TEI Roundtable No. 31: Research and Experimentation Credits
Unraveling research, risk, documentation, and litigation

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After COVID-19 forced the cancellation of TEI’s 70th Midyear Conference in March, we explored different ways to deliver content to our members and meet their continuing professional education (CPE) needs. With the support of several dedicated TEI sponsors, we launched our first-ever virtual midyear conference—a series of free CPE webinars open to all TEI members and in-house tax professionals worldwide—and this roundtable is, we hope, a productive by-product of that webinar. The presenters for this webinar, sponsored in July by Mayer Brown, were Kathleen King, a managing director at Alvarez & Marsal, and Alex Sadler, a partner at Morgan, Lewis & Bockius LLP. Doug Rodolph, director of federal controversy at Walmart, moderated the webinar.

Doug Rodolph: I’m going to turn it over to Kathleen to get us kicked off with the R&D campaign and the LB&I [Large Business & International Division] directive.

Kathleen King: Thank you, Doug. Good morning and good afternoon to everyone joining us today. I certainly appreciate the opportunity to speak again with Doug and with Alex. The first section that we’re going to talk about is a fairly new development. The IRS announced a new campaign around research issues in early 2020. The IRS campaign program is an audit technique that was first created back in 2017. The stated goal for the program is to focus IRS resources on what [are] deemed to be significant compliance issues or risks. When they first announced the IRS campaign program, I know many of the people that I work with in the research credit space anticipated that research credits would at some point be added to the program. I’ve been dealing in this space for almost thirty years now, and it’s always been a very contentious area, as [is] just about any issue that’s really factually intensive. So, not a surprise, I would say. The one thing that was a little bit surprising is that they added not only Section 41 issues but also Section 174 expense issues to the list of campaigns. If you look back over the history of research credits, in particular going back to the discovery test regime and the number of unfavorable court cases that came out during that timeline, all the cases determined that the projects at issue met the 174 test. So, by and large, 174 has been a test that’s primarily been accepted by the courts. I think that what we’re seeing here is a little bit of an overall change in tone and process coming from the IRS. I know that Alex and I recently heard some interesting observations from an IRS appeals officer. First, he was emphasizing how it was important for the appeals team, both the appeals officer as well as the engineering resource for the appeals team, to be able to explain how they got to the settlement amount. He noted that the number of formal dissents that were being filed for an appeal settlement was the highest that he’s ever seen. This is a very experienced IRS appeals officer. So, it was an interesting observation that he thought the overall tone was evolving. It’s a little bit early in the IRS campaign program, so it’s still difficult at this point to fully appreciate what the potential impact is going to be from this campaign designation. I think it’s fair to assume that additional audit resources will be issued, though, and it’s not too early to start assessing what your potential areas of risk may be should an IRS exam start.

Closely on the heels of the announcement of the IRS campaign on research issues, there was another release that came out on the centralized risk assessment of research credits. Research issues were very broadly defined as part of LB&I centralized risking process. I would say, by and large, they defined the research issues wide enough to fit in just about any potential issue that you can think of in this area. They specifically called out three areas as [being] in the scope of the guidance: 1) qualifying research activities; 2) qualifying research expenditures; and 3) substantiation requirements related to research credits. The couple points I would observe as the way these issues were worded were, first of all, as it defined qualifying research activities, it used the words “performed by the taxpayer.” I thought that was an interesting choice of wording, considering that you can have subcontractors that are also performing research on your behalf. I don’t know if there was any intent by that language, but as I looked at those words, that stood out to me. I think that on the topic of research issues related to expenditures, I thought it was interesting that they used the words “estimated” and “allocated,” because over the years, one of the IRS’ strongest concerns is that there’s a lack of precision. They like project accounting. They have concerns about cost center methodologies because they’re not as precise as they otherwise expect them to be. They want this really tight nexus of the expenditure. So, their focus on the words “estimated” and “allocated” [was] interesting. Then, finally, on the substantiation requirement, I thought it was interesting that they pointed specifically to the base amount. Because, again, as we’re going to talk about a bit later in the presentation, I do believe that there will be an increased focus through the campaign process and the centralized risk assessment process on really being able to substantiate your base amount and the incremental piece of the credit.

So, what’s the impact of this designation as a campaign? I think that there is clearly a stigma that comes with a campaign designation. There is a tendency for the IRS to view things that are campaigns as being subject to abuse and akin to a tax shelter. So that really creates some skepticism on the part of the IRS team. I think one thing that may actually benefit taxpayers as a part of this process is a renewed standardization of IRS audit tools, such as mandatory IDRs [information document requests]. It would be helpful if that information was published when taxpayers were preparing their claims and return work papers. It is often more challenging to document responses a couple years after the tax year is over and the return is being examined. I think it would be very helpful to have updated audit technique guides. It’s been at least fifteen years since any substantive changes have been made to the research credit audit technique guides. The LB&I directive on centralized risking provided some framework on the centralized risking process and how it was going to be applied to research credits. This is not applicable to CAP [Compliance Assurance Process] taxpayers, who have to go through a different process. If you file amended returns, or if you’re otherwise selected for IRS examination, then you should expect those filing to fall within the scope of the centralized risking process. There are a lot of questions as to what this really means for the scope of the audit. However, it is fair to assume that it will start with some kind of questionnaire, likely driven by an IDR that will be used to assess your risk in the research credit space.

Once a questionnaire or an initial IDR response is received by the IRS, there will likely be some type of centralized review by a research risk team. That team is going to be composed of subject-matter experts within the IRS, engineers with the IRS, other revenue agents. It’s supposed to be a collaborative-type process with the Exam team and national office, but it’s something where, based on your responses, they’ll make a determination whether or not it makes sense for the research credit to be reviewed. Based on our recent experience, this assessment is all about common areas of risk in the research credit area. Many of these are risk areas going back many, many years. Despite new regulatory guidance that’s come out on Section 174 on supply costs and internal use software, very little has changed on these primary areas of risk. Alex, I know that you spend a lot of your time supporting taxpayers in especially contentious areas; any thoughts or experiences you’ve had on some of these risk areas?

Alex Sadler: Yes, and before I give them I would also like to thank TEI and Mayer Brown and the membership for the opportunity to speak today. I would completely echo your list here as potential areas of risk in the current environment. I would say ninety percent or even more of the controversies that we get involved with have one of these issues. Substantiation, for years now, is a continuing issue for the majority of taxpayers who use cost center accounting, and the issue is simply whether the documentation and information collected is good enough to support the claimed credit. The standards that the government applies relative to the taxpayers’ standards sometimes are different, and that leads to disputes over proof. Relatedly, it’s a pretty common audit technique for engineers, for taxpayers who use cost center accounting, or sometimes project accounting, to run stat samples of what they consider to be high-risk job titles, like high-level VPs or administrative support. We’re seeing more and more process of experimentation challenges in light of a case that we’ll talk about, Siemer Milling, which holds the taxpayers to pretty high standards. That’s again a very factual issue. For heavy manufacturers who make large volumes of products and spend a lot of resources on process and product development and treat supplies that otherwise would be production-side costs, we see a lot of challenges as to whether those costs, those heavy-supply costs, qualify. For government contractors, engineering firms, and supply chain participants, there’s a lot of funded research activity, which is a very contract-based review. Lastly, pilot models, I consider that to be the next frontier. Those regulations were finalized in 2014; there’s been a lot of positions being taken over the ensuing years, and those are working their way through the system. I anticipate that those will be a source of a lot of activity going forward.

King: We’ll be covering some special issues, both recent court cases that impact those issues we just listed as well as some documentation strategies that you can use to help mitigate some of the risks that arise from those topics. In concluding this section, one of the key takeaways is that the risk is greater if you are claiming a research credit just in terms of the IRS—not necessarily a risk of sustainment, but just the risk of audit itself, which in and of itself can be very painful. If you’re looking to really hone in on what your risk areas are, the slides list publicly available resources that would be helpful for you to review. You can just Google them, and I think they’ll be helpful for you to assess your risk. In particular, I think the CAP program research credit questionnaire and the issues that are identified there are pretty good flags in terms of what an initial IDR might be trying to get to. They are looking for amended returns, business acquisitions that may change your structure, changes in methodology, use of a third-party provider, and just obviously the dollar size of the credit itself. With that, Doug, do you want to do the first polling question?

Areas of Risk

Rodolph: Absolutely. So, that will take us to our first polling question covering the material that Alex and Kathleen just went through. Which of the following is not likely to be an area of risk: supply costs for pilot models, salaries of scientists, process of experimentation, or base amount computation? We’ll give you a minute to respond to that, then we can flip over to the results and progress to the next section. Kathleen, if you wouldn’t mind, which one of these is not likely to be an area of risk?

King: Obviously, all of these carry some level of risk depending on what industry you’re in and the level of the individual, but I think the answer that we were looking for was that the salaries of scientists are the ones that are probably least likely to be challenged. We have found that, by and large, the IRS has been somewhat reasonable with the clearly technical folks. If it says something like “production scientist,” then they may question something like that, but, by and large, if you have developers or scientists and they’re doing some sort of job title assessment, they’ve been pretty good about allowing those.

Rodolph: Great. Alex, if you wouldn’t mind sharing with us some of the recent R&D case developments.

Sadler: Of course. I’m going to walk through a handful of recent cases, “recent” being defined as over the past year. I’m going to go from newest to oldest. The newest case, Audio-Technica, is quite new; it was decided by the Sixth Circuit, which covers the Upper Midwest, less than a month ago. To cut to the chase, I think this decision sounds a warning of sorts for taxpayers not to neglect their base amount computation. Just to review the case in a nutshell, Audio-Technica is a high-end audio equipment manufacturer based in Ohio. It claimed the research credit for product development activities. The IRS disallowed it, and the company filed a refund claim in federal district court and, kind of in an unusual strategic decision, they opted for a jury and had a jury trial. The jury agreed that Audio-Technica had engaged in qualified research, and it was a resounding victory for the taxpayer. It was great while it lasted. The problem was with the base amount computation. For other years not involved in this suit, Audio-Technica had decided to go to Tax Court and was able to settle those cases with the IRS, and in those settlements the IRS agreed with the taxpayer’s fixed-base percentage reflecting 1984 to 1988 QRE [qualified research expense], so it was a regular credit taxpayer. That makes everybody’s life easier. However, in the refund case, the government wanted to challenge the fixed-base percentage. Audio-Technica filed a pre-trial motion saying, “Look, they’ve already agreed to it. They should be estopped or precluded from challenging it,” and the district court agreed with the company. After Audio-Technica won with the jury, the government appealed on that issue and said, “We should have had the right to challenge the base period,” and the Sixth Circuit agreed with the government on that specific point. It reasoned that, well, the government had agreed with the fixed-base percentage, but that was in the context of a negotiated settlement, and that is different from the situation where the government argues for a base amount computation and the court agrees with it. That situation might estop the government from taking a contrary position, but not when it merely takes a settlement position. The implications, I think, are that many taxpayers have a base amount computation that is decades old, and the government has just kind of agreed to it, said that’s fine, and everybody’s agreed with it and moved on. Taxpayers should take care and recognize that the Exam team can change their mind, and if an issue brews and a dispute arises, they can add that to the list, and they are not bound to their earlier agreement and they can decide strategically to challenge it. You might want to take a fresh look and consider the integrity of your base amount computation. The other implication is to consider your base-period investigation, even with alternative simplified credit taxpayers. You know, it’s not that hard to go back three years, but it’s a little bit harder, and this one is a little bit of a gentle warning that you should make sure you’re able to demonstrate the integrity of your base numbers as well.

The next case that we’ll talk about is Populous Holdings. This is an unpublished decision by the Tax Court, issued this past December. To cut to the chase, this case is good news if your company performs research under contracts, such as a government contractor, engineering firm, or supply chain participant. If you’re in one of those businesses, I would recommend that you retrieve this opinion from the Tax Court or an advisor, because it’s very helpful. The case involves whether the funded research exclusion, which is a tool available to the government to knock out claims pretty easily, applied to research performed by an architectural design firm under five sample design build contracts. The court decided no, the design firm’s research was not funded, and it reasoned that the contract payments were contingent on success, and that Populous Holdings was at risk because the contracts were fixed-price contracts. The court reasoned that fixed-price contracts are inherently risky for the contractor if the research is unsuccessful, and that makes sense as an economic matter. If you have a fixed-price contract and you do some testing, you do some research and it doesn’t work out, it fails, you’re going to have to do it over again to perform the contract, and when you have a fixed price that’s going to be on your nickel. Therefore, the fixed-price nature of the contracts puts the contractor at risk. It is starting to become, I think, a well-established rule of law that fixed-price contracts put the risk on the contractors and render that research unfunded, which is a helpful principle for taxpayers. Secondly, the contracts gave the clients ownership of the documents created as a result of the research, and the government argued that that meant that the taxpayer did not retain substantial rights in the research, which is a requirement not to be funded. The court disagreed with that. Just because you give the client ownership of the documents doesn’t mean you don’t also have the right to use the results of your research and use it on future projects and in future business. Accordingly, the taxpayer was not deprived of substantial rights, and the research was not funded. The implication is that payments under fixed-price contracts are by their nature contingent and not funding. In addition, unless the contract broadly conveys all rights to be intellectual property created by the research, absent that type of broad, all-inclusive grant, the researcher retains substantial rights. I find it notable that the Tax Court allowed the research credits in full to the taxpayer in this case, which was an architectural design firm, which is a little bit on the edges of your normal researchers, such as manufacturers or technology firms, and it is an area where there’s a lot of disputes. Here, the Tax Court, although it didn’t address the qualification issue directly, allowed the credits for research to produce architectural designs.

The next case is Harper v. United States, which is an unpublished opinion by the district court in Southern California that dismissed the taxpayers’ refund suit for defective refund claims. It is currently on appeal, and oral argument will occur this fall. So, expect an appellate opinion next year. In a nutshell, the taxpayers were husband and wife. The husband owned an S corp construction company that did work on military bases and did innovative design. They didn’t claim the research credit on their original returns. Their provider came in and did retrospective look-back studies and claimed research credits for two past years, 2008 and 2010. The taxpayers claimed the credits, and they did so by filing amended returns on Form 1040S because they are S corp owners, and attached a Form 6765. In my experience, that’s how everybody claims a research credit. Instructions to the Form 6765 say if you want to claim the research credit, go figure it and file this schedule, and that is how you do it. The taxpayers, when they filed suit, the Department of Justice made a clever argument that the regulation governing refund claims doesn’t say just attach a form, it says you have to set forth in detail each ground upon which the refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. The Department of Justice argued that the taxpayers, by just giving numbers on the 6765, had failed that standard. The district court agreed with that argument and dismissed the case. The court said that the refund claims were defective because they did not give the IRS sufficient information about the claims. I personally question the district court’s reasoning in this case. We did file an amicus brief to the Ninth Circuit. In my judgment, the taxpayers used the form designated by the IRS. They gave due notice of the information that would allow the IRS to audit the claim, and in fact the IRS did audit the claims, but it’s going to be up to the Ninth Circuit, obviously, not me. Until then, I think as a matter of best practice, the safest course, or belt and suspenders, would be to attach, if you’re going to do an amended claim claiming the research credit, a narrative description of the activities just to inoculate yourself against any challenge like this that the claims didn’t provide sufficient information.

The last case I’m going to talk about is one you probably heard about already, because it’s been around for about a year, and it’s been getting some play in audits. It’s called Siemer Milling. To cut to the chase, the lesson here is that claimants need to be able to walk the walk when they claim the research credit. They need to be able to prove it. The case involved a wheat miller, which is a very mature industry, that had two plants, had an R&D department, had a testing lab, and it engaged in seven plant projects to develop or improve products or processes. As somebody just eyeballing these projects, having worked in this area for some time, on the whole these seem like good, reasonable projects. The studies were performed by a reputable regional CPA firm. However, the Tax Court concluded that the taxpayer failed the process of experimentation test for all seven projects. To summarize the reasoning, it said the standard was the taxpayer has to show that the project involves a methodical plan involving a series of trials to test the hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis. Kind of a high school textbook definition of the scientific method. The court said that Siemer just didn’t do it. It said while Siemer stated they were engaged in a process of experimentation, there was little in the record to support this assertion. When I step back and try to read between the lines as to what happened here, my own view is that Siemer put on a streamlined case for pragmatic reasons. The credits at issue were not particularly large. That’s a legitimate strategic judgment, but it comes with risk. In this case, that risk played out. Unfortunately, the result of that is an opinion that has given the IRS ammunition to deal with taxpayers and to elevate the process of experimentation requirement and challenge taxpayers’ ability to meet that requirement. One silver lining of the case—and maybe this was the taxpayer’s primary focus, given the small credits involved—the IRS had asserted penalties, and the Tax Court said “No, no. This is a taxpayer who gave all this information to the advisor and relied in good faith on the advisor and had worked with this particular advisor for many years,” and that established good faith and reasonable cause. So, if you’re in an audit where [the] Service suggests penalties may be appropriate and you had a study, the first place I would go would be this opinion to show even in the case of the taxpayer loss the Tax Court declined to impose penalties, which is helpful.

There are two cases that I’m aware of that are working their way through the system; one is United States v. Oehler, which is another federal district court refund suit. It’s interesting for certain taxpayers, because it involves an electrical engineering contractor and the normal four-part test, how does it apply to engineering firms who aren’t making new widgets or new products, but they’re actually coming up [with] new systems and putting new plumbing and electrical systems in the buildings—is that creditable? This case, if it doesn’t settle, may give us some helpful information. Then secondly, there’s a case in Tax Court, Boswell v. Commissioner, which involves agricultural research. These are experiments conducted on crops, and the issue is whether supplies, seed, and water and whatnot used in experimentation while you’re growing the crops are creditable QREs. Now I would agree those meet the criteria under the statute, those are QREs, but the government disagrees, and that is currently pending on cross motions for summary judgment.

That is a quick breeze-through of recent case law and some thoughts on implications for taxpayers. I think we have our next polling question.

Not Binding Government to Previously Agreed-Upon Base Amount

Rodolph: Thank you, Alex. So, we’ve got, of course, our next polling question. In which recent case did the court refuse to bind the government to a previously agreed base-amount computation, Siemer Milling, Populous Holdings, Harper or Audio-Technica? If you’ll make your selection, we’ll try to let it sit there for a minute so everyone can respond. In the meantime, I did get a couple of questions that were submitted. The first one, jumping back to the section that Kathleen covered: Is the IRS focusing on the new partnership audit guidelines or are they focusing on corporations? As we think about campaigns—Kathleen or Alex—do you see any type of focus on partnerships, or is it an across-the-board focus with the new campaign?

King: I guess I’ll weigh in and then Alex can give his impressions as well. Again, the majority of studies that I’ve worked on have been at a corporate level, whether it’s a C corp or an S corp. However, I have one recent audit that involves a partnership that is part of a larger controlled group. The partnership adds some additional complexity to the audit review process because the partnership return is being evaluated separately by a separate IRS team. The partnership review is primarily focused on the calculation mechanics, not the research activities or expenditures themselves. So, I would say that the primary focus of the program is corporations, but clearly if you claim research credits on an amended return, it is in scope for the LB&I risking.

Rodolph: Great. Thank you. Here’s another question: “What is the rationale for treating cases in which the customer pays for the research, but the taxpayer does not retain substantial rights as funded research?”

Sadler: I think I understand the question, and it’s an excellent question, because the funded research exclusion—if you read the statute, it just says research is funded to the extent it’s paid by under a contract or to a third party. The regulation came out in the mid-1980s, and all out of the blue the substantial rights requirement was invented and embedded within the regulation. It’s not clear to me that Congress fully intended the substantial rights requirement as reflected in the regulation. If I were to try to rationalize it myself, I would say that the research credit is intended to stimulate activities where a taxpayer is coming up with new products, new services, things that benefit the economy. However, the research credit is not intended to incentivize contract research arrangements where you’re just performing a service, where you don’t really have a dog in the fight or skin in the game and you’re just performing a service. I don’t think Congress really intended to incentivize the contract research arrangement. In that sort of arrangement, the researcher’s just going to get paid by the hour and doesn’t retain any rights in the research. Congress didn’t really care to incentivize that type of service engagement, whereas where you’re really doing research and you’re at risk, and if you’re successful, you’re going to be able to do great things and help employ people and create new products, that’s what Congress wanted to get at. I think that is the underlying rationale for the requirement. However, I am less sure that Congress intended for the requirement to apply beyond the contract research situation.

Rodolph: Thank you. I’ll put one more question out there quickly, and then we’ll move on to another section. There’s a question: What guidance is there to take capital expenses, which are pilot models, as QREs?

King: I would say that the primary guidance out there is obviously the new Section 174 guidelines/regulations that came out several years ago now. Obviously those are specifically on point for 174 expensing. I think that the plain language in the statute for Section 41 is also very powerful. It simply requires that supplies be used in the research process. I think that as you’re trying to justify how supply costs clearly meet the requirements under 174 of a pilot model, then the next step to claim the research credit is to point it back to how the pilot model is critical to the research process. And this is true with any type of supply cost, whether it’s a consumable item or something for sale to your customers or something that’s used in your business. It’s really making sure that you can connect it back to the research process and why the cost of that item was so critical to the research process. Alex, did you have a couple others?

Sadler: As usual I agree with you. In my mind it’s, Does IRC Section 263A trump IRC Section 174? Does IRC Section 174 trump IRC Section 263A? Two-sixty-three A, both in the text of the statute and in the regulations, says that this requirement does not apply to research or experimental expenditures under 174. So, if you meet the criteria of research experiments under 174, then you don’t have to be capitalized, and then I go to what you said, the most recent amendments to 174. I think they’re pretty clear that if you incur the cost up front to develop or improve a new product, it doesn’t matter if you end up being a capital asset if the research succeeds. The focus is on, Were you doing research in the first place? To me, that provides a pretty compelling legal justification for treating capital expenses as QREs if they meet the Section 174 criteria.

Documenting R&D Activities

Rodolph: Thank you. I guess with that we’ll go ahead and progress into the next section. Alex, if you wouldn’t mind getting us kicked off on documenting R&D activities?

Sadler: Sure. This section of the presentation relates to substantiation, which is just a fancy word for proof. As a research credit directly reduces income tax, taxpayers bear the burden of proving that they are entitled to the credit, as the Service will be very quick to remind you. This relates to both do the activities qualify—are the scientists, contractors, and other workers, are they engaged in qualified research—and two, do the costs qualify? Have you adequately identified the cost and shown that they fall into one of the eligible areas? The regulatory language, if you go to the general research credit regulation, 1.41-4, the last section of the regulation, has in my mind very general and somewhat unhelpful language. It just says that taxpayers have to retain records in sufficiently usable form and detail to substantiate the expenditures are eligible. I don’t find that that provides very useful guidance to taxpayers. I do find it useful if you dig back into the legislative history and you trace the evolution of this requirement over time; you’ll see that there has been a push and pull between Congress and the Service over how strict are the substantiation requirements and how strict is the standard. When you go back and you see statements by Congress and we see acknowledgments by the Service, you realize that the standard is not perfection, no matter what an examiner may say to you. The standard is reasonable. What is reasonable given the nature of your business and your research, and more importantly, what is reasonable given the nature of how your books and records are kept and your costs are accounted for? I see this play out time and time again for taxpayers who use cost center accounting or departmental accounting, which is most manufacturers in America. If you’re a law firm or an engineering firm or something like that, you may do project accounting, but most companies track cost by cost center, and the Service will come in and say, “Well, OK. Identify every product, business component, or project that a cost center engaged in,” but that’s not how books and records are kept. It’s not impossible. However, it is an extremely expensive and time-consuming request. I think when you go back and dig into the history, a reasonable response is to push back politely and say, “Look, you have to tailor your requests around how our books and records are kept. That’s what Congress has advised. We use cost center accounting, so ask questions that are tailored to that.” What activities are they engaged in? What are the types of projects they are engaged in, and are the qualification percentages for a particular cost center, are they reasonable? And that’s fine. But that’s kind of how I see this area play out. As the bullet rightly says, you know, you should focus your substantiation efforts and activities on the areas that give the highest value to your credit or that would be the largest risk areas on audit. Kathleen, do you want to pick up on the likely areas of risk?

King: Thanks, Alex. Yes. On this slide here, there’s three main things that we’re trying to emphasize. Again, this is documentation for whatever project or cost you’re trying to document. Three are key points to keep in mind. First, the documentation really [must] be relevant to the tax year under review. If you’re in an industry where you have limited documentation, then obviously you’re going to have to do the best you can with the information that’s available. Interviews with subject matter experts have been time and time again by the courts deemed to be relevant and applicable forms of substantiation, which is very helpful. That’s why it’s important to make sure that the interview process is done somewhat contemporaneously with the tax year, because that would be an area that the IRS may push back on. As you’re assembling documentation, look at the tax years that are referenced on those documentation materials, and to the extent possible, make sure it’s in the tax year where the credit’s being claimed. Obviously, many projects span multiple years, and so it may be [that] documentation at the outset is particularly helpful in identifying areas of uncertainty. You may not know that some of the technical challenges are going to arise until you get further into the testing process. It’s not a one-size-fits-all, but I would try and keep that in mind. I would say that many companies, as you’re documenting your credit, either through internal resources or through external providers, get questionnaires or memos that help substantiate why the four-part test is met. In general, I would say by and large the IRS appreciates to some degree that these memos focus on the tax requirements for qualifying research and try to put the science in simpler terms. However, the reality is when the IRS looks at those memos that are prepared for the tax return, they realize that they’re somewhat self-serving because they weren’t produced as part of the research process. They were produced by the tax department with significant input from the research areas. The tax department involvement puts a little bit of a taint in their mind on it: “Am I really just hearing what you want me to hear, or is this the full information?” And that’s why I think that artifacts from the development area are a critical part of the documentation process. If you have to rely on interviews to substantiate a lot of the questions, make sure that you get some sort of sign-off from the individuals that are involved and be as precise as possible in terms of what additional documents are available.

In terms of framing the research activities, even things as simple as press releases are often good ways to find references to improvements to projects. Certainly any big change coming out, even new pieces of capital that are going into your business, are frequently found there, and so it’s a good place for you to review to make sure you’re not missing any projects. Then, obviously, patent applications are a good source as well. Documentation is particularly important for areas of risk such as the process of experimentation test—and we label these as risk areas because they are points that come up frequently during an IRS examination process. Alex touched on the Siemer Milling case earlier. There the court viewed the activities as not satisfying the methodical plan requirement. The court concluded that any available documents (including oral testimony) were merely narrating the steps of the process. And this is in contrast to the UCC case, which again when they were addressing the process of experimentation, they were looking for that methodical plan. I think those are the key words to take away in terms of a preplanned series of tests. Anything that you can find that helps demonstrate that you have a standard development method, that you have development environments, you have research labs, all of those things are very helpful in terms of trying to substantiate the process of experimentation.

In terms of the four-part test, the ones that get the most questions are the process of experimentation and technical uncertainty. We are quickly running out of time. We’ve talked a lot about supply costs. My message on this slide is the key thing, is tying why the supply costs are relevant to the four-part test. Why did you need it to prove the research? How is it used in the research process? Then more specifically, how does the supply cost fit within the process of experimentation? The other key point on this slide is making sure that, especially when you’ve got large supply costs or pilot models, that you’re differentiating that cost from a normal production item. Look at what some of the case law focused on: Is the primary purpose of the supply cost research, or was the primary purpose production? Anything you can find along those lines. Then, another common area of challenge is job titles. We do want to make sure that you’re looking for those keywords, whether it’s “quality” in the title or “VP,” those titles, under a normal IRS exam, will frequently be challenged. For your executives, one of the things I would suggest is to see if they’re listed as inventors on any recent patents. That has been a very compelling piece of evidence for executives, as well as calendars that show their clear participation in design reviews or meeting minutes. Do you want to do the next question?

Rodolph: Absolutely. That will take us to the next polling question. Which of the following is a likely area of risk during an IRS examination of [a] research credit claim: amended returns, prior year audit adjustments, internal use software, or all of the above? While everyone responds, is it possible, Kathleen—will you go ahead and dive into the next section on COVID-19?

King: Sure. There are a couple of topics we want to address on COVID-19. One area that is not directly related to the research credit is the five-year NOL [net operating loss] carryback in the CARES Act. As you’re doing the five-year NOL carryback, you might discover that these changes will impact your research credit position as well. So to the extent that you are already amending a prior year return, this might be an opportunity for you to review your original research credit position. You may know of areas that were missed when you originally filed that may warrant amending your research credit as well. It’s also a good time to assess your credit carryforwards to see if you can get some more benefit coming out of those as well. There’s an old Rev[enue] Ruling 82-49—it’s actually an old investment tax credit ruling—which provides that a credit does not have to be claimed on a tax return before it can be carried forward to an open tax year. Basically this ruling says that if you would not have been able to use a credit in a closed year, then you have the ability to amend a carryforward coming out of those years. One big caveat on amending carryforward credits is that the ASC final regulations require that you must make the ASC election on a return. It can be on an amended return, but you have to make an affirmative election. So, as long as that election is in place, this may give you some opportunity to not only benefit from the NOL carryback, but enhance your credit position as well. I also highly recommend that you consider what the impact of COVID-19 may be on your 2020 credit position. If your company is experiencing layoffs, this may impact the availability of documentation. Start thinking about how you can close any documentation gaps. In addition, you should consider whether your 2020 credit may be down due to layoffs in your engineering and technical workforce. This may play into your year-end provision calculations or your estimated tax payments. And the next slide is back to you, Alex.

Sadler: Yes, I am just going to touch on the state of affairs in Appeals and audits right now. The slide is titled “People First Initiative,” which was the initiative announced by the Service in late March, basically, except [in] high-risk situations, suspending audits from April 1 to July 15. Well, July 15 was last week, so the People First Initiative has now expired. But I think it’s safe to say that audits and Appeals are not returning back to normal, because life is not returning back to normal as the pandemic continues. There are no official statements, and very little to go by, but we have some information in dealing with Appeals officers. Appeals has a travel restriction in place through September 1, and it’s likely to be continued, and that effectively means no in-person conferences are going on at the present time. Appeals is encouraging virtual conferences where they’re suitable for the issues and the taxpayer agrees with the virtual conference. We have some experience with virtual conferences. They’re not perfect, but you can make them work. You do lose something, as you would expect, but it’s not a terrible alternative. I would say for my client you have to evaluate whether the issue is suitable. Is it a single issue, or is it multiple issues? How important is getting the issue resolved in the near future? Because if you want an in-person conference, it probably will be next year before you have one. Appeals has indicated to me at least that they are willing to postpone in-person conferences. And sometimes that’s the right call. If you have a four-day Appeals conference with ten issues, you are probably going to want to do that in person, and so they will postpone it and secure the necessary statute extension. Exams, with the People First Initiative having expired, in-person conferences are allowed now, and I know anecdotally that they have occurred, as I know Kathleen [does] as well. The rules are that all parties involved in the meeting have to wear face masks, and the agents have to put a social distancing plan in place, and it has to be signed off on by managers. On-site visits are permitted, but there are the expectations that will be done only when absolutely necessary. Agents, as you would expect, should consider alternatives such as video conferencing, apps, or putting a hold on the audit, assuming the statute allows that to happen. So, you know, these are unprecedented times, and we’re all having to adjust and work through it. These are some audit management ideas during the pandemic. I imagine that the audience has been living this and has many of its own ideas. And these are just some best practices.

Audits are happening actively, and so you need to stay vigilant. In-person conferences are not the norm right now, and it’s hard. You may consider multiple phone conferences or even two video conferences in place of one in-person meeting to make up for the lost human interactions. If you’re resource-constrained, as many businesses are, you may ask for more time. Agents, we found, are willing to build in more time to review a draft IDR before it’s issued. Continuing regular calls is always a good idea just to keep people on the same page. Especially right now, when resources are tight on both sides. It’s good to communicate and really discuss options for streamlining the audit, limiting the scope of the audit, finding the issues that really are worth the thought for both sides to spend time on. Witness interviews, in my experience, are very difficult to do virtually. Hard to prepare the witness; it’s awkward. Technology is not perfect. And so, if you can pause witness interviews for a while, I think that’s [the] best case. You can offer detailed factual presentations in lieu of interviews. We will do this to help bridge the gap in understanding to satisfy the Exam team and their need for information for the time being. If you do proceed with interviews, I would—just based on personal experience—I would build in extra time to work with the witness beforehand, practice the technology, do dry runs. Because it’s harder because you’re not there. You don’t have the human interaction. You don’t have the time to work with the witness and to kind of read their body language and take breaks and manage the interview. It puts a premium on interview preparation. Revisiting strategy for appeals and litigation, again, you just have to know your issue and know how important an in-person conference is, and things like that. None of this is going to be surprising or new information, but they’re good things to think about as you work through the current audit environment.

Rodolph: Alex, on that note it looks like we’ve progressed to the last polling question. What is the name of the IRS program launched to provide relief to taxpayers on a variety of issues during COVID-19: Your Business Matters, Happiness Is a Refund Check, People First Initiative, or Because You’re Worth It? Alex, while we let everyone have a chance to respond, would you mind touching on some high points as we are closing out the hour, which is hard to believe for me, but touching on some high points for being litigation-ready?


Sadler: Sure, and I will be brief. Obviously, no one wants to litigate their case. It’s expensive and uncertain and time-consuming and disruptive. However, sometimes you have to; sometimes you don’t have any choice. I mean, the Service may force you into it. So, you want to be prepared in that contingency. The vast majority of cases, as one would expect, do settle, but you can always sleep better if you’re prepared. The cardinal rule in every research credit case is the taxpayer bears the burden of proof. What does that mean? It means that the government can just say when you’re dealing with them, “I don’t buy it. I don’t see qualified research. You don’t get any credit.” The only way to overcome that position, and I’ve seen that position many times—it’s frankly strategically sometimes not a bad position for them to take—well, you have to kind of put up or shut up, and present your case and prove your case. “Here’s our activities, here’s our evidence, and this is why they qualify,” and that burden rests with the taxpayer. The burden is highlighted by a couple of the recent cases that we talked about. Siemer Milling shows that the taxpayer has to prove that they engage in the process of experimentation and there is the scientific method definition of a process of experimentation. I would contextualize that with a lot of regulatory guidance and language. How that plays out or what that looks like is going to vary according to the taxpayer, its business, or the nature of the research, and it doesn’t have to follow the textbook definition. But you do have to prove that you went through a methodical, systematic process of eliminating uncertainty, and that’s going to be the taxpayer’s burden. So, you need to think about that as you’re collecting documentation. Audio-Technica, again, highlights the base-year QREs, and that is a part of your element of proof. You have to be able to prove that those are the activities, those are the QREs you incurred for those years, and you didn’t perhaps incur additional QREs. There’s been a lot of case law about that, but it’s difficult; you should think about it in advance. COVID is presenting unique challenges. Employees are working from home, some people have been furloughed, priorities of companies have changed, duties have changed, documentation practices have changed. You have to think about how you are going to overcome and deal with those challenges, because in two years, in three years, when these claims are audited, the service is probably not going to be willing to give taxpayers a break.

In one minute or less, I would say you want to find the very best experts within your business to speak for the projects, and I think there’s a premium on that for this year. I think there’s just a premium on good fact-gathering and documentation this year, because it’s harder in the current challenges of the current environment. I would think about very robust write-ups—better than past years—collecting more robust documentation. I don’t think you just want to rely on past-year percentages and roll them forward, because people have changed, their responsibilities have changed. I think you should rethink your study practices and may want to consider stat sampling. You need to consider virtual techniques for conducting your audit. I would say, you know, hopefully you have an understanding with the audit team where everybody’s comfortable and there’s a lot of trust. If you feel like the claim is going to attract a lot of attention, or the claim is attracting a lot of attention, and it’s going to take a while to play out and get a resolution, you want to think about your ability to maintain the documentation. You may want to consider overriding your normal document retention and destruction practices and putting a hold order in place. Usually, when I get involved, there is a dispute on the horizon or actively going on, and one of my first pieces of advice would be you want to put a hold in place, because if you lose documentation that exists during the audit, it’s low-hanging fruit for the government and it makes your life very difficult. So, that’s a good practice. I kind of flew through those, but those are some thoughts on how to improve your chances in the case that the government challenges your claim somewhat vigorously.

Rodolph: All right. Well, Alex, Kathleen, thank you so much for sharing today. And thank you, everyone, for being with us for this TEI virtual session presented in conjunction with Mayer Brown. If you would like to explore future virtual midyear sessions, please visit TEI’s virtual education information center. That’s at tei.org/virtual. Thank you again, we appreciate you joining us.

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