Trinity v. US again highlights the need for strong documentation to substantiate R&D tax credit claims

By Randy Eickhoff, President, Acena Consulting, LLC

Over the last year or so, a number of court cases have come to closure that have helped taxpayers better understand how to both define and secure research and development tax credits. These cases, for the most part, have been taxpayer friendly resulting in broader application of the R&D tax credit regulations. In addition, these cases have helped to highlight both the types of activities that qualify for R&D tax credits and the types of documentation allowable for securing this tax incentive provided by the federal and state governments.

Most recently, Trinity Industries completed their tax credit claim securing some of the tax credits they sought based upon the development of a number of new prototype ships. The facts of Trinity industries, Inc. v. US are fairly straightforward, Trinity claimed R&D tax credits on six development projects for tax years ending in March, 1994 and 1995, all new experimental ships contracted for by various customers.  The key points from the case are summarized below:

Documentation

Due to a number of factors, the accounting records related to the expenditures for each project were unavailable, and as a result, the court was forced to review each project at the project level to determine if each met the requirements for qualified research and development.  While it appears from the descriptions noted in the court records that each project could have qualified on some level, Trinity could not produce accounting records to demonstrate expenditures at a level below the overall project.  As a result, the court allowed only two of the six projects as qualified research and development.

Shrinking Back Rule

The regulations for the R&D tax credit, allow taxpayers to claim expenses where 80% or more of the costs are directly related to a process of experimentation to discover information.  Because Trinity did not offer any cost data below the project level, the court could not follow prior case law allowing them to estimate the applicable costs associated with subsystems within the each project that could have qualified.  What is it significant is that the court accepted that qualified research did occur, and as a result allowed testimony and high-level financial information to estimate the qualified research expenses.

Defining the Business Component

A business component is defined in the statutes as the development or improvement of a product, which is to be held for sale, lease, or license or use by the taxpayer in a trade or business (IRC Section 41(d)(2)(B)).

Each of the project noted in this case were special order contracts for various customers; the government argued that because of these projects were “special order” they did not meet the “held for sale” requirement of the business component test.  The court disagreed, noting that “the government cites no authority for that proposition.”

Integration of Systems Can Qualify

The government argued that the development effort related to additional engineering to make different systems work together was “nothing more than ordering off a menu,” rather than complex engineering required to integrate various systems.  The court disagreed with the government, recognizing that the interactions of these systems are not simple, and many times not intuitive.

Summary

Over all, the Trinity industries result is a win for taxpayers.  The case again reasserted a number of concepts that are critical to taxpayers receiving the benefits intended by Congress.  This case also recognized a taxpayer’s right to secure those tax credits available to them under the law.

About the Author

Randy Eickhoff is president of Acena Consulting and has more than 20 years as a tax professional and client advocate.  He has been the owner of two successful professional services firms and has helped secure more than $7 million in research tax credits for his clients.  Mr. Eickhoff is a licensed CPA and a member of the California Society of CPAs.

For questions or additional information please visit www.acenaconsulting.com