTL-2 minus RTL-1) - new spread
Utilized = new spread
CB/CF = credit - new spread
Control Groups
- Brother-Sister: when five or fewer individuals own 50% common ownership and 80% effective control.
- Parent-Sub: when a Parent company owns greater than 80% of the subsidiary
Wages that can be taken as QREs?
Wages, dividends, and bonuses. Fringe benefits cannot be used as wages.
SOL Code Sections
- 6501: Time limit IRS has to assess tax.
- 611: Taxpayer time limit to file for a claim or refund
If an IRS deadline falls on a holiday–when is it due?
Next business day
Will the unused credits expire if there is not enough tax liability?
Explain carry back and carry forward.
Non-utilization year (NOL): as a company if you have more losses, then you don’t owe taxes and can’t utilize any credits
Can still carry back and carry forward but the credit can’t be utilized in NOL
ABC filed 2017 S-Corp return on 5/15/2018–how long do they have to amend? What if the return was filed on 2/15/2018? What if the return was filed on extension?
- 5/15/2021 (three years after filing)
- 3/15/2021 (early filing–have three years after filing deadline)
- Even when filing on extension–still have three years.
1.41-4 Example 3
X is engaged in the business of manufacturing food products and currently manufactures a large-shred version of a product. X seeks to modify its current production line to permit it to manufacture both a large-shred version and a fine-shred version of one of its food products. A smaller, thinner shredding blade capable of producing a fine-shred version of the food product, however, is not commercially available. Thus, X must develop a new shredding blade that can be fitted onto its current production line. X is uncertain concerning the design of the new shredding blade, because the material used in its existing blade breaks when machined into smaller, thinner blades. X engages in a systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a different material from that of its existing shredding blade and, if so, what material will best meet X’s functional requirements.
X’s activities to modify its current production line by developing the new shredding blade meet the requirements of qualified research as set forth in paragraph (a)(2) of this section. Substantially all ofX’s activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of the taxpayer’s research activities. X identified uncertainties related to the development of a business component, and identified alternatives intended to eliminate these uncertainties. Furthermore, X’s process of evaluating identified alternatives was technological in nature, and was undertaken to eliminate the uncertainties.
1.41-4 Example 4X is in the business of designing, developing and manufacturing automobiles. In response to government-mandated fuel economy requirements, X seeks to update its current model vehicleand undertakes to improve aerodynamics by lowering the hood of its current model vehicle. X determines, however, that lowering the hood changes the air flow under the hood, which changes the rate at which air enters the engine through the air intake system, and which reduces the functionality of the cooling system. X’s engineers are uncertain how to design a lower hood to obtain the increased fuel economy, while maintaining the necessary air flow under the hood. X designs, models, simulates, tests, refines, and re-tests several alternative designs for the hood and associated proposed modifications to both the air intake system and cooling system. This process enables X to eliminate the uncertainties related to the integrated design of the hood, air intake system, and cooling system, and such activities constitute eighty-five percent of X’s total activities to update its current model vehicle. X then engages in additional activities that do not involve a process of evaluating alternatives in order to eliminate uncertainties. The additional activities constitute only fifteen percent of X’s total activities to update its current model vehicle
In general, if eighty percent or more of a taxpayer’s research activities measured on a cost or other consistently applied reasonable basis constitute elements of a process of experimentation for a qualified purpose under section 41(d)(3)(A) and paragraph (a)(5)(ii) of this section, then the substantially all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is satisfied. Substantially all of X’s activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of X’s research activities. X identified uncertainties related to the improvement of a business component and identified alternatives intended to eliminate these uncertainties. Furthermore, X’s process of evaluating the identified alternatives was technological in nature and was undertaken to eliminate the uncertainties. Because substantially all (in this example, eighty-five percent) of X’s activities to update its current model vehicle constitute elements of a process of experimentation for a qualified purpose described in section 41(d)(3)(A), all of X’s activities to update its current model vehicle meet the requirements of qualified research as set forth in paragraph (a)(2) of this section, provided that X’s remaining activities (in this example, fifteen percent of X’s total activities) satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4).
1.41-4 Example 1X is engaged in the business of developing and manufacturing widgets. X wants to change the color of its blue widget to green. X obtains from various suppliers several different shades of green paint. X paints several sample widgets, and surveys X’s customers to determine which shade of green X’s customers prefer.
X’s activities to change the color of its blue widget to green are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section because substantially all of X’s activities are not undertaken for a qualified purpose. All of X’s research activities are related to style, taste, cosmetic, or seasonal design factors.
1.41-4 Example 2 The facts are the same as in Example 1, except that X chooses one of the green paints. X obtains samples of the green paint from a supplier and determines that X must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints X has used. X obtains detailed data on the green paint from X’s paint supplier. X also consults with the manufacturer of X’s paint spraying machines. The manufacturer informs X that X must acquire a new nozzle that operates with the green paint X wants to use. X tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines.
X’s activities to modify its painting process are a separate business component under section 41(d)(2)(A). X’s activities to modify its painting process to change the color of its blue widget to green are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. X did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machines eliminated X’s uncertainty regarding the modification of its painting process. X’s activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control.
IUS Test
Internal Use Software Test
1) Highly Innovative
2) Significant Economic Risk
3) Commercially unavailable.
IUS Definition
Software that is developed by TP for use in general administrative functions that support the conduct of a TP’s trade or business.
Examples: Accounting software, HR software
Two ways that software is not IUS?
- Developed for third party use: software that is developed to enable the TP to interact with third parties, or to allow third parties to initiate function and review data on a TP system.
- Developed for commercial sale: software that is to be sold, leased or licensed, or otherwise marketed to third parties.
High Threshold of Innovation Test
- Highly innovative: measurable improvement in speed, efficiency, or cost in business;
- Significant economic risk: higher uncertainty–dedicate significant resources (time and money);
- Not commercially available
Dynetics
Facts: Awarded 7 different contracts to develop missiles (U.S. government agencies, Boeing, University of Alabama). Contract with air force included both fixed-fee and cost-plus-fixed fee line items. Other contracts were all time & materials, cost-plus-fixed-fee contracts, and fixed-price level of effort contracts.
TP arguments: 6 contracts at issue in this case. TP argues that a course of dealing existed between it and its contracting partner in which regardless of the plan terms of each contract, TP was expected to produce a successful result in order to receive payment. TP also argues that each of the contracts included either an inspection clause or a warranty clause or termination clause that put TP at financial risk if results were not successful.
Government argument: Under each sample contract, TP would be paid regardless of whether research was successful. TP also fails to retain substantial rights in two of the contracts.
Holding: Contracts were funded. Course of dealing argument is parol evidence–the court may only consider such evidence if the contracts are ambiguous. Court found that contracts were not ambiguous and so was limited to the language within the four corners of the contract. Inspection and warranty clauses within the contracts were also not enough. Clauses included language stating that payment was contingent on level of effort rather than success or outcome. Warranty clauses also did not put TP at financial risk–TP was paid to correct or replace nonconforming services. With regards to rights, Dynetics tried to argue similarly to Lockheed–but Court said that rights retained were incidental benefits and industry know-how.
Populous
Facts: TP is an architectural firm. 5 contracts sampled–all fixed-price–established that economic risk prong was satisfied using Geosyntec since fixed-price contracts are inherently risky.
Issue: Did TP retain substantial rights?
Government argument: No substantial rights because ownership of documents clause. Client owned project-related documents and contract prohibited TP from using or recreating any distinctive original, material exterior features without client’s consent.
Holding: TP retains substantial rights. Ownership of documents does not mean clients had exclusive right to TP’s research. No provision in K that prohibits petitioner from using related researched technology in its business. No provision in K that prohibited use of research performed or required TP to pay client for use of its research. Both parties here have rights which is okay.
Johnson
Facts: Edwards was a controls engineer. Contracted with hospital to design control system for hospital.
Issues:
1. Primary designer
a. Edwards had a maintenance K that did not specific design. Edwards produced design documents and sequence of operations to show they created technical specifications. Court says just because K doesn’t say design doesn’t mean you weren’t the designer. Three ways to test if you were a designer:
- Analyze existing conditions to prior specifications;
- Modified to better operate;
- Tested with simulations
2. Allocation letter
a. Person that signed was not valid. Court said there is no one specific person that must sign it from the government building.
b. Spot on letter that says amount of deduction. Designer put in 100% deduction. IRS argued that percentages weren’t allowed and that a numeral amount is required. Court said it doesn’t matter–it’s the same thing.
3. Modeling
a. IRS took issue with the modeling methodology used to see if it was energy efficient. IRS said if you only designed controls and taking deduction for controls you should only model that and make sure that the control system is meeting that efficiency – court said you should model the entire building and compare to reference building.
4. Placement service date was incorrect
IRS argued that Edwards was still working on the building in 2014 so they can’t claim for 2013. Court said it was correct—does not need to be the date it was fully operational just when it was functionally in use
5. Deduction cannot exceed the cost of property.
UCC (Supplies part only)
Facts: TP was in the business of manufacturing chemicals and plastics. TP requested an R&D credit for the costs of all supplies used in these projects even though they would have been used if the research and projects hadn’t been carried out. UCC was turning crude oil into petroleum—had coking building up in the pipes. Testing the process of adding the additive into the petroleum to see if it had an impact. UCC took everything as a supply expense including the petroleum.
- Whether the cost for supplies used during these projects would have been used in TP’s manufacturing process regardless of any research performed? Yes. The cost for supplies used during these projects would have been used in TP’s manufacturing process regardless of any research performed and therefore,
- Whether they qualify as “an amount paid or incurred for supplies used in the conduct of qualified research?” No. They do not qualify as “an amount paid or incurred for supplies used in the conduct of qualified research” and should properly be excluded.
TG Missouri
Company develops production molds to manufacture automotive parts. TG Missouri would sometimes construct the tool themselves or consult with a 3rd party. After the 3rd party toolmaker finished constructing the production mold, TP purchases the mold. TP owned some molds, some of them owned by customer but kept at TG facility.
Issue: Whether production molds TP then sold to its customers are assets subject to depreciation.
Hold: No.
TA: The molds that were sold to its customers are not subject to depreciation allowances because the petitioner does not have any economic interest in the production molds it has sold.
MUST BE DEPRECIABLE IN THE HANDS OF THE TP.
Siemer Milling
Issues:
1. POE
* IRS says methodical plan involving a series of trials to test a hypothesis is required. TP evaluates software products–not qualified research because not experimentation.
* Information must rely on the principles of the physical or biological sciences, engineering, or computer science. TP may not use conclusory statements to state work is technological in nature.
* IRS states that the TP cannot face the same uncertainties for more than one year. The court says that is not a requirement for TP to face a different uncertainty each year.
* IRS argues that TP does not employ anyone with the title of engineer or anyone with an engineering degree and therefore could not have performed research that relied on principles of engineering. Court says no specific degrees are required.
No penalties were imposed since TP had a reasonable reliance on a competent tax advisor when claiming R&D credit and relied on tax advisor in good faith.
Little Sandy Coal
Facts: Makes ships
ii. Three main issues:
a. Didn’t meet sub all. Sub all rule stating at least 80% of TP’s research must constitute elements of a POE applies to activities, not to physical components of the product being developed or improved. TP did not satisfy this requirement.
b. 2021 case–court held that one who provides direct supervision or support of research is not “engaged” in research.
i. Supplies are not activities, when the faction is described in 1.41-4(a)(6), it is computed using costs as a measure of activities, the costs of supplies used in the development of the product are not taken into account. First court said this is a K therefore you can’t be using it for uncertainty—appellate court said you can be doing it for both.
c. Novelty approach
i. Court uses trinity—appellate court agreed
d. No documentation proving shrink back
i. First court denied supply QREs
2. Explain the equation for sub all
a. Original court
b. Appellate court
The taxpayer, a shipbuilding company, claimed the R&D tax credit for qualified research expenses attributable to the design and construction of 11 new vessel types that it had never built before. After reviewing documentation for two of the 11 vessels, the IRS asserted, and the tax court upheld, that the taxpayer failed to meet the “substantially all” test, it failed to properly apply the “shrink back” provisions, and it failed to provide contemporaneous documentation to sufficiently substantiate its R&D credits.
Ultimately, the appellate court upheld the rejection of Little Sandy’s claim for the R&D tax credit just as the IRS and lower court did, but primarily due to a failure to properly document the activities that it claimed qualified for the credit.
“Substantially all” and the process of experimentation for R&D tax credit
While the appellate court upheld the denial of the credit, it went on to reject the tax court’s conclusion that direct support and direct supervision of qualified research are categorically excluded from the process of experimentation, a position widely asserted by the IRS during recent examinations of R&D credits. Instead, the opinion indicates that these activities must be analyzed and — if they constitute elements of a process of experimentation — then direct support and direct supervision of qualified research should be included in both the numerator and denominator of the fraction used to apply the “substantially all” test.
One component of qualifying for the credit, according to IRC Section 41(d)(1)(C), is that “substantially all of the research activities must constitute elements of a process of experimentation,” and Section 1.41-4(a)(6) further explains that taxpayers must show that “research activities that constitute elements of a process of experimentation” (the numerator) constitute at least 80% of “research activities” (the denominator).
In the Little Sandy Coal case, the taxpayer claimed that wages and costs associated with activities performed in direct support and direct supervision of qualified research activities should be counted in both the numerator and denominator of the fraction when calculating if the 80% test was met. The tax court ruled that these amounts should be considered “research activities” and included in the denominator, but that direct support and direct supervision lacked sufficient connection to a process of experimentation to be included in the numerator.
The Court of Appeals noted that this would make a taxpayer’s ability to pass the “substantially all” test dependent on how expensive a pilot model would be. The higher court ruled that costs associated with direct support and direct supervision of research activities qualify for inclusion in both the numerator and denominator of the 80% calculation, as long as the costs in question qualify as “research expenses” deductible under Section 174 of the Internal Revenue Code.
The higher court ruled that costs associated with direct support and direct supervision of research activities qualify for inclusion in both the numerator and denominator.
Documentation and the R&D tax credit
An important lesson to be learned from the Little Sandy Coal case is the significance of documentation when presenting an R&D tax credit claim to the IRS. The taxpayer in this case made numerous claims about test procedures, pilot models, subcomponents, and time allocations but failed to retain sufficient records to show how it met the criteria of IRC Section 41.
For instance, Little Sandy claimed that certain components of the pilot models would improve the function, performance, reliability, and quality of the boats, such as a stern notch and towing bridle on a tanker and an outboard side plate on the dry dock. But the company’s documentation failed to break out the specific costs of the research expenses directly allocable to these improvements, as is required by the shrink back provision in Sec. 1.41-4(b)(2). They took what observers have termed an “all-or-nothing” approach in saying that the overall improvements to the vessels met the requirements of the credit claim. Had Little Sandy documented costs more carefully and tracked them to different subcomponents of the vessels developed, it seems they might have been able to salvage at least some of the R&D tax credit claim.
Getting the most for R&D spending
As the Little Sandy Coal case demonstrates, taxpayers that claim the R&D tax credit need to meet both the requirements of the law and the exacting standards of documentation expected by the IRS. A system of contemporaneous recordkeeping, including notes, test results, time-tracking data, cost data, and evidence of technological uncertainty or scientific experimentation, is a critical component to substantiating a claim for the credit.
