The Tax Court in Brief – February 20th – February 24th, 2023
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
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Tax Litigation: The Week of February 20th, 2022, through February 24th, 2023
- Avery v. Comm’r, T.C. Memo. 2023–18| February 21, 2023 | Lauber, J. | Dkt. No. 23237–18L (Collection Due Process and a Lawyer’s Race Car Business Expense Deductions)
- Fairbank v. Comm’r, T.C. Memo. 2023-19| February 23, 2023 |Weiler, J. | Dkt. No. 13400-18
Moore v. Comm’r, T.C. Memo. 2023-20| February 23, 2023 |Colvin, J. | Dkt. No. 18632-19
Summary: Petitioner Gayla Moore was the sole owner of Nevco, Inc. (Nevco), a subchapter S corporation, during the tax years in issue (2014 and 2015). Nevco claimed the section 411 credit for increasing research activities (research credit) on its 2014 and 2015 Forms 1120S, U.S. Income Tax Return for an S Corporation. The credit flowed through to Gayla Moore and Scott Moore’s individual income tax returns. Nevco manufactured scoreboards and other types of equipment for sports venues. Mr. Moore was the vice president of Nevco. From 2004 to 2006 an outside consultant advised on Nevco’s personnel and inventory requirements. The consultant was hired as chief operating officer from 2006 to 2016 and served as president and COO during 2014 and 2015. He focused a majority of his time on new product development. He had a base compensation $85,092 in 2014 and $178,956 in 2015, and he received various bonuses during those years. Nevco also employed engineers, and the president and COO was the direct supervisor of a few. The engineers engaged in qualified research during 2014 and 2015. They developed a number of new sports-venue-related products for Nevco, and the president and COO made various executive decisions regarding the design and development. The Tax Court describes, at length, five of the products – Scoreboard Truss, Scorbitz, New Caney Ribbon Board, MPCX–2, and a Slim Shot Clock.
The Moores filed their 2014 and 2015 joint income tax returns on Forms 1040, U.S. Individual Income Tax Return. Nevco filed its 2014 and 2015 income tax returns on Forms 1120S. Nevco claimed research credits on those returns, which flowed through to the Moores individual income tax returns for 2014 and 2015. Nevco used the base period 1984 to 1988 to calculate the fixed-base percentage for its 2014 regular research credit. Nevco used the alternative simplified credit method to calculate its 2015 research credit. An accounting firm prepared the Moores’ Forms 1040 and Nevco’s Forms 1120S for both 2014 and 2015. The IRS determined deficiencies in the Moores’ income tax of $68,263 for 2014 and $141,945 for 2015.
Key Issue: Whether (and if so to what extent) Nevco is entitled to a research credit under section 41 for compensation paid to the president and COO during 2014 and 2015?
Primary Holdings: The president and COO did not engage in direct supervision or direct support (as provided by section 41(b)(2)(B)(ii)) of persons who performed qualified services during 2014 and 2015. And, even though he was extensively involved in new product development, the record did not show the portion of his work on new product development which meets the requirements of “qualified research” under section 41(b)(2)(B)(i). Thus, Nevco cannot consider the president/COO’s wages in computing the research credit for 2014 and 2015.
Key Points of Law:
Research Credit. Section 41(a) establishes the method for computing the research credit. See 26 U.S.C. § 38(b)(4). A taxpayer’s qualified research expenses include “inhouse research expenses” “which are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer.” Id. at § 41(b)(1)(A). A taxpayer’s “in-house research expenses” include “any wages paid or incurred to an employee for qualified services performed by such employee.” Id. at § 41(b)(2)(A)(i). Section 41(b)(2)(A) includes as wages “all remuneration . . . for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” See id. at §§ 41(b)(2)(D)(i), 3401(a). An employee performs “qualified services” by either “(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.” Id. at § 41(b)(2)(B).
Qualified Research. Under section 41(d), four requirements must be met in order for an activity to be “qualified research.”
(1) The research expenditures must be eligible to be treated as expenses under section 174. 26 U.S.C. § 41(d)(1)(A). Under section 174(a)(1), “[a] taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account.” Those “expenditures so treated shall be allowed as a deduction.” Id. at § 174(a)(1). Treasury Regulation § 1.174-2(a)(1) defines “research or experimental expenditures” as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”
(2) The research must be undertaken to discover information which is “technological in nature.” Id. at § 41(d)(1)(B)(i).
(3) The application of that research must be “intended to be useful in the development of a new or improved business component of the taxpayer.” Id. at § 41(d)(1)(B)(ii).
(4) “Substantially all of the activities of” the research must “constitute elements of a process of experimentation for a purpose” related to “a new or improved function,” “performance,” or “reliability or quality.” Id. at § 41(d)(1)(C), (3)(A).
Excluded Activities. Section 41(d)(4) provides a list of activities that are specifically excluded from the definition of qualified research. Treasury Regulation § 1.41-4(a)(5)(i) defines “process of experimentation” as “a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.” Treasury Regulation § 1.41-4(a)(5)(i) also provides that a process of experimentation
involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).
Treasury Regulation § 1.41-4(a)(4) provides as follows regarding the use of technology in the process of experimentation:
For purposes of section 41(d) and this section, information is technological in nature if the process of experimentation 10 used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement.
Direct Supervision and Direct Support. Section 41(b)(2)(B)(ii) considers applicable credit for qualified research and “engaging in the direct supervision or direct support of research activities which constitute qualified research”. Under Treasury Regulation § 1.41-2(c)(2):
The term “direct supervision” as used in section 41(b)(2)(B) 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.
Treasury Regulation § 1.41-2(c)(2) specifically excludes from the definition of direct supervision “supervision by a higher-level manager to whom first-line managers report.”
The regulations under section 41(b)(2)(B)(ii) provide that the term “direct support” includes services in the direct support of either “[p]ersons engaging in actual conduct of qualified research” or “[p]ersons who are directly supervising persons engaging in the actual conduct of qualified research.” Treas. Reg. § 1.41-2(c)(3). Treasury Regulation § 1.41- 2(c)(3)(ii) provides as examples of direct support a secretary “typing reports describing laboratory results derived from qualified research,” a laboratory worker “cleaning equipment used in qualified research,” and a machinist “machining a part of an experimental model used in qualified research.”
Insights: This opinion illustrates the careful attention a taxpayer should take when desiring to allocate compensation of an executive-level employee to a research credit for qualified research performed by others. The Tax Court appears to have wanted the Moores to more thoroughly allocate the portion (i.e., the number of hours) of the president and COO’s work on new product development which was qualified research. The Court was careful to distinguish between qualified research and new product development with respect to Nevco’s operations. And, the Moores did not present estimates of the amount of time the executive spent on qualified research as distinguished from the broader category of new product development. The Tax Court analyzed the matter on a product-by-product basis.