Annette Nellen
Annette Nellen
The Research Credit — The Saga Continues

Stringent enforcement, confusion in the courts and calls for both modification and permanence continue to describe our temporary federal research tax credit.

June 25, 2009
by Annette Nellen, CPA/Esq.

Since its enactment in the Economic Recovery Tax Act of 1981, the research tax credit has been a temporary provision, renewed over 10 times. It will expire at the end of 2009. Its temporary nature has meant delays in regulatory guidance. Various court decisions have offered some guidance although decisions have not always been consistent.

This article looks at current proposals to modify the credit and make it permanent. In addition, the Internal Revenue Service’s (IRS) focus on credit claims and a recent court case that challenges part of the IRS approach are explained. For more information on the credit, see Our Neglected Federal Research Credit.


President Obama has followed the approach of his predecessors by calling for the research credit to be made permanent. The Administration's FY 2010 revenue proposals note that the credit is "an important component of economic growth," but that its effectiveness is harmed by its temporary nature. (General Explanations of the Administration's FY 2010 Revenue Proposals (PDF), May 2009.) The Joint Committee on Taxation estimates that this proposal will cost $23 billion over five years and $68 billion over 10 years (JCX-28-09, June 2009).

H.R. 422 (111th Congress) extends the research credit through 2010. It also increases the percentage for the alternative simplified credit (IRC §41(c)(5)) from 14 percent to 20 percent and makes that credit permanent (thus ending the regular credit formula after 2010). Similarly, S. 1203 would make the simplified credit the permanent and only formula after 2010. S. 1203 also increases the percentage for taxpayers without three prior years of research expenditures from six percent to 12 percent.

Additional proposals include H.R. 783 and S. 37 to make the credit permanent as it currently exists, with its two possible credit formulas. H.R. 1545 would make the credit permanent and increase it for taxpayers with a certain amount of domestic production activities.

Claims, Clashes, Cohan and Cases

Some taxpayers have either overlooked the credit or discovered after filing that they were entitled to a larger credit. Thus, after the research has been performed, the taxpayers and their tax advisers attempt to identify and document the qualified research and the expenditures that qualify for the credit. The IRS is quite concerned over the accuracy of many of these claims which may lack contemporaneous documentation, be based on estimates or be "prepackaged."

The IRS treats research credit claims as a Tier I issue. Generally, a risk analysis is performed to determine if examination is warranted. A mandatory IDR (Information Document Request) is provided. In May 2008, the IRS issued Research Credit Claims Audit Techniques Guide to provide “guidance on how IRS examiners can more efficiently and effectively evaluate RC claims, particularly those that are prepared under the most common approach, Prepackaged RC Claim Studies.”

The Guide clearly indicates the IRS concern with “packaged” claims: “There is a growing trend among taxpayers and their representatives, to submit prepackaged material to support research credit claims. These submissions are usually delivered to examiners in multiple binders. While the submissions often set forth the methodology employed in preparing the research credit claim, the submissions frequently fail to substantiate that the taxpayer paid or incurred qualified research expenses (“QREs”) as claimed.”

Another issue noted is that some claims do not indicate a “nexus between QREs and qualified research activities (QRAs)." That is, for example, taking some percentage of the wages paid to individuals in a particular department conducting research is not enough to show that the work was for "qualified research."

The Guide notes that preparer penalties should be considered in some instances, as well as the penalty for erroneous claims for refund or credit under §6676.

With a key focus of a research credit claim examination on substantiation, issues have arisen as to the details of documentation needed, particularly when it appears that some qualified research likely occurred. The Guide notes the Eustace case (TCM 2001-66, aff'd 312 F.3d 1254 (7th Cir. 2002), stating that the court did not allow the taxpayer to apply the Cohan doctrine (39 F.2d 540 (2nd Cir. 1930)) to estimate the qualified research expenditures when documentation was not complete. The Tax Court questioned whether the research met the definition of qualified research yet acknowledged that at the subcomponent level, it may have. However, the taxpayer lacked substantiation to quantify the wages devoted to that research. While the taxpayer stated that the Cohan rule required the court to make a reasonable allocation of salaries to the subcomponent level, the court disagreed that it had such a mandate and it declined to make an allocation. Exhibit E of the Guide is devoted to issues of substantiation. In addition, to the Eustace case, it discusses a 2008 claims case, U.S. v. McFerrin, 102 AFTR 2d 2008-6269 (DC TX). In June 2009, this case was vacated and remanded on appeal (No. 08-20377 (PDF) (5th Cir.)).

The IRS brought suit against the McFerrins, shareholders in four S corporations, for a refund claim that the IRS declared it paid erroneously due to a clerical error. The claim was for a research credit of $472,092 plus interest of $129,136 related to an 1120S where no credit was originally claimed. In 2003, one of the S corps contracted with a consultant for a research credit study for 1999 through 2002. The court agreed with the IRS that the records were not sufficient to indicate that research and amounts claimed were valid. While the court acknowledged that some research occurred, the records could not prove it was qualified research and the court declined to apply the Cohan doctrine. The court described this doctrine as allowing a court to "estimate the allowable credit" but "only when it is clear that qualifying expenses were actually incurred in the relevant tax year."

On appeal, the 5th Circuit stated with respect to application of the Cohan doctrine: "If McFerrin can show activities that were “qualified research,” then the court should estimate the expenses associated with those activities. The district court need not credit McFerrin's reconstruction of expenses from years after the fact. ... But the court should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate." The court also noted that the lower court had applied some definitions of qualified research incorrectly.


While the research credit was created and renewed to benefit the economy, some taxpayers have likely found it to be a difficult or mysterious provision. Why has the credit remained temporary for over 25 years despite a strong political desire to encourage more R&D in the US? Why did some companies that incur R&D expenditures fail to claim the credit on timely filed returns? Why have the IRS and some courts sometimes taken a strict approach in defining qualified research and allowing the credit?

Looking Forward

The cost of a permanent research credit has been a roadblock to permanence in the past. Given today's reality of accepting large budget deficits and other proposals with high price tags, 2009 might indeed be the year the credit becomes permanent. That should enable companies to make better use of it in long-term decision-making. One of the best actions for the credit would be for the Administration to take a more proactive approach to it. Timely and clear guidance on how to claim the credit and taxpayer outreach to ensure that more businesses know of it (and so can claim it on regular returns rather than amended ones), may enable the credit to best achieve its purpose of encouraging more R&D and promoting economic growth in the U.S. We'll see.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San Josť State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA's Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.