Tax Insights
from Washington National Tax Services, National R&D Practice
Taxpayer performed ‘qualified
research’ on most projects, but
‘unreasonable’ compensation paid to
CEO does not qualify for research
credit
October 6, 2014
In brief
In a decision issued October 1, the US Tax Court ruled that a company engaged in ‘qualified research’ for
purposes of the Section 41 research credit in 11 of 12 projects analyzed by the court. However, the court
further ruled that much of the compensation paid to the company’s CEO was unreasonable and therefore
did not constitute ‘qualified research expenditures’ (QREs) eligible for the credit. (Eric G. Suder, et al. v.
Comm’r, T.C. Memo. 2014-201)
In detail
Background
Eric Suder was the founder
and, during the years at issue
(2004-2007), CEO of Estech
Systems, Inc. (ESI), a
Subchapter S corporation
that develops various
telephone-related products
for small and mid-size
businesses. The Tax Court
explained that, “However, he
did not perform the typical
duties of a CEO. He spent
most of his time
brainstorming ideas for new
products and ways to
improve existing
products….His co-workers
thought of him as the ‘chief
idea guy’ and the ‘product
visionary….[He] spent little
time managing the day-today operations of ESI’s
business.”
components, and writing
high-level concept diagrams.”
He also helped ESI engineers
implement his architecture.
That task fell primarily to
Douglas Boyd, ESI’s
president and COO. The
other key executives were
Senior Vice President Harvey
Wende, who “spent much of
his time working directly with
Mr. Suder on product
development,” and Buzz
Hansen, ESI’s chief
technology officer, whose “job
was to design the architecture
of new products,” which
entailed “researching new
technologies, deciding what
technologies to incorporate
into ESI’s products, selecting
appropriate electronic
During the years at issue,
Suder owned 90% of ESI’s
stock. Boyd owned the
remaining 10%.
ESI employed a systematic
product development process
for its various projects during
the years at issue, consisting
of concept development,
hardware and software
development, and testing.
ESI claimed QREs for 76
projects. The parties
stipulated that 12 projects
were representative of the 76
for purposes of determining
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whether ESI performed qualified
research for purposes of Section 41(d).
More than 95% of the claimed QREs
were wage QREs, and of those, about
2/3 represented wages paid to Suder
— $8.6 million for 2004, and over $10
million for each of 2005-2007.
Tax Court decision
Qualified research
To determine whether ESI was
entitled to research credits, the Tax
Court first examined whether ESI
performed qualified research on the
12 projects. This required the court to
measure ESI’s work on each of the 12
projects against the so-called ‘fourpart test’ in Section 41(d). The IRS did
not dispute that the 12 projects
satisfied two prongs of the test — that
the research be undertaken to
discover technological information,
and that the information to be
discovered be useful in the
development of a new or improved
‘business component.’
With regard to the third part –
whether the expenditures connected
with the 12 projects are eligible for
treatment as expenses under Section
174 — the key issue was whether
uncertainty regarding the capability,
method, or appropriate design of the
12 projects existed at the beginning of
ESI’s product development activities
in each project. The court found that
the taxpayers presented ‘extensive’
and ‘credible’ evidence regarding
project uncertainty, and that various
aspects of this evidence contradicted
statements in the report and
testimony presented by the IRS expert
witness, who characterized ESI’s R&D
activities as routine. The court
concluded that there was at least one
uncertainty in capability, method, or
design at the beginning of each of the
12 projects, and therefore that all 12
satisfied the Section 174 test.
2
Under the fourth part of the Section
41(d) test, the taxpayer’s activities
must constitute a ‘process of
experimentation.’ The evidence
presented by the taxpayers persuaded
the court that “ESI clearly had in place
a very detailed, multi-level, systematic
process for development of all facets
of its phone systems,’ and therefore
that ESI used a process of
experimentation to resolve
uncertainties in all 12 projects.
The court, however, found that the
experimentation undertaken for one
of the 12 projects was not for a
‘qualified purpose,’ meaning one that
relates to a new or improved function,
performance, reliability, or quality.
The evidence presented by ESI
indicated that the Chameleon project
was undertaken to allow a user to
change the look and feel of an ESI
product. Projects undertaken for style,
taste, or cosmetic purposes are not
considered undertaken for qualified
purposes.
The Tax Court therefore found that 11
of the 12 projects satisfied the fourpart test for qualified research, and
therefore that 91.67% (11/12) of the 76
projects at issue constitute qualified
research.
Observation: The Tax Court found
that ESI’s qualified research activities
included senior management strategy
and project follow-up meetings,
regression analysis, and beta testing
within customer environments. IRS
examiners often challenge the
inclusion of such activities in research
tax credit examinations.
QRE support
The Tax Court then analyzed whether
ESI substantiated the claimed QREs.
As a preliminary matter, the court
accepted the taxpayers’ estimated
percentages of the time ESI employees
spent performing qualified services.
These employee percentages had been
made by Mr. Wende following years of
working closely with R&D consultants
on an R&D study for earlier tax years.
The court found that the combination
of Mr. Wende’s credible testimony,
the credible testimony of ESI’s other
witnesses, the credible testimony of
the government’s witnesses, and the
documentary evidence in the record,
supported Mr. Wende’s percentage
allocations as reasonable estimates of
the percentages of time ESI’s
employees spent performing qualified
services for 2004-2007.
The court distinguished its earlier
decision in Shami v. Comm’r, T.C.
Memo. 2012-78, explaining that “We
find the testimony petitioners
presented in these cases, unlike the
testimony in Shami, to be credible
and reliable” (emphasis added). (For a
discussion of Shami, see PwC Insight,
April 30, 2014.)
Observation: Once again, the Tax
Court reminds taxpayers of the
importance of credible testimony as a
method for providing adequate
documentation of claimed QREs.
Unreasonable compensation
The court then turned its focus to
Suder’s wages. To determine whether
the wages paid to Suder were
‘reasonable’ — a requirement for
deduction of R&D expenditures under
Section 174(e) that is identical to the
reasonable allowance requirement for
deductible salaries and compensation
under Section 162(a)(1) — the court
looked at several factors:
 Suder’s qualifications and work
duties
 Suder’s wages relative to his
stockholdings and the company’s
income
 Suder’s wages as research expenses
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 Suder’s wages compared with those
of other CEOs.
The court’s analysis of each of these
factors led it to conclude that Suder’s
compensation was unreasonable. The
court noted that, “perhaps the most
important factor in evaluating the
reasonableness of Mr. Suder’s
compensation for 2004-2007 was how
it compares to the compensation paid
by companies similar to ESI to CEOs
similar to Mr. Suder for performing
similar services.”
The taxpayers and the IRS each
presented an expert witness to testify
on this issue. The areas of expertise of
the IRS’s expert (Dr. Hafiz) are
transfer pricing and valuation. The
areas of expertise of the taxpayers’
expert (Mr. Longnecker) are executive
compensation and corporate
governance.
The court found Mr. Longnecker’s
report to be the more reliable of the
two. It therefore accepted his
computations of base salary, annual
incentives, and long-term incentives
at the 90th percentile for 2004-2007
as reasonable amounts that someone
in Suder’s position would be paid for
performing similar services.
However, the court rejected as
‘erroneous and unreliable’
Longnecker’s inclusion of a
substantial royalty component — $8.6
million for 2004, $8.8 million for
2005, $9.6 million for 2006, and
$10.1 million for 2007 — in his
estimate of reasonable compensation
for Suder for those amounts. The
court noted, “Petitioners admit in
their reply brief that ‘Eric Suder was
not, and has not, ever been
compensated through royalty
payments of any kind.’ It appears that
Mr. Longnecker included royalty
amounts in his compensation analysis
in an attempt to justify Mr. Suder’s
wages.”
Having accepted Longnecker’s
estimates (excluding the royalty
component) of reasonable
compensation for Suder, after having
accepted Wende’s percentage
allocation of Suder’s time — 75%
qualified services, 25% nonqualified
services — the court held that
reasonable wage QREs for Suder were
$1.7 million for 2004, $1.8 million for
2005, $1.9 million for 2006, and
nearly $2 million for 2007.
The court further found that while the
taxpayers had ‘substantially
understated’ their income for 20042007 due to their claiming excess
research credits, they had acted with
reasonable cause and good faith in
claiming the excess credits and
therefore were not liable for accuracyrelated penalties under Section 6662.
Observation: The unreasonable
compensation finding by the court
was based on reasoning from several
cases involving reasonable
compensation determinations in
closely held businesses. ESI is a
Subchapter S corporation that files a
Form 1120S return, and Suder owned
90% of its stock. It does not appear
that this analysis could be used to
exclude compensation of a highly
compensated employee of a publicly
traded company who owns at most a
very small percentage of the
company’s stock.
The takeaway
The taxpayers did not fully prevail in
this case because the Tax Court held
that a considerable portion of the S
corporation’s owner’s compensation
was not reasonable under Section
174(e), which significantly reduced
ESI’s claimed research credits.
However, because the taxpayers
provided substantial and credible
evidence — including written
documentation, expert reports, and
oral testimony — the court allowed the
taxpayers to claim the remaining
research credits and imposed no
penalties on the taxpayers for their
substantial understatement of income
for the years at issue.
The Suder decision thus serves as a
strong reminder of the importance of
credible documentation and
testimony in cases involving research
credit claims, which are highly
dependent on facts and
circumstances.
Let’s talk
For a deeper discussion of how this might affect your business, please contact:
Research & Development
Kendall Fox
+1 646 471 3261
kendall.b.fox@us.pwc.com
Brett Ritter
+1 703 918-6689
brett.ritter@us.pwc.com
Joe Maselli
(646) 471-5156
joseph.f.maselli@us.pwc.com
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