In Field Attorney Advice 20171601F the IRS concluded that a taxpayer had used an inappropriate method to determine wages related to in-house research expense. That allocation was used by the taxpayer in computing its research credit under IRC §41.

Wages are considered to constitute in-house research expenses only to the extent they meet the definition of wages paid for qualifying services under Reg. §1.41-2(d). As Reg. §1.41-2(d)(1) begins:

(1) In general. Wages paid to or incurred for an employee constitute in-house research expenses only to the extent the wages were paid or incurred for qualified services performed by the employee. If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense.

In this case the taxpayer admitted that the employees had performed both qualified and nonqualified services.

Reg. §1.41-2(d)(1) continues to provide a method to be used to compute the allocable wages unless the taxpayer can demonstrate a more appropriate method:

In the absence of another method of allocation that the taxpayer can demonstrate to be more appropriate, the amount of in-house research expense shall be determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the taxpayer to the total time spent by the employee in the performance of all services for the taxpayer during the taxable year.

In this case that method presented a problem for the taxpayer, as the taxpayer did not track what portion of its employee’s time was spent performing qualified research services. Thus, the taxpayer was faced with a basic inability to use the regulatory method.

To deal with this, the taxpayer came up with its own method to estimate the proper amount of wages that should be allocated to qualified research services using a two step process. The FAA describes the taxpayer’s methodology as follows:

First, Taxpayer estimated the portion of the total liability for wages it incurred for the performance of qualified services. Taxpayer’s controller identified which employees he believed to have performed qualified services at any time during the taxable year. The controller then estimated the fraction of each employee’s time that the employee spent performing qualified services. Taxpayer multiplied this fraction by the employee’s total wages for the year. The resulting product represented Taxpayer’s estimate of the total amount of a particular employee’s wages for the time spent performing qualified services. The controller then added the amounts calculated for each employee to calculate his initial estimate of total wages incurred for qualified services.

Second, Taxpayer multiplied the estimate it calculated in step one by a fraction. The denominator of the fraction is the number of projects that Taxpayer believed to involve more than 50 hours of work by employees and that might have involved at least one employee who conducted qualified research during some part of the project. The numerator is a subset of the projects in the denominator, with respect to which Taxpayer, after investigating a random sample of the projects, determined that an employee performed qualified research during some part of the project.

Taxpayer determined that roughly 52 percent of the projects described by the denominator of this fraction involved an employee engaged in qualified research at some point. In analyzing this sample, Taxpayer only considered whether the project involved qualified research at some point. Taxpayer did not determine what percentage of total project costs, such as wages, were attributable to the performance of qualified services.

The memorandum goes on to note that it appears the taxpayer used that second step to deal with the fact that the controller’s estimates may have been inaccurate. As the FAA goes on to explain:

As the controller only estimated how much time Taxpayer’s employees performed qualified services based on the controller’s understanding of how the employees spent their time, the controller may have included time spent on activities that were not related to qualified research, even if the activities may have resembled the performance of qualified services. Consequently, this adjusted estimate allegedly reflects the cost of Taxpayer’s employees doing activities resembling research, but reduced by the fraction of Taxpayer’s projects that did not involve qualified research.

Now the question was whether this method is acceptable to allow the taxpayer to treat the computed portion of the wages as eligible costs in computing the research credit.

The obvious problem, and one the FAA uses ultimately to disallow the use of this estimate, is that the regulation only allows the use of an alternative method if the taxpayer demonstrates the taxpayer’s method to be “more appropriate” than that outlined in the regulation.

In this case, there’s little question the taxpayer’s method is far more practical, as it seems likely the information simply doesn’t exist to perform the computation outlined in the regulations. But the FAA concludes that the taxpayer’s method is not likely to produce a “more appropriate” calculation of such wages and provides the following hypothetical example to demonstrate the shortcomings of the taxpayer’s method:

Assume a taxpayer, T, employs 100 employees who conduct 50 projects in the year at issue. T’s total wage expense for the year is $1,000,000. T conducts an analysis similar to that employed by Taxpayer.

In the first step of T’s analysis, T approximates the amount of its liability for employees’ wages that was incurred for the performance of qualified services. T estimates the ratio of how much time each employee performed qualified services to how much total time each employee spent working for T during the year. T then multiplied this ratio by the employee’s wages for the year. In conducting this step, T estimates that $100,000 of wages it incurred for the year should be considered incurred for qualified services.

But, T cannot determine what portion of its employees’ time was actually spent performing qualified services with respect to a specific project. T did not track this information. To adjust for the fact that its estimates may have been inaccurate, T conducts an additional step. In this second step, T analyzes a random sample of two projects its employees conducted, Project A and Project B, to determine whether its employees engaged in qualified research at some point during those projects. Project A involved employees who engaged in qualified research. Project B did not. Therefore, T concluded that 50 percent of its projects involve qualified research.

T then multiplies its $100,000 estimate of wages that were incurred for the performance of qualified services by 50 percent. T concludes that it incurred $50,000 in QREs for the year. But assume further that actually the wages related to Project A were less than those related to Project B. T actually incurred $3,000 and $7,000 in wage expenses with respect to Projects A and B, respectively. Even assuming that all of T’s wage expenses related to Project A are QREs, only 30 percent ($3,000 / ($3,000 + $7,000)) of T’s wage expenses are QREs.

If T were to multiply its $100,000 estimate of its wage expenses that were incurred for the performance of qualified services by this 30 percent, T would conclude that it incurred only $30,000 in QREs for the year. Accordingly, if T had sampled the portion of its expenses that were related to qualified research, not the portion of projects, T would have concluded that a different portion of its expenses were QREs.

As illustrated above, the conclusion Taxpayer draws from its analysis is illogical. Taxpayer reached a conclusion about the portion of its expenses that represented QREs based on an analysis of the portion of its projects that involved qualified research. Some of Taxpayer’s projects may cost more or less than others. Because a certain portion of projects involve qualified research does not mean that the same portion of expenses are QREs.

The FAA concludes that the taxpayer must use the method prescribed in the regulations and cannot use its own two-step estimation method. As a practical matter, since it seems likely the information does not exist to perform the regulation’s calculation, the taxpayer would be barred, effectively, from counting any of the wages as qualified expenses.

Many readers may object to this view, noting that it seems most likely the taxpayer’s method would understate the amount of qualified wage expense vs. what would be determined if the calculation prescribed by the regulation is performed. The IRS did not directly deal with this consideration, except to create an example (arguably somewhat contrived) that demonstrated how it could overstate the expense.

But, ultimately, the problem is that if the regulation is not itself invalid, the taxpayer must demonstrate not that its method does not overstate the expense. Rather, the taxpayer must demonstrate why its method is “more appropriate” than the method outlined in the regulations. It is certainly possible a sympathetic judge might grant that the taxpayer a bit more leeway—but taking the case to court would be an expensive proposition.