A recent lawsuit filed in the U.S. District Court for the Middle District of Louisiana highlights three important questions that every taxpayer should consider before attempting to claim research and development (R&D) tax credits.
In 2016, Cajun Industries LLC, a civil construction company based in Baton Rouge, Louisiana, amended its 2013 tax returns to claim that it had qualified for $1.3 million in R&D tax credits. The company filed this amended return based on the findings of a tax consulting firm that they hired in 2015. Asserting they had overpaid for their 2013 taxes, they successfully obtained a refund of more than $575,000.
Grisby's loss can be your gain if you take into account the issues raised by the court and make sure to always ask yourself these three critical questions before attempting to claim R&D tax credits.
Have you documented all research and development activities?
One of the main legal problems faced by Cajun Industries during this lawsuit was their lack of proper documentation for research and development activities. The IRS asserted that Cajun Industries did not keep sufficient records to prove that employees were conducting research. As R&D tax credits are only available for projects in which companies engage in technological or scientific research to design and/or create new or improved business components, it is essential that companies maintain documentation to prove such activity occurred.
Grisby argued that since their methods of construction fundamentally relied on engineering principles, they naturally had to conduct research in order to determine the best construction techniques. However, the IRS did not agree with this assessment. The court found that simply proving that the business component relied on a fundamental principle of science was not sufficient to qualify for the R&D tax credit. Cajun Industries would have needed to provide documentation demonstrating exactly what the new or improved construction process was and how it was different from similar projects.
The main takeaway from this situation is to keep your records in order. Before applying for R&D tax credits, ensure that you have ample documentation recording all research and development activities, showing how they led to improvements and documenting the number of hours spent on R&D.
Could the project be considered funded?
IRC Section 41, which contains the R&D tax credit provision, includes a rule known as the “funded research rule.” This rule states that a project is not eligible for R&D tax credits if it was funded by a party other than the taxpayer. Importantly, a project is considered to have been funded by another party if the taxpayer does not own rights to the research or does not bear the risk of failure.
In the case of Cajun Industries, the court reviewed four sample projects and deemed all of them ineligible due to the funded research rule. Three contracts specifically stated that they were works made for hire, and after extensive legal analysis, they were disqualified on the basis that Cajun Industries owned none of the research rights.
The fourth sample project was a bit more complex. It had a fixed-price contract, which typically do not break the funded research rule because the contractor (i.e., the taxpayer) bears the risk of failure. The contractor must complete the project for a set price, regardless of what it ends up costing, so they take on the financial risk. However, this particular fixed-price contract contained clauses compensating Cajun Industries for almost every potential financial risk. In reality, it was the customer who bore the risk of failure, so the project was considered to be funded by them.
The Cajun Industries case demonstrates the importance of carefully examining contracts. It is not enough to see a fixed-price contract and automatically assume it will not break the funded research rule. Make sure you analyze the entire contract to ensure your company will retain research rights and to determine which party will ultimately be taking on the financial risk.
Are you working with the right tax firm?
Ultimately, Grisby was the one responsible for fraudulently claiming R&D tax credits, not the tax firm he hired. We cannot say with any certainty what recommendations this firm did or did not make. However, we can speculate that working with a different tax firm may have resulted in a better outcome for Cajun Industries.
Engineered Tax Services is proud to have a qualified, professional, licensed and legal R&D community that is backed by audit defense. As a professionally licensed firm, we adhere to impeccable standards in the industry. When it comes to R&D tax credit evaluations, our clients can trust that we will provide transparent and effective services to help them achieve their business goals.
Contact us today to schedule a consultation and discuss how we can help you take advantage of R&D tax credits. Our expert team offers tailored solutions to maximize your R&D tax credit opportunities.