The government's judicial attack on research credit refund claims has morphed from litigating the substantive nature of refund claims – whether the asserted research meets the requirements of section 41 of the Internal Revenue Code – to whether the administrative claim filed with the Internal Revenue Service and the follow-on complaint filed in federal court are procedurally sufficient. Premier Tech, Inc, v. United States, (Fed. Dist. Ct. Utah, July 15, 2021), and Intermountain Electronics, Inc. v. United States, (Fed. Dist. Ct. Utah, July 16, 2021), are recent cases discussing the procedural challenges. The cases were both decided in the federal district court in Utah, one day after the other, but each by a different judge.
The government's motion to dismiss the research credit tax cases was two-pronged. First, the government moved to dismiss the case based on an assertion that the taxpayer's administrative claim filed with the IRS lacking specificity. In other words, the government argued that the IRS could not understand why the taxpayer wanted a tax refund. A valid administrative claim filed with the IRS is necessary to give the federal court subject matter jurisdiction if the IRS disallows the claim and the taxpayer litigates the disallowance in federal court.
In Premier Tech, the taxpayer filed an amended tax return that included Form 6765, “Credit for Increasing Research Activities.” The taxpayer's Explanation of Changes section of the amended tax return stated that the claim was for research credits and that Form 6765 provided the amounts of qualified research expenses and the calculations of the refund amount. The government asserted that the refund claim – apparently referring to the Explanation of Changes – lacked specificity because it did not spell out every single element of qualification and quantification for the research credit. That level of excruciating detail is not required. The Premier Tech court found that the amended return and Form 6765 put the IRS on notice about the nature of the claim and that the IRS could not now say that its own forms were insufficient to constitute refund claims. Consequently, to defeat to the government's motion in a tax credit case, a taxpayer should, at a minimum, file a formal amended return including Form 6765. The amended return should be complete in all respects as should the Form 6765.
A taxpayer filing a refund claim typically hopes that the IRS Service Center receiving the claim will survey the claim and allow it without sending it for a full examination. With that motivating hope, a taxpayer may not be eager to reveal in the Explanation of Changes that the research credit claim is for an activity with which the IRS has not had long audit experience or that the supporting documentation is not so robust in the excruciating detail that the IRS might be expected to demand. If the IRS disallows the claim and the taxpayer litigates the disallowance, the taxpayer may then rely on Premier Tech as authority for the adequacy and specificity of its refund claim. Of course, the authority of Premier Tech is not national in scope, so a taxpayer is not assured that the Premier Tech approach will work effectively everywhere. Obviously, a more detailed explanation of the research diminishes the risk that a government motion to dismiss for lack of subject latter jurisdiction will be granted but heightens the risk that the refund claim will be selected for examination.
In Intermountain Electric, the IRS selected the research credit refund claim for examination and examined it over a period of five years before denying it. The taxpayer filed a complaint in federal court alleging that the IRS erroneously disallowed the claim. The Government again argued that it had no notice of the taxpayer's claim because the amended return and Form 6765 lacked the requisite factual specificity even though the taxpayer completed the forms as required. The court finessed the issue, stating the taxpayer's responses to the IRS's information document requests during the five-year audit showed that the IRS considered the taxpayer's refund claim. The consideration constituted waiver by the IRS of any defect in the filing of the claim.
Having lost its motions in both cases to deny federal court subject matter jurisdiction, the Government then moved the federal court in both cases to dismiss the taxpayers' complaints for failure to state a claim. To defeat this motion, a taxpayer must allege sufficient facts in its complaint to state a claim for relief that is plausible on its face. In Premier Tech, the taxpayer's complaint did not allege the specific facts constituting qualification and quantification of the research credits, instead referring numerous times to the amended return and Form 6765. The court found that the references were sufficient to defeat the government's motion.
The Intermountain Electric court reached a different conclusion. The taxpayer's complaint alleged, for example, that the taxpayer conducted a “process of experimentation,” which is one of the statutory tests that a taxpayer must pass to claim research credits. The taxpayer did not, however, allege facts describing the experimental process in which the taxpayer engaged. The court found that the taxpayer had alleged only statutory labels and conclusions, but no facts. The court dismissed the complaint without prejudice, which provided the taxpayer with an opportunity to replead with sufficient facts tending to prove that the taxpayer engaged in credit-worthy activities.
The IRS's administration of the research credit seems to have taken a dark turn. The government's counsel in Premier Tech asserted in their brief that the taxpayer's attorney and tax consultant had a history of filing research credit cases based on estimates rather than facts, that they resisted providing facts if they litigated a case, and that in one case the court sanctioned them for dumping thousands of documents on the government rather than specifying facts. The judge in Premier Tech responded to the government's assertions: “The United States' broad criticisms of Premier's representation have no bearing on the merits of the Motion or Premier's claim. It is not appropriate for the government to use this Court to attack or harass … [the taxpayer's attorney and tax consultant], and the Court will not tolerate this behavior going forward.”
One wonders if, regarding research credits, the government has succumbed to a fortress mentality. The IRS publishes a list of “Dirty Dozen Tax Scams.” (News Release 2021-144, 07/1/2021). The IRS stated that the scams on the list are “generally marketed by unscrupulous promotors who make false claims about their legitimacy” and are “new ways to cheat the system.” The research credit is on the IRS's dirty dozen list. It does not belong on the list. Nor does a disparaging comment about a taxpayer's attorney and tax consultant belong in a government brief. The credit is one of the most difficult tax provisions to administer, not only for the government but also for taxpayers. Frustrations exist on both sides. The IRS has made some effort to ease the administrative burden, like permitting reliance to some extent on financial statement research expenses as evidence of entitlement to the tax credit. Nonetheless, Congress must do a better job of devising a research credit that broadly incentivizes the performance of research and does not serve as fertile ground for disputes and litigation. Although bills are pending in Congress to increase the amount of the credit and even to require the IRS and Small Business Administration to educate small businesses about the availability of the credit, no pending bill addresses the disputes and flurry of research credit litigation.
© 2021 Miller, Canfield, Paddock and Stone PLC National Law Review, Volume XI, Number 217
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