The Internal Revenue Service (IRS) allows the taxpayer to capture only the amount of an employee’s wage that is allocated to performing qualified services. If the employee is performing both qualified and nonqualified services, the taxpayer must provide a reasonable estimate of the ratio the employee spent performing qualified services.
Although the IRS does not identify a specific person or employee who must allocate time to each employee, they do require the taxpayer to establish a nexus between the allocated time and the qualified services using adequate documentation. The person providing the time allocation must be credible and have direct knowledge of the activities being conducted by those who are being claimed with any qualified time.
Here are two main things to consider:
- What can a reasonable estimate be based on?
- Who can be allowed to provide estimates?
Both are very important to ensure requirements are met and can be backed up. All facts must be backed up based on the taxpayer’s actions, activities, records, and documents. Keep in mind that, in the event of an examination, the client’s Subject Matter Experts (SMEs) are the ones who the authorities will want to speak to – not their R&D consultants or the tax department. Therefore, it’s very important that the SMEs are the ones who relate information to us, including time allocation attestations, based on their intimate knowledge of the work they’re doing.
To determine an allocation of time spent by individuals who potentially performed qualified research, we must work with individuals who had direct knowledge of the activities by the employee for whom the allocation is necessary. Having an SME provide this type of time allocation is an acceptable practice, in the absence of any time-tracking or similar contemporaneous allocations, when the evidence provided by the taxpayer has been convincing.
In Fudim v. Commissioner, the court allowed allocations from Mr. Fudim, who had direct knowledge of the activities that he and his employees conducted. If an individual with direct knowledge of past activities is consulted in preparing the study’s time allocations, the evidence produced by such individual should be considered accurate and convincing.
This was further re-established in Suder v. Commissioner, where the court made no adjustments to allocations, and further supports this methodology where the SME has first-hand knowledge of the employee activities, the SME has a reasonable basis for allocations considering the role of the employee in the qualified research activities, there was adequate evidence of qualified projects, and sufficient examples of the employees’ roles in qualified projects. In this case, the taxpayer identified the Senior Vice President of product operations as the appropriate SME to allocate employee time spent performing qualified services. During the proceedings, it was uncovered that the SME was actively involved in qualified activities and intimately familiar with the research and development activities undertaken by the taxpayer. The Tax Court agreed that the identified SME was an appropriate choice to make the employee allocations, given his involvement and knowledge of the qualified services. This ruling established that testimony by a credible SME is sufficient to substantiate employee wage allocations for qualified activities, so long as they are credible, have direct first-hand knowledge of the activities, and it was based on corroborate records and documents.
In addition, several relevant cases have discussed the process in which taxpayers have allocated wages to qualified services, outlining some best practices for taxpayers. In Union Carbide Corp. v. Commissioner, the taxpayer claimed a percent of wage qualified research expenses (QREs) for the entire production staff based on the amount of time spent on experimental runs for qualified projects. Here, the taxpayer failed to identify specific employees who conducted qualified activities and the Tax Court held that the taxpayer failed to establish the nexus between qualified wages and the qualified activities. This ruling highlights the importance of identifying a SME with knowledge of employees and their activities to allocate time spent performing qualified services.
Using a SME to allocate employee time ensures the allocations are accurate and reliable. The SME will also have knowledge of documentation and communication that exists to quantify the allocations. Another applicable case that helped establish best practices for taxpayers is Shami v. Commissioner. The taxpayer claimed QRE wages for qualified activities where the wages of the Chief Executive Officer (CEO) and Executive Vice President (EVP) made up eighty percent of the claimed QREs. The taxpayer made this claim based on the fact that they were involved in direct research. The taxpayer failed to present any documentation to substantiate the allocated time for both the CEO and EVP. This ruling emphasizes the importance of accurate and reasonable allocations being based on corroborative records and documentation. Neither the CEO nor the EVP had any formal education or training in engineering or chemistry to perform qualified research, and they were not able to produce any corroborative records to prove that they were involved in the research activities.
This means that the SME will be able to make informed decisions about how to allocate employee time based on their expertise and understanding of the company’s processes and procedures. Additionally, using a SME to allocate employee time can help to ensure that all necessary documentation and communication is in place to track and report on the allocations. This can help to improve the overall efficiency and effectiveness of the company’s operations.
Using a SME to allocate employee time can also help to ensure compliance with tax regulations and laws. The SME will be able to accurately document and communicate the allocations, which can be used to substantiate any claims made to the IRS. This can help to minimize the risk of audits or disputes with the IRS and ensure that the company is in compliance with all relevant regulations. Overall, using a SME to allocate employee time can provide a number of benefits for a company, including improved efficiency, compliance with regulations, and accurate documentation and reporting.
References
1 CIR T.C. Memo 1994-235 (1994)
2 T.C. Memo 2014-201 (2014)
3 CIR T.C. Memo 2009-50 (2009)
4 CIR T.C. Memo 2012-78 (20120)