Research Tax Credit Records Must Be Kept for 40+ Years

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A frequent question is how long one has to keep records for tax purposes. The United States v. Quebe, No. 3:15-cv-294 (S.D. Ohio 2019) case provides the answer for research tax credits. The answer is that you have to keep records that pre-date the formation of your business by twenty years and then you have to keep these pre-formation records and be able to produce them today, almost 40 years later, to be able to take the research tax credit.

Facts & Procedural History

The taxpayer is an electrical contractor. It was founded in 2002 and acquired several companies in that year. The companies reported research tax credits for 2009 and 2010 and the IRS issued refunds to the taxpayer for the credits. The IRS then brought suit to recoup the refunds as erroneous refunds. After discovery, both parties filed for summary judgment, which the court addresses in the current court opinion.

The Research Tax Credit

The research tax credit rewards taxpayers for performing research in the U.S. The benefits can be significant. There are a number of hurdles that have to be overcome to claim the credit. The calculation presents one such hurdle.

The research tax credit is generally computed based on an increase in research spending from a base period to the current credit year. The base period is generally the last several years in the 1980s, for older companies.

If the company did not have at least $1 of gross receipts and qualified research expenses in the 1980s base period years, then mechanical start-up rules apply. The first year for the start-up rules is the first year that $1 of gross receipts and qualified research expenses were incurred.

The Parties Arguments

The IRS argued that the taxpayer incurred qualified research expenses and had gross receipts in the 1980’s base periods by way of the two business entities the taxpayer acquired in 2002. The research tax credit rules do require that taxpayers combine commonly controlled entities in computing their research tax credits.

In applying these combined research tax credit rules, according to the IRS, the start-up calculation rules could not be used.

The taxpayer argued that the start-up rules had to be used. It argued that the research activities in the 1980s were not qualified as they were funded. The research tax credit rules do exclude funded research. Research is funded in some cases if the work is performed by the researcher pursuant to time and material contracts.

The taxpayer also argued that the research activities in the 1980s was not qualified given that the research function was different back then, and the work back then was not qualified under the four-part test.

The Court’s View of the Evidence

The court noted the taxpayer’s funded research argument and its non-qualified activity argument. But other than noting the arguments, it does not appear that the court fully understood the import of the taxpayer’s arguments.

Funded research and non-qualifying activities in the base period cannot be included in the current year or the base period years. This is mandated by the consistency rule, which the court did not even address. The consistency rule says that the same amounts excluded in the current period have to be excluded from the prior period. Because you are comparing the same amounts from the current to base period years, this rule prevents the very abuse that presumably the court intended to avoid–namely, it ensures that the credit is only available for the increase in spending. This is the very purpose for the base period in the calculation.

Instead of addressing the merits of the taxpayer’s arguments, the court focuses on the evidence presented. It notes the government’s burden in an erroneous refund suit, but also notes the taxpayer’s burden to show that it qualifies for the credits. Given the court’s language, it is not clear how the government met its burden in this case. The government’s mere argument that the taxpayer performed qualified research in the 1980s–which is now almost 40 years ago–would not seem to be sufficient. The same can be said of the testimony that was not clear on this point or why the taxpayer’s funded research and non-qualified activity defenses weren’t accepted.

The court passed on the government’s burden in an erroneous refund suit and focused on the burden for the taxpayer. Oddly, the court concludes that the taxpayer has a burden and that the same inconclusive testimony that is sufficient for the government is not sufficient for the taxpayer. This is particularly interesting in that the taxpayer is tasked with proving a negative–i.e., prove that you did not perform research in the 1980s–and proving a position they did not take on their tax returns. It is hard enough to prove that you performed research in the 1980s, yet alone that you did not perform research in the 1980s, particularly when your position is that you did not perform research in the 1980s.

An Impossible & Unreasonable Standard

Setting aside the court’s view of the burdens and evidence, the case touches on a very difficult issue for the research tax credit. Specifically, it touches on the acquisition rules and what documentation is needed to satisfy the rules.

The research tax credit rules require taxpayers to aggregate research expenses and gross receipts when acquiring a business. But when a taxpayer acquires a business, as the taxpayer did here, it may not be provided sufficient information to calculate the research tax credits going forward in the future. Should this forever preclude the taxpayer from being able to take the research tax credit (or relegate them to taking an alternative simplified credit)?

In this case, given the court’s view of the burdens and evidence, the taxpayer would have to present the contracts and other evidence from the companies it acquired in 2002. These would be the contracts and evidence from the late 1980s–twenty years before the taxpayer acquired the companies. This means that the taxpayer would have to be able to present these nearly 40 year old records and information to qualify for the research tax credit today.

Suffice it to say, that it is highly unlikely that a taxpayer who purchases a company in 2002 would be provided with this type of information from the 1980s for the companies it acquires. And even if the information was available, that the company would keep the information for a research tax credit it intended to take 10 years after the acquisition.

This sets an unusually high burden that negates the very purpose for the research tax credit. This case is a prime example. The taxpayer engaged in qualified research, as conceded by the IRS, and tried to take credit for this activity as provided for by Congress, but it was denied credit for not meeting an impossible and unreasonable documentary standard.

A Low Fixed Base Percentage

But all may not be lost for the taxpayer. The parties in the case are taking the opposite position than normally taken. Typically it is the taxpayer arguing that they had qualified activities and the government arguing that they did not.

Presumably the presence of research in the 1980s resulted in no research tax credit being available for these years if the start-up rules are applied. But if the taxpayer accepts the court’s conclusion that some research was performed in the 1980s, it is probable that the research would be minimal in comparison to the current year. This would mean that the taxpayer would have a very low fixed-base percentage and may have even larger research tax credits by not applying the start-up rules.

If the taxpayer re-computes its credits without using the start-up rules and it does produce a larger credit amount, would the IRS or court accept that position? Or would the IRS and court continue to argue that the evidence–the very same evidence than the court relied on in this case–is now insufficient for the taxpayer?

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