Court: Business Doesn’t Have to ‘Reinvent the Wheel’ for R&D Tax Credit
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A decision issued by the U.S. Tax Court on October 1st in Eric G. Suder, et al. v. Commissioner was once again generally favorable and supportive of businesses capturing the Credit for Increasing Research Activities (aka R&D tax credit). This particular case involves credits captured between 2004-2007 by Suder’s company, Estech Systems Inc (ESI), a Subchapter S corporation that designs and develops telephone systems for small and midsize businesses.
In court, the Internal Revenue Service (IRS) argued that ESI did not attempt to solve any uncertainty related either to the capability or method to develop or improve its products or to the appropriate design of these products. The IRS also argued that ESI’s projects were based on existing know-how and on the integration of known components in a new product.
An expert witness for the IRS went as far as stating that there were no technical challenges present in ESI’s projects, that the new or improved products were the result of routine work and consisted of nothing more than simplified, low-cost versions of products already on the market. In addition, the IRS argued that ESI’s substantiation was not sufficient to support its estimated allocations to qualified research.
The Court disagreed with the IRS on all of these arguments.
4 key takeaways from Suder case
The most interesting takeaways from the Court’s Memo for the Suder case include the following explanations:
- There is no expectation that a business has to ‘reinvent the wheel’ for its research and experimentation activities to be eligible for the R&D tax credit.
- The uncertainty requirement of Section 174 Research and Experimental Expenditures may be satisfied even if the business knows that it is technically possible to achieve a goal, but is uncertain of the method or appropriate design to reach that goal.
- Consulting publicly available manuals or online references for general information does not necessarily imply that the knowledge required to develop or improve a product or to determine the appropriate design was available to the business.
- Sufficient and credible documentary and testimonial evidence can support estimated allocations of wages for qualified research activities.
The research challenge of complex systems
Another important notion discussed in the Suder case concerns research projects where multiple known components are integrated in an effort to develop a new or improved product. Just like it did in a previous case concerning ship design (Trinity Industries, Inc. v. Commissioner), the IRS argued that ESI was choosing appropriate designs by committee, like ordering off a menu, and assembling together existing, already functional components. The Court again disagreed with the IRS, finding that such argument greatly oversimplifies the process undertaken by ESI.
Like in Trinity, the Court explained that determining the appropriate configuration of a product made of multiple sub-systems could involve significant research effort.
Complex designs in which multiple systems can interact with each other in different ways present unique challenges. The performance and behavior of a sub-system can be very different when it is isolated than when it is working along with other systems. Extensive research or experimentation is often required to determine the appropriate configuration to achieve the target specifications .
The Court’s decision on this is particularly important because many manufacturing projects follow a similar process.
If you have questions about the R&D tax credit and whether your business might be eligible, check out our new Frequently Asked Questions guide, “What You Need to Know About the Research Tax Credit.”
Louis Guay is a Cost Segregation, Tax Credits & Incentives Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.
