The Federal Research & Experimentation Tax Credit has had no shortage of publicity. The potentially lucrative credit has been heralded by taxpayers, taxpayer advocates, and industry groups for the lucrative tax savings it can provide as a reward and stimulus for investing in qualifying research activities. At the same time, the IRS has designated R&D Tax Credit claims as a Tier 1 audit issue, meaning they are paying special attention to R&D claims. This designation reflects the IRS viewpoint that many R&D claims might be failing to meet the qualification or documentation standards required for substantiation.

Earlier this month, a taxpayer saw the major portion of an R&D tax credit claim rejected by the tax court in Basim Shami and Rani Ardah, Et Al. v. Commissioner. So what do practitioners need to know about R&D credits? How should they advise clients to proceed in an area that could be very beneficial, but is also subject to significant IRS scrutiny? Clients that qualify should receive benefit, but how can a practitioner be sure that the claims would withstand IRS review?

As was well-publicized in 2007, the IRS released new audit directives to manage increased activity and interest surrounding the Federal Research and Experimentation Tax Credit. In 2009, two critical court case decisions, Union Carbide Corporation & Subsidiaries v. Commissioner (T.C. Memo 2009-50) and United States v. McFerrin (570 F.3d 672), produced tax court decisions that have provided further guidance and clarification regarding R&D Tax Credit claims. This year, another significant case was decided.

By combining the knowledge and insight gained from these directives and tax court case decisions, taxpayers can be well prepared to develop and defend R&D Tax Credit claims.
IDR Provides Insight into Building Defensible Claims

Concurrent with the Tier 1 IRS focus on the R&D credit, the IRS modified Form 4564, the Information Document Request (IDR), which serves as the initial inquiry into a taxpayer’s R&D credit calculation. This 19-question, standardized form reveals the IRS’s concerns over any potential disconnect between the taxpayer’s qualified research activities (QRAs) and qualified research expenses (QREs.) If a taxpayer fails to establish a direct connection between their QRAs and QREs, the credit could be disallowed. The language and focus of Form 4654 promotes the IRS’s favored project accounting method when determining QRAs and QREs as opposed to the more commonly used and GAAP-friendly departmental or activities accounting method.

IDR Form 4564 stresses investigation of, and support for, individual research projects (the creditable improved business components) as is technically required in the Code. However, the IRS must know that most

U.S. companies, due to budget and other resource constraints, have a very difficult time tracking qualified expenses and specific employee research activities on an individual project basis. Research “department” expenses and time are natural products of the U.S. GAAP reporting and consolidation procedure. It’s usually extra, non-financial record keeping performed on the side by engineers and technicians that conform more squarely to the IRS’s preferred project accounting method. It is this disconnect that often becomes the focus of the examination of a taxpayer’s QRAs and is first revealed to the examining agent in the response to Form 4564.

To counter this, it is essential to redirect the IRS’s focus away from its standard checklist and redirect the conversation toward spotlighting the valid documentation of QRAs that the taxpayer can produce. In other words, an effort must be made to move away from the IRS’s preferred project approach and towards substantiating the credit claim through the activities approach. The project approach does not bypass the requirement for establishing nexus, but provides an alternate and more feasible approach for taxpayers. This absolutely must be performed with contemporaneous documentation. When contemporaneous documentation is lacking, extra measures must be taken to produce accurate and detailed personal interviews recorded on tape and in writing as well as individual activity questionnaires and project-specific questionnaires to supplement and strengthen the existing documentation. However, a company chooses to identify activities, whether by project or department, it is essential that qualifying research expenses can be tied to these activities.
R&D Credit Tax Court Opinions

Some very significant recent tax court decisions have helped taxpayers understand the acceptable methods of qualifying and substantiating research activities. The first decision, Union Carbide Corporation & Subsidiaries v. Commissioner, produced an important memorandum decision on March 10, 2009. This tax court memorandum most notably permits the use of “close approximations”, as determine by the “Cohan Rule” (Cohan v. Commissioner, 39 F.2d 540, 543-544), when qualifying and quantifying research activities. The second decision, United States v. McFerrin (570 F.3d 672), helped further define “qualified research” and a “process of experimentation” in a June 9, 2009, decision from the United States Court of Appeals for the Fifth District. And earlier this month, Basim Shami and Rani Ardah, et al. v. Commissioner reinforced the importance of contemporaneous documentation and supporting testimony, especially when management wages are included in QREs.

The Union Carbide tax court memorandum allowed the use of oral testimony and close approximations to sufficiently substantiate qualified research expenditures under the Cohan Rule. This memorandum supported the use of the Cohan Rule and provided the following insight into the R&D credit:

• Clarification of the Discovery Test, which previously required qualified research activity to involve discovering information far beyond the taxpayer’s existing knowledge. The Union Carbide memorandum emphasizes that this test only necessitates qualified activity to involve an effort to discover technological information.
• Activity relating to the development of the manufacturing method may be qualified, even if conducted after a product is ready for commercial production. However, efforts must be made to identify and separate production costs from qualified research costs.

• With regard to maintaining consistency when qualifying and quantifying research activities in the base years and the credit years, the consistency of the particular type of records is not required. Also, the consistency rule was determined to apply at the entity level – not the control group level – when the credit is computed and applied to an aggregate group of companies.

The original United States v. McFerrin case decision disallowed McFerrin’s entire $472,092 R&D Tax Credit claim for tax year 1999 in an Oct. 31, 2005, ruling. The credit claim was rejected on grounds that trial and error was not an acceptable form of experimentation; qualified projects did not demonstrate a high level of innovation; QRAs did not expand or refine existing principles; and insufficient project detail was provided. The credit was disallowed and McFerrin was forced to repay the original credit amount in addition to nearly $130,000 in interest.

The McFerrin district court decision, however, was overturned in the United States Fifth Circuit Appellate Court in June 2009. The appellate court determined that the original 2005 decision was based on the 2001 Proposed R&D Credit Regulations, not the new 2004 Final Regulations that should have taken precedence in the ruling. These new regulations provide the following guidelines for qualified activity:

• Discovery of new information does not need to be revolutionary. Rather, the discovery of new information must be intended to eliminate uncertainty re­garding the development of a final product or process design, the taxpayer’s ability to produce the design, or the technique used to develop the product or process.
• Qualified experimentation can include systematic trial and error, virtual or physical simulations and modeling.
• Qualified activity must involve uncertainty during product or process development, identification of alternative solutions and an evaluation of alternatives.

Recently, the decision in Basim Shami and Rani Ardah, et al. v. Commissioner highlighted the importance of properly qualifying and documenting management wages. In this instance, the taxpayer hired another outside provider to develop R&D credit claims for tax years 2003, 2004 and 2005. The provider included nearly $30 million in management wages over a three year period for two individuals whose titles and educational backgrounds did not indicate a strong likelihood that they would materially participate in qualifying research. Additionally, the taxpayer failed to provide any documentation that established how much, if any, time was spent by management performing R&D activities. The court found the provided testimony to be unreliable and contradictory. The IRS is very clear in their expectations for substantiating management involvement in qualifying research activities. Taxpayers and practitioners should be meticulous in maintaining and presenting contemporaneous evidence to support such inclusions.
Conclusions

In McGuire Sponsel’s experience to date, tax examiners have not raised any immediate objections to reliance on personal interviews, detailed questionnaires or the proper utilization of the Cohan Rule supported by valid, contemporaneous documentation. We have found IRS examiners to be reasonable in their application of the code and regulations, provided that taxpayers have made the necessary effort to identify activities which truly meet the requirements for qualifying activities, and that records are kept or developed which create nexus between activities and expenses. We have settled full IRS examinations of clients’ research credit claims without the IRS making any proposed adjustments by submitting a detailed response to the IDR Form 4564 with supporting documentation attached. The IRS expects credit calculations to be supported with reliable, contemporaneous documentation. The IRS expects that QRAs will be provided with detailed explanations of how they meet statutory definitions. They are also on the lookout for questionable inclusions, such as unsubstantiated management wages as seen in the recent Basim Shami and Rani Ardah decision.

In summary, the IRS means what it says when it comes to the desire to see both project accounting and contemporaneous documentation in its audit methodology. With a concerted effort to counter with an activities approach, supported by the recent court decisions and inclusion of full employee participation in interviews and detailed questionnaires, taxpayers can be successful in satisfying examiners’ requirements and protecting clients’ research credits.

On December 23, 2011 the IRS released the long awaited Temporary Regulations that clarified and expanded upon the treatment of expenditures to repair tangible property under 263(a) and 162(a).   The determination as to whether an expenditure is capital or deductible as a repair has been under discussion for years.  The IRS has come out with multiple proposed regulations that agree with the new Temporary Regulations in parts, but also disagree with them in other areas.

The regulations define “unit of property” under §1.263(a)-3T.  The definition creates a reference point for determining if a project is a capital or a deductible repair.  The regulations require that the taxpayer separate the building and specific “building systems” when determining if a project constitutes a deductible repair.  If an improvement is a repair relative to a building component or building system, it must be treated as an improvement and capitalized, even if it is inconsequential to the overall building.  The temporary regulations define building systems to include (1) the heating, ventilation, and air conditioning systems (“HVAC”); (2) the plumbing systems; (3) the electrical systems; (4) all escalators; (5) all elevators; (6) the fire protection and alarm systems; (7) the security systems; (8) the gas distribution systems; and (9) any other systems identified in published guidance.

It is important to note that this is a change to the proposed regulations.  Under the definition of “unit of property” if an improvement to a HVAC system results in a betterment to that system, the expenditure is considered an improvement to the building. This change makes the Temporary Regulations consistent with case law.

The IRS also takes time to define the unit of property for leased buildings.  Under the new regulations the unit of property for a leased building is “each building and its structural components or the portion of each building subject to the lease and the structural components associated with the leased portion.”  Meaning that when it comes to leased properties not only do we need to look at how an improvement affects a “building system” but also the effect it has on the building components of the leased space, which could be smaller than the whole building.

The IRS also defines when a taxpayer must capitalize amounts paid to improve a unit of property.  If the improvement results in one of the following the taxpayer must capitalize:

1. Betterment to the unit of property
2. Restoration of the unit of property, or
3. Adapts the unit of property for a new or different use

In order to determine if an improvement constitutes a betterment the IRS provides three examples of retail stores.

Another change from the 2008 proposed regulations deals with the replacement of a major component.  Under the 2008 proposed regulations the IRS created a 50 percent test.  The temporary regulations do away with the 50 percent test in favor of a standard designed to more closely follow the approach used by courts.  Under the Temporary Regulations a taxpayer must consider both the “quantitative and qualitative significance of the part or combination of parts in relation to the unit of property.”  In order to provide further guidance the regulations provide examples of improvements to roofs, roof membranes, HVAC systems, fire protection systems, electrical systems, plumbing systems, windows and floors.

One of the biggest potential benefits to taxpayers with the Temporary Regulations deals with dispositions.  Under the new regulations the IRS allows for the retirement of a structural component of a building under section 168.  This will allow for the disposition of components of a larger building prior to the disposition of the entire building.  This allows a taxpayer replacing a roof, or lighting system to dispose of the original system when it is removed from service.  This increases the importance of a quality cost segregation study on a property.  The study should recognize individual systems that may be replaced prior to the replacement of the entire property.  This added benefit to taxpayers will allow them to dispose of assets prior to the end of their tax life.

Due to the change in the disposition rules it is recommended that taxpayers look at their original assets when completing new capital expenditures.  Because of the advantageous tax treatment of lighting and HVAC under 179D many taxpayers are upgrading their facilities.  This may allow for a taxpayer to dispose of some of the original items at the same time.

The IRS has also come out with two Revenue Procedures to cover the changes in accounting methods that may present themselves due to the new changes under the Temporary Regulations.  Rev. Proc. 2012-19 addresses issues incurred with repair and maintenance, materials and supplies and other related method changes.  Rev. Proc. 2012-20 addresses depreciation, disposition and related method changes.  Both Revenue Procedures are in effect for tax years beginning on or after January 1, 2012.

The new Temporary Regulations cover 255 pages and the new Revenue Procedures each cover 48 pages.  They contain many provisions and this is simply a summary of some of the provisions included.  If you have questions regarding these changes please contact David McGuire or another McGuire Sponsel representative.  In the coming months we will issue some more specific examples of how these changes will affect specific industries.

On Monday, March 12, the United States Tax Court filed a case that at first glance deals a serious blow to cost segregation studies on residential apartments. However, upon further review, this court case is not as detrimental as it might appear.

The case in question is AmeriSouth XXXII, Ltd. v. Commissioner, T.C. Memo 2012-67. In this case AmeriSouth purchased an apartment complex in 2003 for $10.25 million. AmeriSouth then commissioned a cost segregation firm to review the purchase to determine the amount of property that was eligible for shorter depreciation than the 27.5-year life given to residential real property. The IRS subsequently reviewed the cost segregation study and found a number of items where they disagreed. The areas of the audit that were at issue included the following:

Site preparation and earthwork

• Water-distribution system
• Sanitary-sewer system
• Gas line
• Site electric
• Special HVAC
• Special plumbing
• Special electric
• Finish carpentry
• Millwork
• Interior windows and mirrors
• Special painting

A major issue, important to note, was that AmeriSouth sold the building prior to the case’s trial. AmeriSouth then “stopped responding to communications from the Court, the Commissioner, and even its own counsel.” Due to the lack of response, the court allowed AmeriSouth’s attorneys to withdraw from the case. AmeriSouth was left to represent itself and failed to file a post-trial brief. Due to these facts, we are left believing that many of the issues covered in this case were not argued as well as they might have been. That said, the precedent set by this case needs to be considered in future cost segregation studies.

This decision in this case took a firm stance against many items that cost segregation practitioners often claim as personal property, including cabinetry, kitchen hoods, and decorative millwork. It is difficult to say how the case would have fared if the taxpayer had been more responsive to the audit. I would be remiss to also not point out that the cabinetry issue has been a point of contention with the IRS for years. The IRS has long argued that kitchen cabinetry is integral to an apartment and should be treated as 27.5-year property. Most cost segregation providers have argued that cabinetry is furniture with a 5-year life under asset class 57.0.

It is also important to point out that AmeriSouth took many positions that most experts in depreciation would disagree with. These include, but are not limited to, their position on sanitary sewers, site preparation and earthwork (for this case’s specific situation), and overhead power lines. Most professionals would agree with the IRS’ position on all of these assets. Many of these assets were not even owned by the taxpayer, including the overhead power lines.

Additionally, the IRS states that there were certain areas where detail was unsubstantiated. In reviewing the electrical system, the cost segregation firm utilized an allocation similar to one used in Scott Paper v. Commissioner to allocate the electrical panels. The IRS was not arguing this position but rather stating that the study “extrapolates from bad data on some of the units… We therefore find that it must depreciate the panels over the life of the apartments.” In this case the IRS did not have to argue the position, but simply argued that the taxpayer did not provide enough information to prove that their allocation was valid.

In conclusion this court case needs to be considered with an understanding of the details around it. The taxpayer used an aggressive cost segregation report, and then was audited. Upon audit the taxpayer walked away from the table and did not substantiate their position. In the Tax Court Memo it even states that “we could dismiss this case entirely” due to the lack of response from the defendant. While this case sets a precedent and gives good insight, the decisions reached and opinions formulated need to be viewed within the confines of the situation.

On February 23 the IRS released an advance copy of Notice 2012-22.  Notice 2012-22 modifies the allowable calculation methodologies for 179D as established under Notice 2008-40.

Under this notice the IRS sets a new set of percentage improvement standards to qualify for the 179D deduction.  Specifically these percentages will make it easier to qualify for the HVAC portion of the 179D deduction.  The standards established under 2008-40 will still exist and taxpayers will be able to choose the more favorable of the two standards based on their situation.

Based on this new guidance applicable percentages will be as follows:

This notice will be effective for property placed in service on or after the effective date of this notice.  If 179D is extended beyond 12/31/2013 the new percentages will be in effect.  If this occurs any prior percentages will no longer be valid.

This is only a summary of this new notice.  If you have any questions please feel free to contact David McGuire at (317) 564-5001.