Siemer Milling and Suder: Two court cases provide guidance on substantiation and the PoE requirement under L.R.C. & 41
When I was at the Service and leading the R&E Credit Program, the field often wished for more published guidance or law on substantiation requirements. There was never an appetite for it by Treasury or Congress and I get it, since taxpayer businesses vary, as well as their record keeping methods. A business must be more concerned with developing new products and processes to make a profit than keeping records to claim a research credit. To make matters worse the credit was temporary for decades and taxpayers were unwilling to invest in record keeping processes for a temporary credit.
However, it is worth remembering tax credits are a matter of legislative grace and taxpayers bear the burden of proving entitlement. The section 41 regulations provide that: “A taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. For the rules governing record retention, see § 1.6001‑1.” Treas. Reg. § 1.6001-1 provides the general record-keeping requirements that apply to all provisions of subtitle A of the Code.
These few sentences are the full extent of the statutory and regulatory requirements on what documentation taxpayers need to substantiate their claims. Given the lack of guidance, not surprisingly, the issue of substantiation in R&D credit cases has been litigated over the past decade, with the courts paying particular attention to the process of experimentation requirement.
Two recent cases, Siemer Milling, and Suder, (the former a win for the Service, the latter taxpayer favorable), provide valuable insight into the substantiation requirements, particularly the process of experimentation test.
While a comprehensive analysis of these cases is beyond this article’s scope, the key takeaway is both distinguish between the phrase “systematic trial and error” as used in Treas. Reg. § 1.41-4(a)(5)(i) from “simple trial and error.”
In Siemer, the Court concluded that the taxpayer failed to substantiate its process of experimentation for the 7 projects under review. Although it acknowledged the taxpayer performed testing and in some cases evaluated alternatives, the court concluded the taxpayer had nonetheless failed to show how these activities were part of a scientific process or systematic process of experimentation repeatedly stating “Siemer did not establish that it had a “methodical plan involving a series of trials to test a hypothesis, analyze data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.”
Unlike Siemer, the taxpayer in Suder demonstrated that it had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved 1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, 2) testing these alternatives in a scientific manner, 3) analyzing the results, 4) refining the initial hypothesis or discarding it for another if necessary, and 5) repeating the same, if necessary. Unlike Siemer, the taxpayer did set forth its new product development process, the steps involved, activities performed, and departments and employees responsible for those activities.
I see the Service slowly making progress in their effort to curtail non-qualified research credit from being claimed, by getting court opinions which more clearly define and stress the need for substantiation. Below are some observations and best practices to enable taxpayers to have a well-documented research credit that will stand up to challenges as they relate to the process of experimentation requirement.
- Taxpayers, like Suder, who can substantiate a formal product development lifecycle, for new or improved product development activities can likely demonstrate a process of experimentation. In these cases, an agent or engineer’s inquiry will generally shift to the purpose of the experimentation (i.e., whether it was used to resolve a technical uncertainty regarding capability, methodology, or product design, or simply validating a design that the taxpayer knew would work).
- Taxpayers who claim research for manufacturing activities (continuous improvement, Kaizen, etc.) where the research claimed often occurs “on-the-fly” and/or in the manufacturing environment, and often does not necessarily follow a structured process, will have a tougher, but not necessarily impossible, substantiation hurdle.
- A critical piece of documentation to have is a clearly stated Product Development Life Cycle (PDLC). The PDLC should not be generic but should reflect the company’s unique process and needs, discussing the steps in the PDLC process, the activities performed, and who performs those activities. This level of substantiation demonstrates that a business has a defined process to create new products or processes. Often, as with Suder, the process is formally documented to meet certain industry certifications and standards.
- For taxpayers like Siemer, where the PDLC may not be as well-defined, or where research is done “on-the-fly,” it is critical that the facts surrounding qualified research is substantiated by someone who can speak to what was actually done. Just speaking at a high level and regurgitating the code and regs without specifically showing what qualified research you did, will not cut it going forward.
- Document challenges/uncertainties faced at each step of the process to demonstrate that the experimentation was undertaken to resolve a technical uncertainty.
Now that the credit is permanent, some companies who have qualified research from year to year, would benefit from establishing internal processes to capture and document their research activity. Our staff, including me are qualified to assist you in ensuring you have a well-documented credit that will stand up under scrutiny.
 Treas. Reg. § 1.41-4(d).
 Siemer Milling Company v. Commissioner, T.C. Memo. 2019-37 (2019).
 Suder v. Commissioner, T.C. Memo. 2014-201 (2014).
 This language originated in Union Carbide Corp. & Subs. v. Commissioner, 97 TC Memo 2009-50. While this was an interpretation by the Court of what the word “systematic” used in Treas. Regs. § 1.41-4(a)(5)(i) means, it has now been directly applied in two court cases.
 Siemer at p. 32, citing Union Carbide Corp. & Subs. v. Commissioner, 97 T.C.M. (CCH) at 1256.