Congress added the research and experimentation (R&E) tax credit to the federal income tax law in 1981 to encourage companies to initiate and expand research programs. Research spending was on the decline, and a substantial tax credit for investing in R&E was needed to incentivize companies to invest in the significant costs of research programs. The credit is designed to offset research expenses such that U.S. manufacturers and other firms will not fall behind foreign competitors in process and product innovation. The R&E credit is valuable to many U.S. companies; however, there are challenges in identifying, documenting, and defending the credit.
QREs and the Cohen Rule
The R&E credit is measured by wages, supply costs and contract research incurred in the company’s R&E endeavors. These qualifying research expenses (QREs) must be substantiated with contemporaneous documentation. Taxpayers should retain the underlying documentation supporting that the computation of QREs meets the requirements of section 41 of the Internal Revenue Code.
The Court of Appeals for the Fifth Circuit has recently clarified the application of the Cohen rule, under which the courts may estimate amounts of expenses if the taxpayer can establish that some expenses were incurred. To apply the Cohen rule, the taxpayer must show that it was entitled to at least some amount of tax benefit. The Cohen rule does not compel the Tax Court to make an estimate of QREs. There must be sufficient evidence to satisfy the Tax Court that at least the amount allowed in the R&E credit estimate was actually spent or incurred for the stated purpose.
Applying the Cohen Rule
The R&E credit is available to many industries. The most recently published IRS R&D tax credit data shows that manufacturing companies accounted for 70% of the total R&E credits claimed each year, thus emphasizing the critical importance of contemporaneous documentation for this industry.
Taxpayers claiming the R&E tax credit should carefully document that its employees performed qualified services and how the supplies were used in the research activities. The Tax Court generally accepts the validity of employee recollections and data extrapolation to estimate QREs, although the Internal Revenue Service has actively opposed the use of employee recollections and extrapolations from existing data to reasonably estimate the QREs.
Taxpayers may apply the Cohen rule and successfully defend the use of estimated QREs in the calculation of the R&E tax credit, but only when the taxpayer proves he is entitled to some amount of tax benefit.