Last week the US Tax Court tightened the line between acceptable and unacceptable documentation when looking at time spent by officers in qualified research and development activities. You can see the decision from Basim Shami and Rania Ardah, Et Al v. Commissioner of the Internal Revenue (click here to see opinion).
In summary, the court looked at estimates provided by the petitioners and determined that they were unacceptable because they lacked any basis other than statements made by the petitioners.
What does this mean for companies currently estimating their employees and officers’ time spent in qualified R&D efforts? Simply that having credible evidence and a basis for estimates can make the difference if audited.
Let’s take a look.
Documenting Effort Wasn’t Done
One challenge taxpayers (as well as CPAs) have when looking at an R&D tax credit is the type of documentation necessary to substantiate the time and effort spent to develop business components. While the Internal Revenue Code and Regulations do not provide specific guidance, court cases have given taxpayers some direction, and as each new case is decided, the lines become a bit more defined.
In the Shami case, officers estimated time spent on qualified activities that were documented through an interview process. According to the court documents, no other basis was provided, and additional interviews with witnesses contradicted statements made by the petitioners Mr. Shami and Mr. McCall.
The court concluded that testimony provided “was insufficient to establish the time Mr. Shami or Mr. McCall spent performing any specific service.”
Relying on the Cohan Rule Fell Short
In recent court cases where estimates have been accepted, the courts have relied on a rule known as the Cohan Rule (based on a court case that allowed estimates that were based in verifiable evidence). While this approach has been successful in other court cases, the court in this case found that without any other evidence, they need not accept nor are required to make any estimates of time spent by the petitioners.
Important Take-Aways for Small Business
While companies of all sizes take advantage of the research tax credit and derive benefits that are important to their continued success, small businesses are most at risk for not developing the right documentation.
As a company grows, so do processes and structure (and documentation); small businesses, however, are at risk because the development necessary to create structure and standards may not have been implemented.
What should a small business glean from this case? Simply that creating even a simple process for documenting time and effort of all individuals involved in the R&D process is important and could save thousands of dollars if the R&D tax credit is audited.
We can’t stress enough the importance of developing a documentation process that will provide a basis for time estimates.
What say you my friends?
What easy and effective methods have you identified to track your R&D time and effort?
Are you using a manual or online system today and what do you like about it?
Do you think the courts should have allowed the Cohan Rule in this case? Why or why not?
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Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.