As the IRS continues to clarify its expectations for Research & Development (R&D) tax credit substantiation – especially in light of recent changes to Form 6765 – taxpayers intending to claim the credit must carefully monitor the landscape and tighten their compliance practices to meet evolving standards. A growing number of Tax Court rulings reinforce this trend. Read about one case here, and more in our previous article. 

In Betz v. Commissioner, the U.S. Tax Court issued a decisive ruling that disallowed the claimed R&D tax credits and imposed accuracy-related penalties. The case involved shareholders of Catalytic Products International (CPI), an S corporation that designs and supplies custom air pollution control systems.

For taxpayers, this case underscores the importance of proper analysis of documentation, technical uncertainty, and funded research.

Case summary: What went wrong?

CPI claimed $501,531 in net R&D credits for 19 projects on its 2014 return, based on employee wages and supply costs. However, the Tax Court found in 2023 that CPI failed to meet several key requirements under Section 41:

• Technical uncertainty: The court determined that CPI’s projects failed to rise to the level of a pilot model designed to resolve uncertainty about a product.
• Process of experimentation: The court found the taxpayer failed to document a systematic process of experimentation. The existence of post-installation testing did not satisfy this requirement.
• Funded research: For five of the 19 projects, CPI did not retain substantial rights to the research results, rendering those activities ineligible under the “funded research” exclusion.
• Inadequate documentation: CPI relied on estimates for employee time spent on qualified services. The court rejected these estimates due to lack of contemporaneous support validating these estimates.

Key takeaways for taxpayers

1. Maintain contemporaneous documentation

The court’s rejection of CPI’s conflicting estimated time allocations highlights the need for records substantiating qualified research activities. Taxpayers should consider retaining:

• Time-tracking systems
• Technical design records
• Calendars
• Correspondence
• Testing protocols
• Employee activity logs   

2. ‘Funded research’ rules are critical

Section 41 excludes research where the taxpayer does not retain substantial rights or bears no financial risk. Customer contracts should be reviewed to confirm compliance with these provisions.

3. Document tax credit methodology

The court allowed accuracy-related penalties under IRC Section 6662(a) because the taxpayer failed to demonstrate why they would be exempt under Section 6664(c)(1) for relying on professional advice. This serves as a warning that unsupported claims can lead to not only disallowance but also financial penalties.

Getting ahead of R&D credit compliance

To avoid the pitfalls seen in Betz, taxpayers may:

• Implement robust documentation protocols that capture technical uncertainty and experimentation.
• Maintain time-tracking systems to substantiate qualified activities.
• Review revenue and vendor contracts for funded research implications.
• Engage qualified tax advisors to evaluate eligibility and defend claims.

What does CohnReznick think?

The Betz v. Commissioner decision is a reminder that the R&D tax credit is not a “check-the-box” benefit. It requires planning, documentation, and a clear understanding of statutory requirements. Businesses should evaluate their compliance efforts to preserve this valuable incentive in light of new compliance standards.