Research Was Not Routine, But Compensation Was Excessive

For the research tax credit, when is research so routine that it does not qualify for the tax credit?  And what if the founder of the company is paid an unreasonably high wage–can the high wage be considered as an expense for computing the credit?  The court addressed these issues in Suder v. Commissioner, T.C. Memo. 2014-201.

Facts & Procedural History

Suder is the founder and owner of Estech Systems, Inc. (“ESI”). ESI is in the business of designing telephone systems for small and midsize businesses. This generally involved designing phone systems by combining customized hardware components and software to operate as an integrated unit.

ESI engaged a tax credit study provider to compute the amount of its research tax credits for 2004 thru 2007. The provider identified seventy six projects that had qualified research during these years. ESI was a Subchapter S corporation. Suder was the 90% owner of ESI.

Qualified Research Expenses

The parties asked the court to consider twelve of these projects as representative of all of the projects in determining whether the research activities were qualified. The court considered the facts for each of these projects and the four tests for determining whether the research was qualified. These tests require that:

• The expenditures connected with the research must be eligible for treatment as expenses under section 174 (the section 174 test). Sec. 41(d)(1)(A).
• The research must be undertaken for the purpose of discovering technological information (the technological information test). Sec. 41(d)(1)(B)(i).
• The taxpayer must intend that the information to be discovered be useful in the development of a new or improved business component of the taxpayer (the business component test). Sec. 41(d)(1)(B)(ii).
• Substantially all of the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality (the process of experimentation test). Sec. 41(d)(1)(C), (3).

The government only contested the section 174 and process of experimentation tests.

The Section 174 Test

For the Section 174 test, the IRS argued that ESI did not satisfy this test because its activities only presented uncertainty inherent in every large development effort, including uncertainty resulting from deadlines, lack of resources, unexpected delays, and human error. The IRS also put on an expert who testified that ESI’s projects created products that merely matched products already available from other vendors and characterized each product as routine. The court did not agree with the IRS or its expert. It concluded that ESI’s projects were complex and presented uncertainties for which no publicly available information provided a solution.

The Process of Experimentation Test

For the process of experimentation test, the IRS argued that ESI merely chose among design alternatives by applying engineering know-how, publicly available knowledge, or by committee. The IRS argued that these methods were not processes of experimentation as required by the regulations. The court did not agree. It concluded that publicly available information did not establish the appropriate design of the products.

Reasonable Compensation

The court also considered whether Suder’s compensation was reasonable as a qualified research expense. The IRS and Suder both presented reports from experts who opined on what amount of salary was reasonable for Suder given the facts. The court accepted the IRS’s expert report and adjusted the wage expenses accordingly.