The U.S. Tax Court recently ruled in favor of the IRS in Scott Moore and Gayla Moore v. Commissioner (T.C. Memo. 2023-20), holding that wages paid to an S Corporation’s Chief Operating Officer (COO) could not be included in computing the R&D tax credit under Section 41 because the taxpayer failed to adequately substantiate time spent on qualified research and did not engage in direct supervision or support.
The COO in the case worked for Nevco, Inc., which manufactures scoreboards for high school and college athletic events and other types of equipment for indoor and outdoor sports venues. The petitioners in the case contended that the COO spent a significant amount of time — approximately 50-65% — on new product development. The petitioners contended the COO’s contributions to product development for the tax years in question were substantial and included:
- Developing a process to design and build a new scoreboard trust
- Leading a development project for a new product that transmits scoreboard information — including defining functional parameters and assistance with the development of integral database technology, for which the COO was named as an inventor on an associated patent issued in March 2016
- Leading a development project for a new handheld device used to operate the S corporation’s scoreboards, which included collaborating with the Director of Engineering to test certain components of the device
- Designing a proposal for a new, slimmer shot clock
The COO also participated in several meetings with the Director of Engineering, who supervised the engineering department and directly reported to the COO.
The petitioners therefore contended that the COO spent significant time on new product development meeting the definition of qualified research under Section 41(b)(2)(B)(i), and engaged in direct supervision or direct support of qualified within the meaning of Section 41(b)(2)(B)(ii) and included 65% of the COO’s compensation in the computation of their 2014 and 2015 research tax credits. The IRS challenged and asserted that the petitioners did not adequately prove this percentage, noting a total lack of written records demonstrating the COO’s use of time.
Although the court acknowledged that the COO spent a significant portion of his time on product development, the court concluded that not all of the COO’s time spent on product development was qualified research. The court further concluded that that there was little record on which to base an estimate of the amount of time the COO spent directly engaging in qualified research; so, it did not allow any of the compensation to be included.
The court also held that the COO did not engage in direct support or direct supervision of qualified research. With respect to direct supervision, the court considered the COO’s job title and his role as supervisor of the Director of Engineering, concluding that the COO was a “higher-level manager” which is specifically excluded from the definition of “direct supervision” under Treas. Reg. Sec. 1.41-2(c)(2). The court also observed that the activities performed by the COO did not constitute “direct support,” citing specific examples provided in the regulations.
Ultimately, it appears that the court’s decision was based largely on inadequate documentation. The Tax Court acknowledged that the COO clearly performed qualified activities — and had the taxpayer been able to substantiate its claim, it appears that the credit would not have been denied. Thus, this opinion emphasizes the importance of properly documenting the methodology used to compute qualified research expenses and maintaining documentation to substantiate the research credit claim.
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