The R&D credit is one of the largest tax incentives available to American businesses. Following the issuance of proposed regulations on the research tax credit in 2001, taxpayers have been given little to no guidance on what constitutes adequate documentation for the credit.
U.S. v. McFerrin and Union Carbide Corp. v. Comm’r, clarify the law and the methods in which taxpayers may substantiate their research credits. In Union Carbide the Tax Court allowed the taxpayer to rely on estimates and employee testimony in substantiating its research credit. In McFerrin, in which Jeremy Fingeret served as lead counsel at the appellate level, the Fifth Circuit went further by ordering the district court to ‘‘look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate’’ of the credit.
By allowing taxpayers to use reasonable estimates based on testimony and by directing the district court to make its own estimates, the courts in McFerrin and Union Carbide refined and expounded on taxpayers’ ability to rely on testimony and estimates to substantiate their R&D credits under the law.
After several years without any substantive court guidance, the Tax Court issued its ruling in the Union Carbide lawsuit. In this case, the court discussed five of Union Carbide’s 106 research projects and the evidence available to substantiate them in detail. Throughout the case, the court rejected the IRS’s view of substantiation and instead allowed Union Carbide to use available evidence. In so doing, the court made many findings that involved the use of estimates and testimony to substantiate the research tax credits at issue. The Tax Court’s allowance of the use of estimates, in particular, will have a significant effect on taxpayers’ accounting for their research credits under the law.
A mere three months after the Tax Court’s ruling in Union Carbide, the Fifth Circuit issued its decision in the McFerrin lawsuit. The district court had previously determined that while some of the projects may have involved some research, ‘‘there were no records of the hours worked on any given project or of the hours worked or supplies used that involved research.’’
On appeal the court held that, under the law, ‘‘if a qualified expense occurred, the court should estimate the allowable tax credit.’’ Finally, the Fifth Circuit ordered the district court to ‘‘look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.’
In summary, the courts have held that taxpayers may rely on all available evidence, including contemporaneous documentation, employee testimony, and institutional knowledge, when substantiating their research tax credits. Further, taxpayers may use reasonable estimates when determining the credits to which they are entitled. This is clearly good news for taxpayers and their accounting and legal services advisers as they seek to take full advantage of the research credit.
Alliantgroup is the nation’s premier provider of specialty tax services. The company, headquartered in Houston, TX, works with alliantgroup accounting and legal services providers and their clients to ensure that they receive the full benefits of all available federal and state government sponsored tax credit and incentive programs, such as the research and development tax credit, export tax incentives, manufacturing tax incentives, federal and state hiring credits, sales and use tax refund reviews, and a dedicated tax controversy services team that assists in various legal matters, including IRS and State Tax Matters and various lawsuits. For additional information please visit www.alliantgroup.com.