Quebe, (DC OH 1/17/2019) 123 AFTR 2d ¶2019-352
A district court has held that: a) a taxpayer mischaracterized the burden of proof for showing that it qualified for the start-up company method for computing the fixed base percentage under the research credit; and b) the taxpayer did not meet the actual burden of proof.
Background—research credit. Under Code Sec. 41(a), a taxpayer may claim a 20% tax credit for the amount of “qualified research expenses” incurred in the performance of “qualified research” that exceed a statutorily defined base amount from an earlier base period.
The statute permits a taxpayer to use a base period of either ’84-’88 or, if certain criteria are met, an alternative base period intended to make the credit available to “start-up” companies that were not in business from ’84-’88. A taxpayer is permitted to use an alternative base period only if the first tax year in which it had both gross receipts and qualified research expenses was after ’83, or if there were fewer than three years in which it had both gross receipts and qualified research expenses during the base period of ’84-’88. (Code Sec. 41(c)(3)(B))
Under the “funding exclusion” rule, a taxpayer conducting otherwise qualified research is denied the credit to the extent the research is funded by any grant, contract, or otherwise by another person or any governmental entity. (Code Sec. 41(d)(4)(H))
Taxpayers must substantiate their entitlement to a claimed credit and are required to retain the records necessary to do so. (Code Sec. 6001; Reg. § 1.6001-1(a), Reg. § 1.6001-1(e)) A taxpayer claiming the research credit “must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” (Reg. § 1.41-2(d))
Background—IRS recovery of erroneous refund. IRS may recover, by civil action, any portion of a tax which has been erroneously refunded. (Code Sec. 7405(b))
Facts. The taxpayers were Mr. and Mrs. Quebe, a married couple filing a joint return. Mr. Quebe was the sole shareholder of QHI, an S corporation. QHI operates as three separate electrical contracting companies, two of which, Chapel and Romanoff, it purchased when it first went into business in 2002.
QHI retained Alliant to perform a “Research and Development Tax Credit Study.” Alliant agreed to be compensated to the extent that it determined that QHI was eligible for the credit.
Alliant concluded that QHI was entitled to claim the research credit for 2009 and 2010. As a result, QHI filed amended S corporation returns for those tax years, on which it claimed the research credit based on the start-up company method. Quebe filed amended individual tax returns for those tax years on which he requested refunds based on the research credit. IRS issued the requested refunds.
IRS then brought this suit in which it contended that QHI was not permitted to use the start-up company method and that therefore QHI did not earn any research credits. IRS argued that QHI had gross receipts and qualified research expenses, both before ’84 and during the ’84-’88 period, through its subsidiaries Chapel and Romanoff.
Quebe contended that the following activities constituted 2009 and/or 2010 qualified research: developing new means and methods, issuing requests for information (RFIs), implementing change orders, value engineering, determining pathways for conduit and wiring, coordination among trades and estimation.
IRS showed that Chapel did the same work in the ’80s that Quebe claimed to be qualified research in 2009 and 2010. IRS cited testimony from Quebe that Chapel resolved uncertainties related to developing means and methods during the ’80s. Quebe testified that he did not know whether Chapel performed value engineering in the ’80s, but that he had reason to believe it did.
Quebe disputed that Chapel and Romanoff had qualified research expenses in the ’80s and asserted that, during that period, Chapel was engaged primarily in Time and Materials-based contracts. They cited Geosyntec Consultants, Inc., (DC FL 2013) 112 AFTR 2d 2013-5488, for the proposition that Time and Materials-based contracts are routinely found to be not qualified under the Code Sec. 41 tax credit under the funding exclusion. Quebe asserted that, in contrast, QHI’s contracts during 2009-2010 were predominantly fixed fee contracts, which he argued are generally not excludable under Code Sec. 41‘s funding exclusion.
Quebe further asserted that QHI had a prefabrication unit in 2009-2010 and that its subsidiaries were the designers of the prefabrication and modularization units integrated in the detailed electrical designs in several projects. Quebe asserted that Chapel did not have a prefabrication division during the ’84-’88 period.
Rizwan Husain Virani, the corporate representative of Alliant, testified that QHI did not engage in research activities in the ’80s.
Quebe concluded with the assertion that there was no evidence that the ’80s base period should apply or that qualified research activities occurred in the ’80s.
Taxpayer loses. The court agreed with IRS that QHI was not entitled to use the start-up company method and granted IRS summary judgment.
The court said that, in cases under Code Sec. 7405(b), IRS bears the ultimate burden of proving that a tax refund was erroneous and to what extent. The taxpayer, however, has the burden of showing its right to any claimed tax benefit.
The court said that Quebe’s arguments failed because he mischaracterized the burden of proof and failed to present admissible evidence creating a genuine issue as to whether QHI engaged in qualified research from ’84-’88. The court said that Quebe argued, at least implicitly, that IRS had the burden of proving that QHI engaged in qualified research from ’84-’88 and therefore was not entitled to claim the tax credit. That view is incorrect. Under the regs, Quebe was obligated to substantiate his right to the Code Sec. 41 tax credit. To do so, he had to come forward with evidence demonstrating that he was entitled to use the alternative “start-up” base period, instead of the ’84-’88 period. (Reg. § 1.6001-1(a)) IRS had the ultimate burden of proving its claim, which it could do by proving that Quebe did not substantiate his right to the claimed tax benefit.
The court said that IRS came forward with evidence that QHI, through Chapel, engaged in qualified research activities in the early ’80s of the same kind for which QHI claimed the tax credit in 2009 and 2010. Quebe asserted that QHI’s subsidiaries were not engaged in those activities in the ’80s based solely on the deposition testimony of Mr. Virani. The court said that Alliant had a financial interest in QHI being able to claim the credit and that Mr. Virani did not have personal knowledge of QHI, much less the business conducted by QHI’s subsidiaries in the ’80s. His testimony was inadmissible hearsay. The rest of the evidence cited by Quebe went to whether or not QHI conducted qualifying research in 2009 and 2010. Thus, there was no admissible evidence from which a factfinder could have inferred that QHI did not engage in qualifying research activities in the ’80s and therefore was entitled to use the start-up base period.
References: For the credit for increasing research activities, see FTC 2d/FIN ¶ L-15300 et seq.; United States Tax Reporter ¶ 414 et seq.