Exhibit E
Published 12-2008

Substantiation Write-Up
 Supporting a Notice of Claim Disallowance
Sample Revenue Agent Report (“RAR”)

THE FOLLOWING SAMPLE WRITE-UP SHOULD BE USED ONLY AS AN AID IN DRAFTING AN RAR FOR DISALLOWING A RESEARCH CREDIT CLAIM FOR REFUND. 

Issue

Whether Taxpayer is entitled to claimed credit in the amount of $X for Year 1 for increasing its research activities under I.R.C. §41?
 
Conclusion

Taxpayer is not entitled to any research credit for Year 1 because Taxpayer has failed to provide sufficient substantiation to support the amount of its claimed credit.  Taxpayer has failed to meet its burden in proving that it has met the expenditures requirement under I.R.C. §41(b) and the technical activities requirement under I.R.C. §41(d).  Further, Taxpayer has failed to show that it has correctly computed its base amount pursuant to I.R.C. §41(c). 

Facts

THE FOLLOWING HYPOTHETICAL FACT SECTION IS ONLY AN EXAMPLE OF A FACT PATTERN.   AN ACTUAL RAR SHOULD INCLUDE ONLY THE FACT PATTERN APPROPRIATE TO THE ACTUAL CASE UNDER EXAMINATION.
 
Taxpayer is in the business of manufacturing widgets in facilities in the United States and worldwide.   Sales in Year 1 were $Y. Taxpayer had over aa number of employees in Year 1. 

Over the last 10 years, Taxpayer made many corporate and trade or business acquisitions.

Taxpayer filed a research credit refund claim (Form 1120X) with the Ogden Service Center in the fall of 2007, for Year 1.  The research credit claimed was in the amount of $X.  Prior to this refund claim, Taxpayer had never previously claimed the research credit.
 
Pursuant to I.R.C. §280C(c), Taxpayer reduced its deductible research expenditures in arriving at taxable income in the amount of the research credit claimed.
Taxpayer engaged Company to prepare its refund claim, supporting studies and project descriptions.

Claimed Qualifying Research Expenses (“QREs”)

Taxpayer claimed in-house research wages for bb number of employees in the total amount of $Z.  Taxpayer did not claim any QREs for supplies or contract research.

Taxpayer asserts that most of the activities performed by its employees were paid for by client fees. 

Because Taxpayer does not have contemporaneous documentation that allocates an employee’s time to qualifying activities, Taxpayer used an estimation process to allocate the employee’s time.

The allocation process was carried out in a series of meetings at various Taxpayer locations.  Each meeting involved senior technical people working at the location, a senior individual from the Taxpayer’s overall management, and a representative from Company.   The group then allocated the time of all personnel working at the location between qualifying and non-qualifying research activity.

The allocations were made for each individual’s entire year’s wages as opposed to allocation of time to specific projects.  There was no allocation of an employee’s time to projects which allegedly resulted in alleged research activity.  There was no allocation of time to new or improved business components.  The resulting estimated percentages of alleged qualifying time, together with employee W-2 records, formed the basis for the calculation of QREs for that location.

QRE allocations were made based solely on the allocation team’s cumulative best recollection.  No supporting records were used in the estimation process.  Employee interviews or questionnaires were not used in estimating an employee’s qualified services.  The estimated allocation was made more than five years after the alleged employees’ qualified services took place. 

The preparation of the claim can best be described as the recollection of managers and senior staff estimating the percentage of employee wages that were QREs.  Every current year employee with QREs had a percentage estimate of wages that were QREs based on either the recollection process or extrapolation of the same percentage to employees perceived to perform similar activities based on similar positions, titles or other factors. 

Claimed Qualified Research Activity

Reports for a small percentage of the projects performed by Taxpayer during Year 1 were prepared which Taxpayer claims demonstrate that it was involved in research activities for the year at issue.  The reports were prepared solely for the purpose of filing the subject research credit claim.  Because Taxpayer did not maintain contemporaneous research records, the reports were prepared from oral testimony and the best recollection of managers and were written many years after the claimed research activity took place. 

A reading of the project reports reveals routine application of engineering principles and routine data gathering and studies.  Qualified research is not readily apparent from the reports prepared for Taxpayer’s claim.
 
Selection of the projects, for which reports were prepared, was based upon a non-statistical judgment sample of projects that Taxpayer viewed as representative.  Taxpayer did not provide the basis for its assertion that the selected sample projects were “representative” in nature.
 
The project reports did not identify employees that may have worked on alleged qualifying activities.  While project activities were claimed on a project basis, actual project costs were not available for claimed QRE projects.

Base Period

The fixed base percentage was determined by Taxpayer to be y%.

The methodology used to estimate the QREs for the base period (1984 thru 1988) was basically the same estimation methodology used to estimate the current year QREs.

The allocation of employee time in support of the base period QRE activities was premised solely upon the recollection of a very small number of employees regarding alleged research activity that took place over 20 years ago.  Very few employees were said to have knowledge of the base years.

Based on recollection, employee time was allocated to alleged research activity for the base period.   The allocation was done for only some employees and the result was extrapolated to the remaining employees.  A large percentage of the salaries in the base period received research activity allocation pursuant to extrapolation.

Documentation of QRE payroll costs and the estimated allocation percentage of gross wages for each employee were only provided for 1985. 

As in the current period, Taxpayer provided a description for only a small number of projects performed by Taxpayer during the base period.  The other projects that were claimed for QRE were not identified.  Project costs were not identified.  The selected project descriptions were said to be representative of the research activity performed during the base period.   Like the project descriptions presented for the current year research expenditures, the project activity descriptions were prepared from oral testimony and best recollection for the sole purpose of the research credit claim submission.
 
Contemporaneous data for QRE activities was not provided.

Review of the selected project descriptions shows that qualified research activities are not readily apparent.  The project titles and examination of the project descriptions connote only routine engineering.

Like the methodology used for current year QREs, Taxpayer has not provided any supporting records or documentation linking an employee’s estimated QRE costs to any qualified activities.

Further, Taxpayer has not accounted for the impact of corporate acquisitions and dispositions on base amount computations both in regard to determining the fixed base percentage and computing the four prior years average annual gross receipts.

Finally, Taxpayer has failed to provide substantiation that it has met the consistency requirements between the current year and the base years. 

Law

THE REVENUE AGENT SHOULD TAILOR APPLICABLE LEGAL ARGUMENTS TO THE FACTS OF THE CASE

General

Section 41 allows taxpayers a credit against tax for increasing research activities. Generally, the credit is an incremental credit equal to the sum of 20 percent of the excess (if any) of the taxpayer's "qualified research expenses" for the taxable year over the base amount, and 20 percent of the taxpayer's basic research payments.

Section 41(b)(1) provides that the term "qualified research expenses" means the sum of the following amounts which are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer: (A) in-house research expenses; and (B) contract research expenses.

Section 41(b)(2) provides, in relevant part, that in-house research expenses include any wages paid or incurred to an employee for "qualified services" performed by such employee, and any amount paid or incurred for supplies used in the conduct of qualified research.

Section 41(b)(2)(B) provides that qualified services means, for purposes of both in-house and contract expenses, (i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.

Treas. Reg. §1.41-2(c)(1) provides that engaging in qualified research for purposes of performing qualified services means the actual conduct of qualified research (as in the case of a scientist conducting laboratory experiments).

Treas. Reg. §1.41-2(c)(2) provides that direct supervision for purposes of performing qualified services means the immediate supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.

Treas. Reg. §1.41-2(c)(3) provides that direct support for purposes of performing qualified services means services in the direct support of either (i) persons engaging in actual conduct of qualified research, or (ii) persons who are directly supervising persons engaging in the actual conduct of qualified research.

Under Treas. Reg. §1.41-2(c)(3)(ii), however, direct support of research activities does not include general administrative services, or other services only indirectly of benefit to research activities.

Section 41(d)(1) defines the term "qualified research" as research,

(A) with respect to which expenditures may be treated as expenses under section 174,

(B) which is undertaken for the purpose of discovering information—

 (i) which is technological in nature, and
(ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and

(C) substantially all of the activities of which constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality, and not for a purpose related to style, taste, cosmetic, or seasonal design factors.

Qualified research does not include any activity described in section 41(d)(4), which includes:

(A) research after commercial production;
(B) adaptation of an existing business component;
(C) duplication of an existing business component;
(D) foreign research;
(E) funded research; and
(F) other exceptions.

Regarding funded research, the general rule is that a taxpayer is required to allocate 100% of its funding to otherwise qualified research unless the taxpayer can meet the pro-rata allocation requirements.  In no event, however, shall less than 65% of the funding be applied against the otherwise qualified research expenses.  The funding provisions are applied separately to each research project undertaken by the taxpayer.  See Treas. Reg. §1.41-4A(d)(3).

The business component is defined as any product, process, computer software, technique, formula, or invention held for sale, lease or license, or used by the taxpayer in its trade or business.  I.R.C. §41(d)(2)(B).

The base amount is computed by multiplying the taxpayer's fixed-base percentage by its average annual gross receipts for the four taxable years preceding the taxable year for which the credit is being determined.  I.R.C. §41(c)(1).  A taxpayer's fixed-base percentage is the percentage that the aggregate qualified research expenses of the taxpayer for taxable years beginning after December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.  I.R.C. §41(c)(3)(A).  Section 41(c)(2) provides that in no event shall the base amount be less than 50 percent of the qualified research expenses for the credit year.

Section 41(f)(1)(A)(i) provides that in determining the amount of the credit under section 41 all members of the same controlled group of corporations shall be treated as a single taxpayer.

Special rules apply if a taxpayer acquires or disposes of a major portion of a trade or business or major portion of a separate unit of a trade or business.  §41(f)(3)(A); §41(f)(3)(B).  The taxpayer's qualified research expenses paid or incurred during periods before the trade or business acquisition are increased by the expenses paid or incurred by the predecessor for any taxable year ending after the acquisition.  The qualified research expenses paid or incurred by the taxpayer during periods before the trade or business disposition are decreased by the expenses attributable to the disposed trade or business for any taxable year ending after such disposition, provided the taxpayer furnished the acquiring person such information as is necessary for the application of §41(f)(3)(A).

Similarly, the gross receipts of the taxpayer for periods before the acquisition or disposition are increased by the predecessor's or decreased by the taxpayer’s gross receipts attributable to the trade or business, or portion thereof, acquired or disposed of by the taxpayer (provided, in the case of a disposition, the taxpayer furnished the acquiring person such information as is necessary for the application of §41(f)(3)(A)).

Substantiation

Tax Credits Generally

Tax credits are allowed as a matter of legislative grace.  New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Stinson Estate v. United States, 214 F.3d 846, 848 (7th Cir. 2000); Hauptli v. Commissioner, 951 F.2d 1193, 1195 (10th Cir. 1991); Schumacher v. United States, 931 F.2d 650, 652 (10th Cir. 1991); Schiff v. United States, 942 F.2d 348, 352 (6th Cir. 1991).  They are allowed only as clearly provided for by statute, and the statute granting the credit should be narrowly construed.  Helvering v. Northwest Steel Rolling Mills, Inc., 311 U.S. 46, 49 (1940); New Colonial Ice, 292 U.S. at 440; Inland Steel Co. v. United States, 677 F.2d 72, 79 (Ct. Cl. 1982).  The taxpayer claiming the credit must clearly establish full satisfaction of all of the statutory requirements.  New Colonial Ice, 292 U.S. at 440; United Stationers, Inc. v. United States, 163 F.3d 440, 443 (7th Cir. 1998), cert. denied, 527 U.S. 1023 (1999) (taxpayer bears the burden of showing entitlement to the [research] credit); 330 West Hubbard Restaurant Corp. v. United States, 203 F.3d 990, 997 (7th Cir. 2000) (“The taxpayer bears the burden of showing its entitlement to a tax credit.”); Hauptli, 951 F.2d at 1195 (“It is a long established tenet of tax law that tax credits are matters of legislative grace, and the burden is on taxpayers to demonstrate clearly that they are entitled to the credit.”); Schumacher, 931 F.2d at 652 (“The general rule in tax law is that tax credits are matters of legislative grace, and taxpayers bear the burden of clearly showing that they are entitled to them.”).

I.R.C. § 6001 Record-Keeping Requirements in General

Section 6001 of the Code provides, in pertinent part, that

Every person liable for any tax imposed by this title, or for the
collection thereof, shall keep such records, render such statements,
make such returns, and comply with such rules and regulations as
the Secretary may from time to time prescribe. Whenever in the judgment of the Secretary it is necessary, he may require any person, by notice served upon such person or by regulations, to make such returns, render such statements, or keep such records, as the Secretary deems sufficient to show whether or not such person is liable for tax under this title.

Treasury Regulations § 1.6001-1(a) provides, in pertinent part, that

any person subject to tax under subtitle A of the Code . . ., or any
person required to file a return of information with respect to
income, shall keep such permanent books of account or records . . .
as are sufficient to establish the amount of . . . credits, or other
matters required to be shown by such person in any return of such
tax or information.

Regulations § 1.6001-1(e) provides, in pertinent part, that

The books or records required by this section shall be kept at all
times available for inspection by authorized internal revenue
officers or employees, and shall be retained so long as the contents
thereof may become material in the administration of any internal
revenue law.

As shown above, the Code and Treasury Regulations impose a broad record-keeping responsibility on all taxpayers, requiring them to maintain adequate records to allow the collection of tax.  The Code also gives the Service authority to require whatever records it deems necessary.  I.R.C. § 6001.

Under the Regulations, taxpayers are required to keep such books or records as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by that person in any return of such tax or information. Treas. Reg. §1.6001-1(a).  The books or records must be kept at all times available for inspection by authorized internal revenue officers or employees, and shall be retained so long as the contents thereof may become material in the administration of any internal revenue law.  Treas. Reg. §1.6001-1(e).

To be entitled to income tax deductions or credits, taxpayers are required to substantiate such items by maintaining records necessary to establish both taxpayers’ entitlement to such items and the proper amount of such items; taxpayers’ self-serving declarations are no substitute for records the law requires. I.R.C. § 6001; Treas. Reg. § 1.6001-1(a); Nguyen v. Commissioner, T.C. Memo 2003-313.

Record-Keeping Rules: Research Credit

It is not enough to engage in qualified research activities to be entitled to the research credit.  Taxpayers claiming the credit must maintain sufficient records detailing and substantiating the expenditures claimed as eligible for the credit. See I.R.C. § 6001; Treas. Reg.  §§ 1.6001-1, 1.41-4(d); Nguyen v. Comm'r, T.C. Memo 2003-313; Boyd v. Comm'r, T.C. Memo 2003-286; Arnold v. Comm'r, T.C. Memo 2003-259 (citing New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934) and Lychuk v. Comm'r, 116 T.C. 374, 384 (2001)). This requirement is consistent with the requirement that every taxpayer must maintain accounting records which enable him to file a correct tax return and permit verification of reported tax liability and/or credit.  See Webb v. Comm'r, 394 F.2d 366, 371 (5th Cir. 1968); Gibson v. United States, 360 F.2d 457, 461 (5th Cir. 1966).

There are specific statutory requirements, as far as recordkeeping, that a taxpayer claiming the research credit must comply with. The Regulations make it clear that the general recordkeeping rules under I.R.C. § 6001 are applicable and that the records a taxpayer must maintain to prove entitlement to the credit must provide sufficient detail about required documentation.  Treasury Regulation §1.41-4(d) reads in part as follows:

A taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.  For the rules governing record retention, see § 1.6001-1. 

Qualified research must be research with respect to which expenditures may be treated as expenses under I.R.C. §174.  I.R.C. §41(d)(1)(A).  Records of taxpayers claiming deductions for research or experimental expenditures must be maintained in sufficient detail to permit verification of the total of the amount of such expenditures deducted upon examination of their returns.  Rev. Rul. 58-356, 1958-2 C.B. 104.  See also §§ 1.174-3(b)(3)(v) and 1.174-4(b)(1)(vi) of the regulations which indicate the accounting segregation which taxpayers are required to make on their books and records with respect to research or experimental expenditures treated in accordance with the provisions of section 174 of the Code.

Treasury and the IRS agree that taxpayers are to be provided reasonable flexibility in the manner in which they substantiate their research credits. “Reasonable flexibility,” however, does not relieve the taxpayer of the burden of keeping a record of their research. 

Burden of Proof

Taxpayers bear the burden of proving the extent of any expense incurred in research and experimentation activities under I.R.C. §41 or §174. United Stationers, Inc. v. United States., 982 F. Supp. 1279 (N.D. Ill, 1997), aff’d., 163 F.3d 440 (7th Cir. 1998) ; Coors Porcelain Co. v. Commissioner, 52 T.C. 682 (1969); Koons v. Commissioner, 35 T.C. 1092, 1101-1102 (1961) (taxpayer failed to establish allocable portion of qualifying expenses under I.R.C. § 174); Kollsman Instrument Corp. v. Commissioner, T.C. Memo 1986-66 (taxpayer failed to satisfy burden under I.R.C. § 174); Allen v. Commissioner, T.C. Memo 1988-166 (mere presentation of cancelled checks separated into categories of patent attorney expenses and costs of components for a geothermal pump was insufficient); Grindle v. Commissioner, T.C. Memo 1993-297 (taxpayer produced no records substantiating nature of claimed expenditures with respect to neon-lighting system and other identified inventions under I.R.C. § 174); Johnson v. Commissioner, T.C. Memo 1993-564 , aff’d in unpublished opinion, 50 F.3d 2 (2d Cir. 1995) (taxpayer’s uncorroborated testimony related to development of computer software program to display nutritional analysis of grocery products failed substantiation requirements).  

Burden of Proof: Tax Refund Actions

In a tax refund case, there is a strong presumption of the correctness of the findings of the Commissioner of Internal Revenue. Boddie-Noell Enterprises, Inc. v. United States, 36 Fed. Cl. 722, 737 (1996) (citing Lima Surgical Assocs., Inc. v. United States, 944 F.2d 885, 888 (Fed.Cir.1991). The taxpayer not only has the burden of rebutting that presumption, but also of establishing entitlement to the specific amount of the deduction claimed.   Boddie at 737 (citing United States v. Janis, 428 U.S. 433, 440-441, 96 S.Ct. 3021, 3025-26, 49 L.Ed.2d 1046 (1976);   Helvering v. Taylor, 293 U.S. 507, 514, 55 S.Ct. 287, 290, 79 L.Ed. 623 (1935);   Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933);   Danville Plywood Corp. v. United States, 899 F.2d 3, 7-8 (Fed.Cir.1990);   Barenholtz v. United States, 784 F.2d 375, 381 (Fed.Cir.1986);   Young & Rubicam, Inc. v. United States, 187 Ct.Cl. 635, 654-55, 410 F.2d 1233, 1244-45 (1969);   L.W. Hardy Co. v. United States, 1 Cl.Ct. 465, 470 (1982)).  In order to overcome the presumption, the taxpayer has the burden of presenting “substantial evidence as to the wrongfulness of the Commissioner's determination.”    Boddie at 737 (citing KFOX, Inc. v. United States, 206 Ct.Cl. 143, 151-152, 510 F.2d 1365, 1369 (1975);   Arrington v. United States, 34 Fed.Cl. 144, 147 (1995)).

The taxpayer’s burden of proof in a tax refund suit in the District Court has been said to be greater than the burden of proof on the taxpayer in a Tax Court proceeding protesting a deficiency proposed by the Service.  Commissioner v. R.J. Reynolds Tobacco Co., 260 F.2d 9, 14 (4th Cir. 1958). 

According to Research, Inc. v. United States, 76 A.F.T.R. 2d 95-5688, 95-2 USTC ¶ 50,407 (D. Minn. 1995):

In a tax refund suit, the burden is upon the claimant to show that the Government has money which belongs to the taxpayer. United States v. Pfister, 205 F.2d 538, 542 (8th Cir. 1953), quoting Lewis v. Reynolds, 284 U.S. 281, 283 (1932). In order to prevail in this matter, the taxpayer must show that the IRS was wrong in its initial determination and that facts exist from which a proper determination of liability can be made. Roybark v. United States, 104 F. Supp. 759, 762, aff’d 218 F.2d 164 (9th Cir. 1954).

Under the traditional evidence rules, in the Tax Court the taxpayer has the burden of overcoming the presumption that the Service’s calculation of the amount of deficiency is correct. United States v. Lease, 346 F.2d 696 (2d Cir. 1965).

In the District Court this presumption of correctness has to be overcome by evidence of a more substantial nature.  Dairy Home Co. v. United States, 180 F. Supp. 92 (D. Minn. 1960).  In addition to showing the Service’s action to be administratively or procedurally improper, the taxpayer must also prove the correct amount of the refund.  Blansett v. United States, 181 F. Supp. 637 (D.C.Mo. 1960).

Estimation

As previously stated, pursuant to the Code and Regulations, any person subject to tax or required to file an income tax return must keep sufficient records to establish the credits claimed.  I.R.C. §6001; Treas. Reg. §§1.41-4(d); 1.6001-1(a)&(e).

When a taxpayer fails to maintain adequate records, the court may sometimes estimate the allowable credit.  Estimation is only allowed when it is clear that qualifying expenses were actually incurred in the relevant tax year and then only if there is sufficient credible evidence to provide a basis for making an estimate.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir.1930); Tyson Foods, Inc. v. Commissioner, T.C. Memo 2007-188; Mendes v. Comm'r, 121 T.C. 308, 316, (2003); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).

Approximations under the Cohan rule necessarily bear heavily upon taxpayers whose inexactitude in failing to keep records created the problem. See Cohan v. Commissioner, 39 F.2d at 544. Tyson Foods, Inc. v. Commissioner, T.C. Memo 2007-188.

One tax treatise maintains that the record keeping habits of taxpayers have changed since the years at issue in Cohan, 1921 and 1922, and that a case can be made for refusing to apply the Cohan rule “to areas in which documentary evidence is customarily requested and retained by the average taxpayer, unless its absence is satisfactorily explained (e.g., destruction by casualty).”Bittker & Lokken, Fed. Tax'n Income, Est.& Gifts ¶ 20.1.9 (2008)(emphasis added).

The current vitality of the Cohan rule in the immediate context is open to question . . .  The present trend, while not to repudiate the Cohan rule entirely, is to not invoke it where the claimed but unsubstantiated deductions are of a sort for which the taxpayer could have and should have maintained the necessary records. 

Lerch v. Commissioner, 877 F. 2d 624, 628 (7th Cir. 1989), aff'g T.C. Memo. 1987-295.

In Tyson Foods, Inc. and Subsidiaries v. Commissioner, T.C. Memo 2007-188, the Tax Court held that the taxpayer was not entitled to depreciate, upon application of the Cohan rule, expenditures for which complete and correct records were not maintained.  The taxpayer did not provide a sufficient evidentiary foundation on which to make an estimate or support its underlying theory that expenses went to moving and installing purchased business equipment.

Notably, taxpayer offered no invoices, relying instead only on a witnesses speculation and a list of vendors and amounts paid. The list of expenditures on which the taxpayer relied was for the entire calendar year and could not be allocated to the fiscal years before the Court.

While the taxpayer repeatedly referred to the list of vendors as a “contemporaneous record,” the court found the list to be contemporaneous only with respect to the recording of amounts that went into a specified bookkeeping account.  The list was “not contemporaneous in the sense that invoices, purchase orders, or journal entry explanations reflect the nature of the items purchased.”

The Commissioner emphasized taxpayer's status in the industry and its employment of in-house and outside accountants and tax preparers “who were well aware of the record keeping requirements of the Internal Revenue Code.”  During the years in issue, the taxpayer was the world's largest fully integrated producer, processor, and marketer of poultry-based food products.

Another notable case is Boddie-Noell Enterprises, Inc. v. United States, 36 Fed. Cl. 722, 737 (1996).  In Boddie, the taxpayer brought an action for an income tax refund, challenging the decision of the Internal Revenue Service denying investment tax credits for various items installed at taxpayer's fast-food restaurants. One of the court’s reasons for denying the taxpayer’s claim was that the methodology employed to substantiate 12-year-old expenditures was inadequate.
 
Some of the alleged expenditures claimed for the credit were derived from studies performed by the taxpayer's expert in 1990, by estimating costs incurred during the years at issue (1978 and 1979) of specific assets based on available documentation and from the taxpayer's extrapolation of the results of its expert's studies to the remaining unstudied units.

The court found testimony based on documents which allegedly once existed, but which were subsequently destroyed, was insufficient to establish the taxpayer’s claim.   Similarly, summary appraisals based on non-contemporaneous records, or data reconstructed from accidentally lost or destroyed documents, are unpersuasive when the value of the property cannot be reliably ascertained  Nor could taxpayer's estimate assumptions, based on guesses without supporting records, form the basis for acknowledgement of a claim.

The court held that the consequences of a lack of contemporaneous evidence on material elements of taxpayer’s claims for tax credit was that the taxpayer's claims should be rejected. The evidence adduced by the taxpayer, by means of the estimates generated by the study, was far too unreliable. The results of the study appeared to be based primarily on after the fact speculations by the preparers of the study.

Although Boddie-Noell relates to an investment tax credit case, the courts findings relating to substantiation and documentation holds true in analyzing a taxpayer’s substantiation for a research credit refund claim.

The Tax Court has considered whether a taxpayer's method of estimating research expenses was "reasonable" in two cases.  Eustace v. Commissioner, T.C. Memo. 2001-66, aff’d, 312 F.3d 905 (7th Cir. 2002), cert. denied, 539 U.S. 903 (2003); Fudim v. Commissioner, T.C. Memo. 1994-235.  The United States District Court also considered whether a taxpayer's method of estimating research expenses was "reasonable" in an unpublished opinion.  See United States v. McFerrin, Civil Action No. H-05-3730, Slip Copy, 2008 WL 2736596  (S.D. Tex. May 12, 2008).  

In Eustace, the petitioner did not claim any research credit on its original returns. After the years in question, petitioner hired a new tax manager, who determined that petitioner should claim research credits relating to the years in issue. The tax manager interviewed employees and delineated the employees and activities that he believed qualified for the research credit. Petitioner then submitted amended returns, relating to the 3 years in issue, to claim the respective research credit "that was erroneously omitted from the original filing of the Form 1120S."

In its opinion, the court noted “at the outset that petitioners' reconstruction of qualifying expenses was unreliable, inaccurate, incomplete, and wholly insufficient to establish what various workers did and whether such expenses qualify for the research credit.”  Eustace, 81 TCM (CCH) 1370, 1373.  Accordingly, and as the petitioner could not tie expenses to specific activities at the subcomponent level for purposes of a shrink-back analysis, the court refused to allow the use of estimation.  Eustace, 81 TCM (CCH) at 1374 (citing Cohan).

In United States v. McFerrin, the United States District Court found the taxpayer’s research credit study was “fundamentally flawed,” “unreliable” and “entitled to no weight.”  United States v. McFerrin, Civil Action No. H-05-3730, Slip Copy, 2008 WL 2736596  (S.D. Tex. May 12, 2008).  
 
Arthur McFerrin was the sole shareholder of four subchapter S corporations.  The general business of the S corporations was to manufacture chemical products, provide bulk storage of chemicals, and purified commodity chemicals.  Most of the chemicals produced had previously been produced in commercial quantities by the S corporations, their customers, or other third parties.  For the most part, the customer provided detailed specifications for the chemical, which the S corporations followed precisely or with minor adaptations.  Most of the “testing” involved checking the product to make sure it was within the parameters established by the customer.  If the product was not within those established parameters, company employees would “tweak” the chemical product to bring it into compliance.   A large part of the work of the S corporations was quality control in connection with established products rather than experimentation or research into genuinely novel areas. 

One of the S corporations contracted with alliantgroup, L.P. (“alliantgroup”) to conduct a research and development tax credit study covering the years 1999 through 2002.  The results of this study formed the basis of the research tax credits claimed by the McFerrins and their companies on amended returns for the subject years.  The research credit was not claimed on any original returns. 

The IRS issued a refund check to the McFerrins in the amount of $601,228.40, which represented the refund they claimed for 1999 in the amount of $472,092.00, plus interest in the amount of $129,136.40.  The United States filed the subject lawsuit seeking to recover the refund amount of $601,228.40, plus interest.

To prevail in an action to recover an erroneous refund, the United States has the burden to prove by a preponderance of the evidence that, among other elements, the taxpayers were not entitled to the refund which the government seeks to recover.  The District Court found that the United States demonstrated by a preponderance of evidence that the McFerrins failed to maintain and produce records or other evidence that supported and substantiated the claimed research tax credit.  The United States, had shown, therefore, that the McFerrins were not entitled to the tax credit or the resulting refund. 

Some of the facts upon which the court based its conclusion were that the results of the alliantgroup study was a report purporting to identify research projects that allegedly constituted qualified research by the companies during the four years covered by the study. The report included the alleged percentage of time that designated personnel spent during each year on “research,” but the report included no reliable basis for those percentages.  

Except in isolated instances, the report did not identify:

a. in which year or years, of the four years examined, the alleged research projects occurred;

b. which of the three entities were involved with the projects;

c. which individual employees were involved with which project; or
 
d. what supply expenses were associated with which projects.

The report simply stated summarily that each of several designated employees spent identical percentages of their time engaged in “qualified research” during each of the years involved in the study. 

Each entity’s qualifying wages were determined by multiplying the designated employee’s estimated percentage of time spent on supposed qualifying projects by his W-2 wages for the year.  The report then totaled the employees’ thus determined wage amounts.

There was no evidence that alliantgroup had engineers, chemists, or anyone with meaningful scientific experience or training on staff.

The court found that the alliantgroup report was based on inadequate investigation and limited information and, as a result, had no probative value.
 
The court found that the United States had demonstrated by a preponderance of the evidence that the McFerrins failed to maintain and produce records or other evidence that supported and substantiated the claimed research tax credit.  It was clear that the taxpayers had no records showing how many hours each employee worked on any given project during 1999 or any other year.  Nor were there records of how many hours any employee’s work involved activities that might have constituted research, let alone qualified research.  There were also no records showing what supplies were used during 1999 in activities that might constitute research.

The McFerrin Court stated that while

it was not Congress's intent that the recordkeeping requirements for the research tax credit be overly burdensome for the taxpayer. It does not follow, however, that no meaningful recordkeeping is required. A taxpayer cannot . . . substantiate its entitlement to . . .  the amount of a research tax credit based largely on speculation and guesswork about workers' activities between four and ten years earlier.

McFerrin, Slip Copy, 2008 WL 2736596 at n8.

The United States had shown, therefore, that taxpayers were not entitled to the tax credit or the resulting refund.

In Fudim v. Commissioner, T.C. Memo. 1994-235, there was no doubt that the taxpayer's family business engaged in qualified research.  This business was a proprietorship lead by Mr. Fudim, who was a highly qualified scientist whose inventions earned him a national reputation.  Mr. Fudim also employed his wife and daughter.  He claimed that he had contemporaneous records identifying the type of work performed by his family for the business, but destroyed them after receiving a "no change" letter from the Service for the tax years at issue.  After the Service decided to reopen the case, Mr. Fudim was forced to rely on his testimony and written summaries of the time he, his wife, and their daughter spent on research. 

Mr. Fudim described in great detail the work he performed.  He established that he was a famous scientist, who had developed many highly innovative products and processes through his business.  Accordingly, there was no doubt that he spent more than 80 percent of his time engaged in qualified services; thus, all of his wages were considered qualified research expenses.  I.R.C. ' 41(b)(2)(B); Treas. Reg. ' 1.41-2(d)(2).

With respect to his wife, the taxpayer submitted evidence of her qualifications as a mechanical engineer and computer programmer.  He also explained what types of activities she performed to support the research (designing, drafting, and performing experiments).  He testified that these activities occurred during May through December of 1987.  Based on this evidence, the court determined that Mrs. Fudim spent at least 80 percent of her time engaged in qualified services during that year.

Although the taxpayer testified that his daughter worked 80.33, 69.81, and 80.00 percent of her time in 1986, 1987, and 1988, respectively, on research and development, the court refused to include any of her wages in the credit computation.   The record did not reveal her age, training, or level of expertise and the taxpayer did not present any evidence as to what specific services she rendered to support the research effort.  There was simply no "credible evidentiary basis" from which the court could estimate the percentage of time she spent on qualified research activities.

Consistency Requirement

Internal Revenue Code §41(c)(6)(A) provides that the QREs taken into account in computing the fixed base percentage must be determined on a basis which is consistent with the determination of qualified research expenses for the credit year, regardless of whether the period for filing a claim for credit or refund has expired for any taxable year that is taken into account in determining the fixed base percentage.  To satisfy this consistency requirement, the taxpayer must show consistency between the QREs in the credit year and its QREs during the base years.

Adjustments must be made to prevent distortions in a taxpayer's qualified research expenses or gross receipts caused by a change in accounting methods used by the taxpayer between the current year and a year taken into account in computing the fixed-base percentage.  I.R.C.  § 41(c)(6)(B).

The consistency rule is designed to insure that there is an accurate determination of the relative increase in qualified research expenses over the amount “typically” spent by the taxpayer relative to its gross receipts.  The increase will be accurately measured only if the taxpayer includes the same type of expenses in the credit computation for both the base years and the credit year.  This rule would apply where the taxpayer has failed to include a particular type of expense in both the base years and credit year computations, thus distorting the true increase in qualified research expenses.

For example, in a case decided under the prior "rolling base period" rules (but equally applicable under the statutory consistency requirement), Research, Inc. v. United States, 76 A.F.T.R. 2d 95-5688, 95-2 USTC ¶ 50,407 (D. Minn. 1995), the taxpayer was denied the research credit because it could not quantify the base period research expenses attributable to its "special system projects."  The expenses associated with these special projects were included in the credit year and the taxpayer admitted that it incurred the same type of expenses in the base period.  The taxpayer could not, however, determine the amount it incurred in the base period because it had destroyed the relevant documentation.  The court disallowed the credit because the relative increase in qualified research expenses could not be measured without considering the expenses incurred during the base period for the same type of projects included in the credit year.

While Research, Inc. applies the repealed law for the three year rolling average base period under former section 30(c), its rationale still applies to the current base period rules under section 41(c) which require an increase in QREs in the determination year over the base amount.

To ensure consistency the taxpayer also has to take into account acquisitions and dispositions of trades or business. 

Analysis

THE REVENUE AGENT SHOULD TAILOR APPLICABLE LEGAL ARGUMENTS TO THE FACTS OF THE CASE

Taxpayer’s reconstruction of claimed QREs is unreliable, inaccurate, incomplete, and wholly insufficient to establish that its claimed research expenditures qualify for the research credit.

As shown in the “Law” section above there are various component requirements that must be met in order to claim the research credit.  There is an accounting component in the form of expenditures under I.R.C. § 41(b) and a technical component in the form of activities under I.R.C. § 41(d).  The existence of excluded activities listed under I.R.C. §41(d) (4) must also be verified.  There is a computational component involving the base amount under I.R.C. § 41(c) as well as the effect of acquisitions and dispositions under I.R.C. § 41(f). 

Taxpayer has not substantiated that it has met any of the requirements for the above listed components.  As discussed above, the consequences of a lack of contemporaneous evidence on material elements of a claim for tax credit is that the claim should be rejected.

The Code imposes a broad record-keeping responsibility on all taxpayers, requiring them to maintain adequate records to allow the collection of tax.  I.R.C. §6001.  The Treasury Regulations make it clear that the general recordkeeping rules under I.R.C. § 6001 are applicable and that a taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.  Treas. Reg. §1.41-4(d).   

It is not enough to engage in qualified research activities to be entitled to the research credit.  Taxpayers claiming the credit must maintain sufficient records detailing and substantiating the expenditures claimed as eligible for the credit.  This requirement is consistent with the requirement that every taxpayer must maintain accounting records which enable him to file a correct tax return and permit verification of reported tax liability and/or credit.   

Taxpayer has maintained no contemporaneous records regarding the credit.  As discussed below, the consequence of failing to keep sufficient records is fatal to Taxpayer’s refund claim.  

Credit Year Expenditures

Taxpayer estimated the total amount of its claimed in-house research wages for all of its claimed employees because it did not have contemporaneous documentation. 

While courts have allowed the use of an estimation method where a taxpayer does not have contemporaneous records, Taxpayer fails both conditions for allowance of its estimation methodology.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930); Fudim v. Commissioner, T.C. Memo. 1994-235.

First, Taxpayer has failed to establish that it engaged in qualified research activities as defined in section 41(d).  Compliance’s reading of Taxpayer’s project reports reveals routine application of engineering principles and routine data gathering and studies.  Qualified research activity was not readily apparent from the reports prepared for this claim.
 
Second, the estimates did not have a "credible evidentiary basis" from which an accurate estimate could be made.

No supporting records were used in the estimation process and the estimation was based upon manager recollection of events that took place more than 5 years before the claimed research activities took place. 

Further, not all employees with assigned QRE percentages were assigned percentages based upon the recollection process.  Non recollection process employees were extrapolated a QRE percentage stemming from a perceived similarity to recollection process employees based upon similar positions, titles or other non-stated factors. 

Like the Eustace and McFerrin cases, Taxpayer’s estimation based purely on dated recollection, estimation and extrapolation falls far short of meeting Taxpayer’s burden of proof that the claimed salaries were paid for qualified research activities.  This case is certainly not like Fudim where there was definitely no doubt that Mr. Fudim spent almost all of his time engaged in qualified services.

Like McFerrin, Taxpayers have not provided any records showing how many hours each employee worked on any given project during Year 1.  Nor have they provided any records showing how many hours any employee’s work involved activities that might have constituted qualified research. 

While unpublished opinions are not generally precedential, the McFerrin opinion is an indication that courts would not be receptive to the type of research credit study that is at issue in this case.

Taxpayer’s estimation methodology faces an insurmountable problem as it lacks a nexus between the “amounts” claimed as qualified research expenses pursuant to I.R.C. § 41(b) and the “activities” claimed by the taxpayer as allegedly qualified pursuant to I.R.C. § 41(d).

Expenditure allocations were made for each individual’s entire year’s wages as opposed to allocation of time to specific projects.  There is no link between the amount of research claimed to have been performed by an employee and the projects which allegedly resulted in alleged research activity.  There was no allocation of employee time to new or improved business components.

Taxpayer’s substantiation that it performed qualified research activities is based on only a small number of project reports prepared solely upon the recollection of company managers many years after the alleged claimed research activity took place.  The project reports did not identify specific qualified activities performed by employees that may have worked on the project.  While project activities were claimed on a project basis, actual project costs were not available for all claimed QRE projects.
   
Selection of the described projects was based upon a judgment sample.  Judgment sampling possesses none of the scientific safeguards inherent in statistical sampling.  The only assurance of accuracy stems from the judgment of the sampler.  Thus, the projection of results from Taxpayer’s judgment sample would only be correct by purest chance

Taxpayer did not provide any evidence that the selected projects were “representative” in nature.  An analysis of the list of employees that worked on the subject projects revealed that estimated wages allocated to Taxpayer’s selected projects made up only a very small percentage of the total in-house wage QREs claimed by Taxpayer.
 
Taxpayer has not provided a requested list of all the projects that make up the activities for which the research credit was claimed.

Because most of the activities performed by its employees relate to projects paid for by client fees, Taxpayer must show that any alleged research performed was not funded research pursuant to I.R.C. §41(d)(4)(H).  While Taxpayer asserts that its claimed employee activity relates to activity in excess of fees paid by its customers, and therefore not funded, Taxpayer neglects the general rule that a taxpayer is required to allocate 100% of its funding to its otherwise qualified research unless the taxpayer can meet the pro-rata allocation requirements.  In no event, however, shall less than 65% of the funding be applied against otherwise qualified research expenses. 

Taxpayer has not provided contracts showing that contracted for projects were not “funded” projects.

Base Amount

Taxpayer’s estimation of its fixed base percentage is even more egregious than its estimation of its current years QREs. 

Again, no contemporaneous documentation was maintained.  While the methodology used to estimate the QREs for the base period was basically the same estimation methodology used to estimate the current year QREs, the allocation of employee time in support of the base period QRE activities was premised solely upon the recollection of only a very small number of employees regarding alleged research activity that took place more than 20 years ago. 

Like the study in Boddie-Noell, where the study was employed to substantiate 12-year-old expenditures, the estimates generated by Taxpayer’s study are far too unreliable. The results of the study appear to be based primarily on after the fact speculations by the preparers of the study.

Like the current year QRE estimations, recollection allocation was done for only some employees and the result was extrapolated to the remaining employees.  The majority of the salaries in the base period received research activity allocation pursuant to extrapolation.

While the computation of the fixed base percentage requires the aggregation of Taxpayer’s qualified research expenses for its 1984 thru 1988 taxable years, documentation of QRE payroll costs and the estimated allocation percentage of gross wages for each employee were only provided for 1985. 

Project activity costs were not identified and Taxpayer provided a description for only a few base period projects which upon review revealed only routine engineering.  Like the methodology used for current year QREs, Taxpayer has not provided any supporting records or documentation linking an employee’s estimated QRE costs to any specific qualified activities.

Finally, Taxpayer has not accounted for the impact of numerous corporate acquisitions on base amount computations both in regard to determining the fixed base percentage and computing the four prior years average annual gross receipts.

Taxpayer’s estimation methodology to compute its base amount is not credible and therefore should be disregarded.  If taxpayers fails to maintain a proper system to capture relevant information, then the "inexactitude is of their own making."  Cohan, 39 F.2d at 544.  Accordingly, taxpayers must have factual support for every assumption underlying their estimates to meet their burden of proof.  Taxpayer failed to produce the required factual support for the assumptions underlying its base amount estimation.

Like Research, Inc., Taxpayer should be denied the research credit in the present case because it has not proven that it correctly quantified its base amount. 

Conclusion

In a tax refund case, there is a strong presumption of the correctness of the findings of the Internal Revenue Service.  In order to overcome the presumption, Taxpayer has the burden of presenting “substantial evidence as to the wrongfulness of the [Service’s] determination.”  Taxpayer in this case has failed to meets its burden of providing substantial evidence that it has met all the material elements of I.R.C. §41.

Taxpayer had no contemporaneous documentation to support its claim and failed to show that its estimation methodologies for computation of current QREs and base amounts were credible methodologies.  Further, Taxpayer has failed to show that its claimed research was not funded.

This is not a case where the credit was estimated based upon the expenditures of a very small number of employees but a case where allegedly qualifying expenditures were estimated for bb employees.  This is a case involving a sophisticated taxpayer that has employed in-house and outside accountants and tax preparers “who were well aware of the record-keeping requirements of the Internal Revenue Code.”  The claimed but unsubstantiated credit is of a sort for which Taxpayer could have and should have maintained the necessary records.   This is not a case where required records were destroyed by no fault of Taxpayer.  As stated above, in estimating an allowable amount, the court bears heavily against a taxpayer whose inexactitude is of its own making.

Tax credits are allowed as a matter of legislative grace.  They are allowed only as clearly provided for by statute, and the statute granting the credit should be narrowly construed.   Based upon the substantiation presented, Taxpayer’s claim for refund is denied.