The Fifth Circuit has issued a ruling that affects the construction/engineering industries. In the case, United States vs. Leonard L. Grisby, the IRS claimed that Cajun Industries LLC did not perform any qualified research activities. Cajun is located in Baton Rouge, Louisiana, and performs basic engineering and design, front-end engineering design, and detailed engineering design for a multitude of clients. Specific to this court case, Cajun filed an amended claim for Fiscal Year 2013 which was fully disallowed due to failing to establish a proper business component and not having the substantial rights needed to claim the credit. The IRS also argued that Cajun had contracts that were considered funded.
So, what does this mean for construction/engineering industries? It means that you must establish the proper business component during your Four-Part Test and read your contracts CAREFULLY. When establishing a business component, it is not enough to say that you have a business component, you must state what that business component is and how the activities you are claiming relate to that development. When it comes to reading your contracts, if there is any indication that you created the work for someone else, you won’t be considered the owner in the IRS’s eyes. The IRS has also noted that if any terms and conditions go against your fixed-fee/lump-sum agreement, the IRS may challenge this and claim you were funded.
What should you consider when conducting your R&D studies if you are in this space? First, the IRS views the ‘product’ business component as a tangible good. Therefore, if you are providing a service, you are not developing a product. In this court case, Cajun argued a product approach yet focused on its “means and methods,” which the IRS viewed as a ‘process.’ Next, be on the lookout for contractual terms such as “works made for hire” as the IRS found this to indicate, in Cajun’s case, that they were developing the work for someone else thus they didn’t maintain substantial rights. Last, if your contract indicates that you will be compensated for all the expenditures incurred, notwithstanding that the contract was a “firm, fixed-price contract,” you may be considered funded. In Cajun’s case, their contracts had language conveying that they would receive full compensation for all loss, damages, or risks of every description.
The newly funded IRS is paying attention to corporate taxpayers in many arenas, including R&D tax credits. The agency is asking for granular detail on refund claims, and it’s asking for more detail on R&D tax credit claims with proposed changes to Form 6765. Such detail will help the IRS grant credits or challenge claims—as it did with Cajun—so robust reports and supporting documentation have never been more important. And that takeaway applies not just to the construction/engineering industries but to any taxpayer claiming the credit.
