Taxpayer files a joint income tax return with his spouse. Taxpayer is a one-hundred percent shareholder of an S corporation ("S Corp") which is a provider of sheet metal components and assemblies to a wide variety of industries, including medical, electronics, communications, appliances, transportation, government, computer, and lawn and garden. Services provided by S Corp consist of laser cutting, sheet metal fabrication, precision machining, welding and assembly.
The Indiana Department of Revenue ("Department") conducted an audit of S Corp for the years 2008 and 2009. S Corp claimed an increase in research activities for 2006 through 2008, which resulted in a "research expense credit" ("REC"). As the sole S Corp shareholder, Taxpayer claimed the REC on his joint individual income tax return. However, during the audit the Department determined that S Corp was unable to substantiate the claimed qualifying research activities and the related expenses and therefore disallowed the credit. The disallowance of the REC resulted in proposed tax assessments.
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Taxpayer protests the elimination of RECs which it claimed on its 2008 and 2009 joint individual income tax returns, along with the resulting proposed assessments for additional adjusted gross income tax for those periods. Taxpayer argues that the RECs were properly claimed for both years.
...In investigating the research expense credit taken by Taxpayer, the Department's auditor requested the documentation upon which S Corp had relied in claiming the credit. Taxpayer stated that the consulting firm conducted a "research expense credit" study at S Corp in the early 2000s. According to Taxpayer, the consulting firm it hired ("CF") interviewed S Corp's employees and determined the baseline of research expense credit that S Corp was entitled to. The majority of the credit represented wages.
Taxpayer provided the following documentation to the Department's auditor: (1) a 4-page analysis by CF that found S Corp qualified for the research expense credit a few years prior to the audit (note that neither S Corp nor Taxpayer had retained the underlying documentation); (2) the job titles and job descriptions for all individuals listed on the wage workpaper; and (3) the workpaper showing the percentage of wages which were allocated to research. When queried by the Department's auditor as to the source of S Corp's wage percentages, Taxpayer stated that CF told him S Corp qualified for an 80 percent allocation. Taxpayer believed then that if S Corp used a percentage less than 80 percent, that would be acceptable.
The Department's auditor asked for S Corp's documentation and support justifying the percentage allocation. Taxpayer stated that he had none. Taxpayer stated that he knew what projects the engineers work on during the year, and he then estimated the percentages based on the baseline developed by CF. In response to questions the Department's auditor asked, Taxpayer stated that he would not be able to document what a particular employee did on a particular day, nor which projects a particular employee had worked on. None of CF's work papers were retained by S Corp.
After the hearing, Taxpayer provided additional documentation, along with a cover letter dated January 17, 2012. First, Taxpayer presented 2007 through 2010 R & D employee listings as well as project lists for each of those years. Second, Taxpayer provided a description of seven 2008 sample product development projects. The descriptions listed the product and industry that the research was intended to benefit, the scope of the research and development work performed by the engineers and skilled tradesmen generally assigned to the project (it should be noted, though, that there was no allocation or estimates of the time these employees spent on each project). Also included with each project was a Job Cost Detail sheet that showed costs related to direct labor (not the engineers), and material and outside services associated with the project. The direct labor information was identified by work center, but not individuals' names. Third, Taxpayer presented a 2008 Research and Development Employee List which included job titles. Attached to this list was a job description of each job title. Lastly, Taxpayer pointed out the list he provided of S Corp's research projects only reflect the product development projects. Taxpayer stated that S Corp's employees were also involved in testing processes the time allocations of which CF had included in its estimated wage allocation for the REC.
Taxpayer notes that "due to the decrease in time spent by the employees on product development and process improvement projects, [S Corp] did not qualify for the federal or state research and development credits in 2010." Taxpayer presents this information as evidence of its good faith and credibility relating to its REC claims for 2008 and 2009.
The use of its consultant's baseline percentages is inappropriate for two reasons: (1) the baseline percentages were developed with a particular set of data, which, according to Taxpayer's own evidence has significantly changed year to year; and (2) the underlying data for the baseline calculations is not available which means the Department has no way of verifying Taxpayer's variation from the baseline year to year.
Again, Indiana adopts the federal interpretation of "qualified services," which includes (1) services rendered in performing qualified research; (2) direct supervision of qualified research activities; and/or (3) direct support of qualified research activities. IC § 6-3.1-4-4; Treas. Reg. § 1.41-2(c)(1), (2), (3). "'Direct supervision' means the immediate supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments)." Treas. Reg. § 1.41-2(c)(2). "'Direct supervision' does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist."
If an employee has performed both qualified and non-qualified services, in the absence of another method of allocation that Taxpayer can demonstrate to be more appropriate, the amount of in-house qualifying research expense shall be determined by a ratio of "total time actually spent by the employee in the performance of qualified services" to the total time spent by the employee in the performance of all the services the employee performed. Treas. Reg. § 1.41-2(d).
Taxpayer provided some documentation about the product development projects in which S Corp was engaged during the years at issue. That information does not specifically describe each employee's involvement in the project such that there is documentary evidence of the actual time spent working on the project or the type of qualified service provided by each employee. Also, the employee lists for each of the years at issue contain the name of Taxpayer himself who is the CEO of the company. Unless Taxpayer demonstrates otherwise, he, as CEO, cannot be assumed to be engaged himself in qualified research activities, or of being a front-line supervisor or supporter of those activities.
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It is entirely possible that Taxpayer performs qualified research activities such that it could qualify for the REC. As stated above, similar to deductions, exemptions, and exclusions, tax credits are matters of legislative grace. The taxpayer who claims a tax credit against any tax is required to retain records necessary to substantiate a claimed credit. In this instance, Taxpayer has not met its burden to show that the disallowance of S Corp's research expense credit was incorrect.
