Suder v Commissioner (2014)

BACKGROUND

Suder v Commissioner T.C. Memo. 2014-201

In 1987, Eric Suder started Estech Systems, Inc (ESI), a tech company involved in developing telephone equipment and software. In 2004 to 2007 he owned 90% of the business. During these years ESI claimed R&D Tax Credit, and Suder claimed flow through credits on his personal returns (of $440,000+ each year). Douglas Boyd owned the other 10% of the business, and claimed $46,748+ each year.

These figures were found by estimating the time all employees spent on R&D activities. However, Suder was later disallowed the 2004-05 credits, and Boyd was disallowed the 2006-07 credits. A number of elements were in question, including:

  • the qualification of ESI’s 12 projects,
  • the eligibility of wages as QREs, and
  • the reasonableness of Suder’s wages.

FACTS & COURT’S DECISIONS

Qualifying Projects

To qualify, projects need to pass the four part test, in that projects must have/be: (1) technical uncertainty, (2) technological in nature, (3) new or improved business component(s), and (4) a process of experimentation. The IRS argued that ESI produced little evidence that showed its projects held technical uncertainty. Instead, it claimed that half of the projects were similar to other products available on the market. However, ESI was able to produce documented evidence that it faced challenges and uncertainties, and therefore the work was unique and not straightforward.

The IRS also claimed that ESI made choices because of ‘engineering knowhow’, rather than a thorough experimentation process. However, the court looked to Trinity Industries, Inc v U.S., where it was found that components bought do not function in isolation, and integrating them required R&D workAs such, the court identified that ESI had in place a systematic process for development of all facets of its phone systems. It also referred to United Stationers, Inc. v. United States and Norwest Corp v Commissioner, where R&D work done to existing software did not qualify. Comparatively, ESI was developing software from scratch. However, one project involved bug fixing of a commercially available product, and so didn’t qualify. So, 11 of ESI’s 12 project qualified.

Substantiation of QRE – Wages

Suder (ESI CEO) spent much of his time developing concepts and designs for innovative hardware and software. Boyd (ESI President and COO) overlooked manufacturing, tech support, sales, finance, and human resources departments. An R&D study was done to identify the QREs that ESI should claim; 75% of Suder’s time (i.e. wage) and 25% of Boyd’s time was claimed as R&D. Employees’ (e.g. engineers, product managers, etc) wages were commonly allocated as 100% R&D.

The IRS argued that ESI hadn’t substantiated QREs claimed, nor provided sufficient evidence for these estimates to be reasonable. The R&D study was performed by a third party, who corresponded with ESI’s Senior Vice President. The court found his experience, combined with the third party taxation assistance, was sufficient to make appropriate percentage allocations. This information was also backed by employee accounts. Wages made up for 95% of the company’s credit claim, and the remaining 5% was attributed to supplies which could be reasonable proven. As such, the court found that ESI effectively substantiated its QREs.

Reasonableness of Suder’s Wages

The reasonableness of Suder’s personal wages (i.e. compensation) was challenged by the IRS. Although most of his work at the company involved conceptual R&D work, by 2004 he was semi-retired and yet making $8,600,000+ each year. Suder’s and Boyd’s wages were proportionate to their shares (i.e. Suder 90%, and Boyd 10%) and moved up simultaneously. However, Suder’s wages were 5.5x ESI’s ordinary income, on average over 2004 to 2007. Also, in this time period, Suder’s wage was considerably higher than it had been in previous years, though he was not named on any patents during this time, which he had been previously. Using expert opinions, the court found that Suder’s base salary, annual incentive and long-term incentive all qualified; however, royalties (i.e. from patents) should not. The allowable wages for the CEO were therefore reduced, but still in the millions of allowable QREs.

LEARNINGS

The main takeaways from this case are:

  • What qualifies as QREs, including:
    • Senior management time (e.g. meeting time, concept designing, ‘steering production’, etc)
    • Management time (e.g. sign off on specifications, strategy meetings, etc)
    • Product managers’ time (e.g. testing, tracking bugs through the testing process, prioritizing issues)
    • Testing time (e.g.  developers’ unit testing, regression and smoke testing, alpha and beta testing phases, etc)
    • Patents, including patent applications not yet granted; particularly for executives who were listed as inventors on the patents
  • The use of estimates (Cohan rule) for employee wage QREs

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