Tax Court provides guidance on qualified research and reasonable compensation for R&D purposes

Man examining computer componentThe Tax Court has delivered an opinion in Suder v. Commissioner (T.C. Memo 2014-201) that provides important research and development (R&D) credit guidance regarding what constitutes “qualified research” and the type of compensation that can be included in the computation of qualified research expenses (QREs).

The court was asked to determine whether the R&D credits claimed by a telecommunications company for 76 projects were qualified research (although the parties selected only 12 projects to examine in detail during the trial) and whether the CEO’s wages represented QREs.

Determining qualified research
The IRS asserted that the activities of the 12 sample projects didn’t include qualified research because they failed the elements of the four-part test requiring a process of experimentation and the elimination of uncertainty. The IRS’s expert witness argued that the taxpayer’s products were similar to other products already on the market, and that the taxpayer was performing routine software development and engineering tasks with no element of technical uncertainty.

The court rejected the IRS expert for failing to provide a factual basis or comparison to support his position. The court instead found that the taxpayer’s expert witnesses credibly testified about projects from personal knowledge and offered a substantial amount of documentary evidence. The court accepted the detailed descriptions of the company’s product development process and the uncertainties present in each of the 12 projects.

The IRS further argued that instead of a process of experimentation, the taxpayer simply chose among design alternatives by applying engineering know-how or publicly available knowledge, or by committee. The court held that the IRS didn’t demonstrate any persuasive distinction between principles of engineering and engineering know-how. The court also declined to explain the distinction between the two, but pointed to the engineers’ wealth of technical expertise and experience in developing and testing the products. The court found that in combination with institutional knowledge and a well-documented product development process, there was a process of experimentation without requiring the taxpayer to “reinvent the wheel.”

Of the 12 projects under review, the court excluded one because it failed to meet the requirement that the research be undertaken for a qualified purpose (a purpose that relates to a new or improved function, performance, reliability or quality). The disqualified project was undertaken to change the look and feel of the user interface and was more of an aesthetic change.

Grant Thornton insights
  • The court rejected a common IRS argument that R&D is “routine” and not qualified. The R&D qualification tests don’t require the taxpayer to “reinvent the wheel.” Using existing components to create new or improved solutions can qualify for the credit.
  • In substantiating its credits, the taxpayer must have credible witnesses that have personal or close knowledge of the relevant facts and present solid, substantiating evidence.

Qualified wages
The court next looked at whether the wages of the CEO and founder of the company, Eric Suder, were reasonable and could be included in QREs. Suder eschewed traditional duties and spent most of his time brainstorming ideas for new products and ways to improve existing products. He was known among his employees as an innovative thinker and extremely hands-on with product development.

In determining the reasonableness of Suder’s wage, the court considered and weighed the “totality of the facts and circumstances when making its decision.” It first looked to Suder’s professional qualifications and work duties, and found that Suder engaged in qualified research activities as president of the company. However, the court also noted that although Suder had devoted a great amount of time and effort to the company in the early years, he was essentially semi-retired by the relevant tax years. He had decreased his time at the office from 60–80 hours a week to 20–30 hours a week.

The court then looked at the reasonableness of Mr. Suder’s wage. It called into question the fact that Mr. Suder and the other company owner were paid wages in ratios roughly proportionate to their ownership interests, which were 90% and 10%, respectively. The court noted that their wages moved up and down in tandem from year to year, which wasn’t true for other employees. Because of this, the court found that Suder’s compensation was, at least in part, unreasonable.

Suder’s wages were composed of a base salary and bonuses. The bonuses were based on factors that included the company’s growth, overall value and cash flow. But the company didn’t introduce any evidence that Suder’s wages were tied to his contribution to R&D at ESI. Moreover, his wages were significantly higher in 2004–2007 than in prior years, notwithstanding the fact that Mr. Suder wasn’t named as an inventor on any new patent applications filed during that time.

Finally, the court considered Suder’s wages relative to those of other CEOs in similar companies who performed similar services. In dicta, the court revealed that this was likely the most important factor in evaluating reasonable compensation. The IRS and the taxpayer introduced expert witness testimony to prove their case.

The court found that the IRS’s witness was not particularly credible. He wasn’t an expert on executive compensation; he relied on a valuation study in his expert report that he ultimately rejected at trial; and he failed to provide any details related to comparable CEOs apart from publicly available information.

The court found that although the taxpayer’s expert witness gave questionable testimony on certain issues, he was by and large credible regarding executive compensation. The court agreed that it was reasonable to compensate a visionary CEO like Suder at the 90th percentile for 2004–2007. The court also agreed with both experts that a reasonable compensation package for Suder should include a base salary, an annual incentive and a long-term incentive.

However, the witness categorized part of Suder’s compensation as royalties on gross revenue. The court took issue with that because royalties aren’t remuneration for services performed by an employee but are instead payments received for the right to use intangible property rights. Although the taxpayer hadn’t categorized part of Suder’s compensation as royalties, the court held the taxpayer to its witness testimony. Accordingly, it held that based on the totality of facts and circumstances, Suder’s compensation for 2004–2007 was unreasonable under section 174(e) and only a portion of Suder’s wages was eligible for inclusion as QREs.

Grant Thornton insights
  • In evaluating reasonable compensation, balance the four factors listed here and find a credible, reliable expert to assist with the analysis.
  • Even though Suder’s wages were reduced, the court still held that 75% of his time spent on qualifying R&D was a reasonable allocation. The IRS often argues that all executive employees should be excluded from the R&D tax credit computation.

Joe Stoddard
+1 801 415 1065

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