Sometimes practitioners disagree on how much
supporting paperwork – if any – should go with a tax return.
The issue can take on a keener edge when one is
working with amended returns or claims for refunds.
COMMENT: For the nerds,
an amended return can technically be a claim for refund – if the amended return
shows a refund.
It also can vary with the tax issue at play.
I am looking at two cases – the first being the initial
hearing and the second the appeal – involving a research tax credit.
The research credit is easier to understand if we
think of companies such as Johnson & Johnson or Pfizer. Lab coats, scientific
equipment, people wearing safety glasses and so forth. The image screams research.
Mind you, there are accounting and recordkeeping
issues that go with this credit.
A routine accounting system would capture functional
costs (think payroll, rent, utilities), departmental costs (think auto parts
versus auto service at a car dealership) and divisional costs (consumer and
industrial, for example). The research credit wants even more detail from the
accounting system. It wants detail at the research activity level.
What is a research activity?
You could be an activity. Say that you are an
engineer. You work in manufacturing, but a portion of your time is spent on
activities that might qualify for the credit. What would be an example? Let’s
say improving a product or the process to manufacture that product.
The accounting system easily captures your payroll as
a functional cost.
The system also captures your payroll as a manufacturing
cost.
What the system perhaps doesn’t do – at least without
upgrades – is break-down your lab time into specific projects, some of which
might qualify for the credit and others which might not. Yep, your time sheets going
forward are going to be a bear.
Let’s be clear: if you are Pfizer, you likely have
tweaked-out your accounting and reporting system to capture 360 degrees of
data, including whatever is needed for the research credit. Our discussion here
concerns more routine companies.
The Harpers owned a company that specializes in
military design build projects. They initially filed returns not claiming a
research tax credit.
Now pause and consider what they do.
Chances are that some of what they do has an element
of uncertainty: what to, how to do it, what order to do it and so on. Depending
upon, that uncertainty might trigger the research credit.
There are four principal requirements to the research credit:
(1) There must be a reduction in uncertainty about
the development or improvement of a product or process.
(2) That development or improvement in turn involves
experimentation – that is, there are different ways to get there from here. The
experimentation involves determining which ways work and which ways do not.
(3) The experimentation must involve hard
sciences: engineering, chemistry and so forth. Experimenting with tax law, for
example, will not work (sadly).
(4) The purpose of the activity must be a new or
improved product or process: performance, function, quality, reliability, that
kind of thing.
The Harpers reviewed what they did and determined that
the company had research activities qualifying for the credit. They amended their
returns for 2008 and 2010. The credit amount was impressive:
2008 $437,632
2010 $388,325
The IRS reviewed the amended returns and denied the
credit.
Off to Court they went. The first case was in California
district court.
The IRS position was both straightforward and cynical:
The
claim must set forth in detail each ground upon which a credit or refund is
claimed and facts sufficient to apprise the Commissioner of the exact basis
thereof.”
Let me rephrase the position: we (the IRS) decide when
we have enough facts and in any event the facts you submit are not sufficient
to apprise us of anything until we say that they are sufficient.
The district court agreed with the IRS. The taxpayer was required to establish all
facts and details for its refund claim. The IRS said that the taxpayer had not,
and the Court said that was all it needed to know.
Wow. Let me think how can this standard can possibly
be abused….
The Harpers appealed the case to the 9th
Circuit Court of Appeals.
Their argument?
- The IRS has the right to notice of a claim and its underlying facts so it can make an informed and appropriate determination. This is referred to as the “specificity” requirement.
- The IRS can always ask one more question. This makes attaching ALL possible paperwork to a claim virtually impossible.
- In practice, the IRS can review a claim with a taxpayer. One way is to audit the claim, of course. This act is considered a waiver of the specificity requirement.
- Why would the IRS review a claim and thereby waive anything? Consider the alternative. Tax practitioners would attach so much documentation to the research tax credit that the IRS would have to lease additional storage to house it all. It is in both parties’ mutual interest to go along and get along.
The Harpers argued that the IRS had waived the
specificity requirement.
How did the IRS do this?
By auditing the claim.
The IRS spent four years auditing the amended returns.
The Harpers provided over 100,000 pages of supporting documentation. At no
point in time did the IRS tell the Harpers that they had not provided ENOUGH
documentation.
I am trying to be fair, but I am distressed by the IRS
behavior.
It is common professional knowledge that the IRS can always
ask for additional information. One can provide it and still get turned down,
but the give and take allows the system – the IRS and tax practitioners - to function
and not be overwhelmed.
Is that what happened here?
Nope.
The IRS did not go to Court arguing that it had
reviewed 100,000 pages of supporting documentation and decided the Harpers did
not qualify for the research credit.
The IRS argument was that the Harpers did not meet the
specificity requirement – meaning the Harpers did not include enough paperwork.
The Appeals Court called out the IRS. It had waived
the specificity requirement by auditing the amended returns.
The Appeals Court sent the case back to the district
court. The case should never have been dismissed for the specificity
requirement.
The Harpers may win or may lose, but they will have
their day in court.
Our case this time for the home gamers was Harper v
United States.