NOTICE: IC § 6-8.1-3-3.5 and IC § 4-22-7-7 require the publication of this document in the Indiana Register. This document provides the general public with information about the Department's official position concerning a specific set of facts and issues. This document is effective on its date of publication and remains in effect until the date it is superseded or deleted by the publication of another document in the Indiana Register. The "Holding" section of this document is provided for the convenience of the reader and is not part of the analysis contained in this Letter of Findings.

The Department rejected Indiana Machining and Milling Company's argument that it was entitled to claim research expense credits; Machining and Milling Company's reliance on employee interviews, estimates, and statistical sampling did not clearly establish it was entitled to the credits.

I. Individual Adjusted Gross Income Tax - Qualified Research Expense Projects and Documentation.

Authority: IC § 6-3.1-4-1; IC § 6-8.1-5-1; IC § 6-8.1-5-4; IDOPCP, Inc. v. Comm'r, 503 U.S. 79 (1992); New Colonial Ice Co. v. Helvering, 292 US. 435 (1934); United States v. McFerrin, 570 F.3d 672 (5th Cir. 2009); Stinson Estate v. United States, 214 F.3d 846 (7th Cir. 2000); Conklin v. Town of Cambridge City, 58 Ind. 130 (1877); Lafayette Square Amoco, Inc. v. Indiana Dep't of State Revenue, 867 N.E.2d 289 (Ind. Tax Ct. 2007); Indiana Dep't. of State Revenue, Sales Tax Division v. RCA Corp., 310 N.E.2d 96 (Ind. Ct. App. 1974); I.R.C. § 41(d); Treas. Reg. § 1.174-2; Treas. Reg. § 1.41-4; Treas. Reg. § 1.6001-1(a).

Taxpayer argues that it conducted qualified, experimental research activities, that it can adequately document the wage expenses related to those projects, and that it is therefore entitled to claim the benefit of credits associated with the qualifying activities.

Taxpayers are individual shareholders/owners of an Indiana company which specializes in precision, computer-controlled milling, and machining. The company's customers include the U.S. military, firearm manufacturers, and aerospace industries.

For simplicity's sake, this Letter of Findings will hereinafter designate the Indiana company as "Taxpayer" because Indiana company is an S corporation which originally claimed the now disputed credits. Any business income - or tax liability - was "passed through" to the individual shareholders. It is those "pass-through" tax credits that are here in dispute.

Taxpayer originally filed 2014, 2015, and 2016 corporate income tax returns claiming no Indiana tax credits. However, along with their 2017 return Taxpayer amended the earlier returns to claim the credits.

In 2018, Taxpayer engaged a consulting firm ("Consultant") to review its 2014, 2015, 2016, and 2017 business activities and prepare a "research and expense study." In a research credit study report issued in 2018, the Consultant concluded that Taxpayer conducted qualified research activities entitling it to claim Indiana labor, supply, and service research expense tax credits which in turn passed on to the shareholders and reduced their own income tax liability.

The shareholders reported and claimed the "flow-through" credits on their individual income tax returns. Taxpayer claimed that it incurred approximately $2,000,000 in qualified research expenses entitling it to claim approximately $100,000 in research and expense credits for the years 2014 through 2017.

The Indiana Department of Revenue ("Department") thereafter conducted an income tax audit of Taxpayer. The Department's audit reviewed Taxpayer's tax returns, business records, and manufacturing records. The audit resulted in a decision denying Taxpayer's originally claimed research credits along with the credits which had "flowed through" and been claimed on the shareholders' individual income tax returns. On the ground that they were not entitled to the flow-through credits, the Department assessed the individual shareholders additional individual income tax because Taxpayer had not established it was entitled to claim the original credits.

Taxpayer disagreed with the Department's decision disallowing the credits and the shareholders' assessments. Taxpayer submitted a protest to that effect. An administrative hearing was conducted during which Taxpayer's representatives explained the basis for the protest. This Letter of Findings results.

I. Individual Adjusted Gross Income Tax - Qualified Research Expense Projects and Documentation.

The Department issued the proposed assessments because it concluded that Taxpayer's activities did not meet the definition of "qualified research." The audit also concluded that Taxpayer was unable to verify the amount of time during which Taxpayer's employees were purportedly engaged in activities which met the definition of "qualified research." As a result of the credit denial, the Department issued the shareholders proposed assessments of additional income tax.

The issues are whether Taxpayer conducted qualifying research activities and whether it can document the extent to which Taxpayer conducted those qualifying activities.

During the years 2014 through 2017, Taxpayer claimed approximately $2,000,000 in qualifying research expenses ("QREs") entitling it to approximately $100,000 in Indiana Research Expense Tax Credits ("RECs"). The "qualifying expenses" stemmed entirely from wage expenses.

The Department's audit concluded that the company's activities did not "overcome the 4-part test" required under I.R.C. § 41(d) which defines "qualified research" as research:

I.R.C. § 41(d) sets out this four-pronged test for verifying qualified research activities. First, the research must have qualified as a business deduction under I.R.C. § 174. I.R.C. § 41(d)(1)(A). Second, the research must be undertaken to discover information "which is technological in nature." I.R.C. § 41(d)(1)(B)(i). Third, the taxpayer must intend to use the information to develop a new or improved business component. I.R.C. § 41(d)(1)(B)(ii). Finally, the taxpayer must pursue a "process of experimentation" during substantially all of the research. I.R.C. § 41(d)(1)(C).

The audit found that Taxpayer's expenditures did not meet the first test - verifying qualified research and experimental expenditures - based on the definition set out in Treas. Reg. § 1.174-2 which states in part:

The audit found that Taxpayer "did not track any research and development expenses and the auditor was unable to verify the amount claimed on the returns . . . ." In addition, the audit found that Taxpayer had categorized these same expenses as either wages or cost of labor under I.R.C. § 174 on its corresponding federal returns.

The audit concluded that the expenses "were directly charged to the jobs being completed by the taxpayer as ordinary and necessary business expenses under section 162 . . . ."

As to the second of the four tests, the Department's audit did not agree that Taxpayer's activities led to the discovery of information or technology which expanded upon and added to the common knowledge of other milling and machining companies. As authority for its position, the Department cited to Treas. Reg. § 1.41-4(a)(3)(i) of the 2001 Final Regulations which states:

T.D. 8930, 66 F.R. 280-01 at 290.

The audit cited to Treas. Reg. § 1.41-4(a)(3)(ii) (T.D. 8930) for the definition of "common knowledge." The regulation provides:

The audit also cited to Treas. Reg. 1.41-4(a)(3) (T.D. 9104) and rejected Taxpayer's contention that it was conducting qualified research necessary to resolve "uncertainties." As stated in the audit report:

The audit noted that Taxpayer had been in the business of machining and milling metal parts for over 50 years and "has several long-time employees with education and experience in the design and programming of the CNC [Computer Numerical Control] machines."

The audit concluded that the claimed expenses did not qualify for the credits because Taxpayer was "not discovering information that is technological in nature" but was simply conducting a reasonable and well-trodden investigatory process of an existing level of information familiar to its long-time employees. As to the second test, the audit concluded that "taxpayer is not discovering information that is technological in nature."

. . . .

As noted in the audit report, "[D]uring the plant tour the taxpayer told the auditors that they would not take a job that they did not know they could do."

As to the third of the four tests, the audit report explained that every QRE expense claimant must "tie the qualified research expenses it is claiming for the credit to the relevant business component." The audit found that Taxpayer failed to adequately "tie" the labor expenses to any of its projects.

Under the Business Component Test, the taxpayer must intend that the information to be discovered during its research will be useful in the development of a new or improved business component of the taxpayer. I.R.C. § 41(d)(1)(B)(ii). A "business component" is a product that the taxpayer either holds for sale, lease, or license or uses in its trade or business. I.R.C. § 41(d)(2)(B). For purposes of this test, the taxpayer must identify the business components for which it claims qualified research activities.

When questioned about the "component" standard, the audit found that Taxpayer was able to cite to the consulting firm's "research and expense study," but the audit criticized this singular reliance because the study itself "could not tie any of the employees' activities or the majority of the time to a specific project (business component)." According to the audit report, "The [Consultant] estimated the time spent by the majority of the employees doing research based on interviews conducted with the Vice President of Manufacturing and the Vice President of Marketing and Sales."

As to the third test, the audit concluded that because it was unable to "tie" any particular component to the activities of any specific employee, "[T]he taxpayer's activities fail the third test [because] the information must be intended to develop a new or improved business component."

Finally, as to the fourth test, the audit referred to Treas. Reg. § 1.41-4(a)(5) (T.D. 8930) which states in part:

The audit also cited to Treas. Reg. 1.41-4(a)(5)(a) (T.D. 9104) which provides in part:

The audit found that Taxpayer failed to meet the "experimentation" standard under either the "discovery" or "uncertainty" tests. As stated in the audit report, "[T]axpayer's capability and method for developing or improving the business component are very certain." Rather, "[T]axpayer has been in the business for many years and has several employees with education/experience to do the job." The audit report further explained:

The audit concluded that under Treas. Reg. § 1.41-4(a)(5) (T.D. 8930), Taxpayer failed to meet the requirement that a claimant engage in a process of "experimentation" because "the [T]axpayer's capability and method for developing or improving the business component are certain [and] the [T]axpayer's evaluation of an alternative to establish the appropriate design is not a process of experimentation."

The audit took an additional step by evaluating the experimentation standard under the Treas. Reg. § 1.41-4(a)(5) (T.D. 9104) less restrictive "uncertainty test." The audit concluded that Taxpayer also failed to meet this less restrictive uncertainty test. The audit report stated:

In other words, even under Treas. Reg. § 1.41-4(a)(5) (T.D. 9104), any "uncertainty" at the outset of a Taxpayer project was insufficient to meet the experimentation standard. In doing so, the audit cited to the preamble of Treas. Reg. 1.41-4 (T.D. 9104) which provides that "merely demonstrating that uncertainty has been eliminated (e.g., the achievement of the appropriate design of a business component when such a design was uncertain as of the beginning of a taxpayer's activities) is insufficient to satisfy the process of experimentation requirement."

Even assuming that Taxpayer established that it was engaged in qualifying research activities, the Department's audit found that Taxpayer failed to adequately document the time and labor expenses which formed the basis for the claimed research credits. Most relevant, the audit found that Taxpayer failed to meet the documentation and substantiation standard under Treas. Reg. § 1.41-4(d) (T.D. 9104). The regulation sets out record keeping and documentation requirement for expenses related to the research credit:

The audit also cited to Treas. Reg. § 1.41-4(d) which sets out the record keeping and documentation requirement for expenses related to the REC:

In turn, Treas. Reg. § 1.6001-1(a) - referred to above - provides:

The audit report also pointed out to Indiana's own general record keeping requirement.

The audit report summarized the standard under which it evaluated Taxpayer's efforts to verify the labor expenses stating that "[t]he common theme in all of the legal authorities . . . is that the [T]axpayer must keep records to substantiate the amounts reported on its returns" and Taxpayer "must have contemporaneous documentation that was prepared before or in the early stages of the research project that describes the principal questions to be answered and the information the [T]axpayer seeks to obtain."

Under either of these standards, the audit concluded that "[T]axpayer has not provided . . . contemporaneous documentation . . . to support the employee research participating percentages that it used to calculate the qualified research expenses (QREs)."

Taxpayer disagrees with the Department's conclusion that it does not engage in qualifying research activities. Instead, it is Taxpayer's contention that its "business components were all unique and required independent analysis to develop the appropriate design of same." In support of this contention, Taxpayer cites to numerous projects which it undertook during the relevant period. For example, Taxpayer points to the development of a "stand-alone depression stop" for one its customers.

Taxpayer also points to a project which required it to "produce a belt bracket for the [a customer] . . . made from 4101 alloy steel."

As a third example of a milling project that required the expenditure of qualified research expenses, Taxpayer points to a project that required it to develop the manufacturing process for an "aviation aerospace project."

Taxpayer concludes that it engages in an "interative" process of "trial and error" during the development and implementation of each of its projects which satisfies each of the four distinct tests set out in I.R.C. § 41(d)(1). Taxpayer summarizes as follows:

In effect, Taxpayer finds it unnecessary to tie its expenses to any particular business component because it regards its entire design and manufacturing process, from inception to execution, as the requisite component.

The Department finds it unnecessary to evaluate whether Taxpayer's projects meet each of the I.R.C. § 41(d)(1) four distinct tests concluding that, in this regard, the audit report stands on its own and because the disputed credit issues are resolved by addressing the documentation issue. Without minimizing Taxpayer's obvious experience, sophistication, and history and without conceding Taxpayer's arguments as to whether these projects constitute "qualified research," this Letter of Findings addresses the documentation issue.

At the core of Taxpayer's argument, Taxpayer concludes that "Indiana law does not require taxpayers to substantiate with written documentation." Nonetheless, Taxpayer argues that it has provided over four hundred pages of supporting documentation including project summary reports, financial documents, design drawings, "travelers," and contracts sufficient to supports its claims to the credits. Taxpayer explains:

Specifically, Taxpayer cites to IC § 6-8.1-5-1(b) which provides:

Taxpayer believes that the four hundred pages of documents provided constitute the "best information available" and that the Department is not only entitled but is required to rely on that information. As explained by Taxpayer, "Indiana does not require substantiation by documentation [and] that documentation is not necessary to prove a taxpayer engaged in a particular activity in the tax years at issue."

Tax assessments are prima facie evidence that the Department's assessment of tax is presumed correct; the taxpayer bears the burden of proving that the assessment is incorrect. IC § 6-8.1-5-1(c); Lafayette Square Amoco, Inc. v. Indiana Dep't of State Revenue, 867 N.E.2d 289, 292 (Ind. Tax Ct. 2007).

IC § 6-3.1-4-1 provides that, "'Research expense tax credit' means a credit provided under this chapter against any tax otherwise due and payable under IC 6-3." Similar to deductions, exemptions, and exclusions, tax credits - such as RECs - "are matters of legislative grace." Stinson Estate v. United States, 214 F.3d 846, 848 (7th Cir. 2000).

The taxpayer who claims the tax credit is required to retain records necessary to substantiate a claimed credit. Indiana and federal law require that a taxpayer maintain and produce contemporaneous records sufficient to verify those credits. See Treas. Reg. § 1.41-4(d). (See also IC § 6-8.1-5-4(a) which requires that taxpayers keep records). Where such a credit is claimed "the party claiming the same must show a case, by sufficient evidence, which is clearly within the exact letter of the law." Indiana Dep't. of State Revenue, Sales Tax Division v. RCA Corp., 310 N.E.2d 96, 100-01 (Ind. Ct. App. 1974) (citing Conklin v. Town of Cambridge City, 58 Ind. 130, 133 (1877)).

Citing Stinson Estate, the circuit court in United States v. McFerrin summarized that "[t]ax credits are a matter of legislative grace, are only allowed as clearly provided for by statute, and are narrowly construed." United States v. McFerrin, 570 F.3d 672, 675 (5th Cir. 2009). See also New Colonial Ice Co. v. Helvering, 292 US. 435, 440 (1934) ("Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefor can any particular deduction be allowed.")

The Consultant's study relied on a sampling of hundreds of Taxpayer's projects. In the face of the large number of Taxpayer's projects, the Consultant employed a "sampling methodology" prepared by a degreed statistician who selected 24 projects which were "independently analyzed through a review of contemporaneous documentation, in connection with employee interviews, to identify the qualified R&D activity undertaken in each project." To that end, the Consultant interviewed employees and also members of its executive team including the Vice President of Marketing, the Vice President of Marketing and Sales, and the President. Wage allocations were determined on a "project based" analysis. To determine which employees worked on which project, the study relied on the executive-level interviews. Based on those interviews, the Consultant attributed a percentage of each individual employee's qualified activities compared to that particular employee's total wages. In instances in an employee's research activities passed the 80 percent threshold, the claimed qualifying wages were changed to 100 percent based on the "substantially all rule." See I.R.C. § 41(d)(1)(C), -3(A).

As noted above, the audit found this methodology deficient. As explained in the resulting audit report:

In addition, the audit noted that qualifying wages included costs attributed to paid employee leave time.

Setting aside issues related to whether Taxpayer was engaged in qualified research, Taxpayer disagrees with the audit's finding that it failed to adequately document its employees' specific activities and wages attributable to those projects. Taxpayer does not argue that it maintained a system of project accounting in order to accurately quantify the research expenses. Instead, Taxpayer relies on employee surveys, job titles, wage statements, and project descriptions in concluding that the Taxpayer paid its employees approximately $2,000,000 million to research and develop methodologies necessary to satisfy their customers' requirements.

While the Department recognizes Taxpayer's apparent good-faith efforts to estimate the qualifying wages of their employees, the Department rejects Taxpayer's argument that the Department is precluded from demanding specific, contemporaneous documentation and that "documentation is not necessary to prove taxpayer engaged in a particular activity in the tax year(s) at issue." Instead, the Department finds the law on this issue clear.

Treas. Reg. § 1.41-4(d) (T.D. 8930) sets out the record keeping and documentation requirement for expenses related to the research credit. As noted above, the regulation requires that a claimant must "[p]repare[] documentation before or during the early stages of the research project, that describes the principal questions to be answered and the information the taxpayer seeks to obtain . . . ." (Emphasis added).

Treas. Reg. § 1.41-4(d) (T.D. 9104) restates the record keeping requirements as follows:

Again, as noted above, Indiana imposes its own record keeping requirement at IC § 6-8.1-5-4(a). The statute requires that each taxpayer "must keep books and records so that the department can determine the amount, if any, of the person's liability for that tax . . ." and requires that the taxpayer keep and maintain "all source documents necessary to determine the tax . . . ."

The Department rejects Taxpayer's argument that it may substantiate and claim the credits "when taxpayers have no documentation of expenses at all." The Department finds that the argument grossly oversimplifies the relevant regulatory requirement and statutory requirements. Instead, it is Taxpayer's statutory obligation to prepare, keep, retain, maintain and produce to the Department contemporaneous records sufficient to verify the credits which it claims pursuant to IC § 6-3.1-4-1 and IC § 6-8.1-5-4. This is especially true in the case of the RECs for which the I.R.C. imposes stringent and detailed parameters and which - if Taxpayer seeks to obtain the benefit of those credits - Taxpayer is required to meet. Treas. Reg. § 1.41-4(d) (TD 8930) and Treas. Reg. § 1.41-4(d) (TD 9104). Under either version, the regulation requires that "any person required to file a return of information with respect to income, shall keep such permanent books of account or records including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information." Treas. Reg. 6002-1.

Indiana case law speaks in general to the issue of the standard required to establish one's entitlement to credits such as that sought by Taxpayer. "[A]n income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the claimed deduction is on the taxpayer." IDOPCP, Inc. v. Comm'r, 503 U.S. 79, 84 (1992). Moreover, where such a credit is claimed, "the party claiming the same must show a case, by sufficient evidence, which is clearly within the exact letter of the law." RCA Corp., 310 N.E.2d at 100-01. (Emphasis added). Thus, every taxpayer's claim against any tax must be supported by records necessary to substantiate the claimed credits and those records are required to be "kept" and "retained" "before or during the early stages of the research project."

The Department rejects Taxpayer's argument that the issue is governed by the "best available information" language found in IC § 6-8.1-5-1(b) because the premise turns the statute on its head. In cases in which the Department audits or reviews a taxpayer's return, the Department is required to issue an assessment. If the taxpayer's documentation is either insufficient or non-existent, the Department is entitled to rely on whatever information it can gather provided that it is the "best" information obtainable. In instances in which a taxpayer is claiming a credit, that taxpayer is required to document that credit by evidence which is with the exact letter of law. RCA Corp., 310 N.E.2d at 100-01.

In this case, Taxpayer asks that the Department broadly interpret the REC record keeping requirements to encompass - as explained in the audit report - estimated wage allocations for employees who dedicated their time to develop support or supervise the development of new and improved designs and manufacturing methods. What Taxpayer here seeks is a form of "summary judgment" in which the Department administratively overturns the audit's finding that the Taxpayer did not provide records to clearly substantiate the amounts of credits reported on its returns and did not provide contemporaneous documentation to support the employee research participation percentages that Taxpayer used to calculate the qualified research expenses. Even if the Department were to agree - and it did not - that Taxpayer likely conducted qualifying research, the Department is unable to agree that there is sufficient quantifiable and verifiable information to allow the credits in the amount originally requested and as here protested.

The Department concludes that Taxpayer has not met the record keeping requirements set out in Treas. Reg. § 1.41-4(d) (TD 8930), Treas. Reg. § 1.41-4(d) (TD 9104), Treas. Reg. 6001-1, and IC § 6-8.1-5-4(a).

The Department is unable to agree that Taxpayer presented documentation of qualifying activities which clearly and plainly established that it was entitled to the $100,000 in credits originally claimed. The Department is also unable to agree that Taxpayer meet its burden under IC § 6-8.1-5-1(c) of establishing that the assessments were "wrong" and its claim to income tax credits was established with "sufficient evidence" which was "clearly within the exact letter of the law." RCA Corp., 310 N.E.2d at 100-01.

Taxpayer's protest is respectfully denied.

February 26, 2021

Posted: 04/28/2021 by Legislative Services Agency