Businesses claiming the research tax credit face a documentation challenge: documenting their research activities from nearly four decades ago.
The fixed-base percentage is part of the calcuaiton. It equires companies to access financial records from 1984 through 1988, a period when many businesses used paper filing systems and floppy disks. This requirement creates numerous practical difficulties that can significantly impact a company’s tax benefits.
The recent Sixth Circuit decision in Audio Technica U.S., Inc. v. United States, 963 F.3d 569 (6th Cir. 2020), explains these challenges and provides guidance on how courts view documentation issues in research credit disputes.
Facts & Procedural History
Audio Technica manufactures high-end audio equipment at its headquarters in Stow, Ohio. The company claimed the research tax credit under Section 41 for several tax years, including 2002-2005, 2006-2010, and 2011, based on its product development activities.
For the 2002-2005 and 2011 tax years, the IRS disputed Audio Technica’s claims, issuing notices of deficiency. Audio Technica filed petitions with the United States Tax Court. The parties reached settlements that were approved by the Tax Court. According to Audio Technica, these settlements used a fixed-base percentage of 0.92%.
For the 2006-2010 tax years, Audio Technica paid the disputed amounts and filed a refund suit in federal district court. As the case approached trial, Audio Technica filed a motion to prevent the government from challenging the 0.92% fixed-base percentage used in the Tax Court settlements. The district court granted this motion, finding that the government was judicially estopped from asserting a different percentage.
The government appealed, and the Sixth Circuit reversed, holding that the prior settlements did not judicially estop the government from challenging the fixed-base percentage.
The Fixed-Base Percentage Calculation
The research tax credit provides a valuable incentive for businesses to increase their research activities. Under Section 41, a taxpayer can claim a credit equal to 20% of the amount by which its qualified research expenses exceed a “base amount.” This base amount is calculated by multiplying the company’s average annual gross receipts for the previous four years by its fixed-base percentage. For companies that operated during the 1980s, the fixed-base percentage represents the ratio of qualified research expenses to total gross receipts during the five-year period from 1984 through 1988. This seemingly simple formula creates enormous documentation challenges for taxpayers. The lower a company’s fixed-base percentage, the higher its potential research tax credit. Even a small difference in this percentage can significantly impact the credit amount.
The Base Period Documentation Challenge
Documenting qualified research expenses (QREs) and gross receipts from the 1984-1988 period presents several fundamental obstacles. Wage QREs typically constitute the largest component of research expenses. To properly document these expenses, companies need to identify which employees performed qualified research activities, what percentage of their time was spent on qualifying activities, and their compensation during the base period. This requires access to decades-old payroll records, job descriptions, performance reviews, and project assignments. For many companies, these records may no longer exist or exist only in fragmented form. Former employees who performed the research have likely moved on, taking valuable institutional knowledge with them. Companies that underwent tax audits during or shortly after the base period may have some documentation preserved in their audit files, but these records are often incomplete for research credit purposes.
Companies must also document payments to outside contractors who performed qualified research on their behalf during the base period. This requires locating contracts from the 1980s, determining which contracts involved qualified research, documenting actual payments made to contractors, and applying the appropriate percentage limitations (generally 65% of payments qualify). Many companies routinely purge vendor files after standard retention periods (typically 7-10 years), making it extremely difficult to reconstruct contract research expenses from the 1980s.
Research supply expenses must be specifically tied to qualified research activities. This requires documentation showing what supplies were purchased, how they were used in qualified research, and that they were consumed or destroyed during the research process. Obtaining this level of detail for supply purchases made during the Reagan administration presents obvious practical challenges. Accounting systems from that era typically lacked the granularity needed to track supplies at the project level.
Companies must also document their total gross receipts from the 1984-1988 period. This generally requires access to tax returns from those years, financial statements, and sales records. While gross receipts documentation is often easier to obtain than QRE documentation (as companies typically retain tax returns and financial statements), companies that have undergone mergers or acquisitions may face significant challenges in reconstructing historical revenue figures.
The Changing Definition Challenge
Beyond the physical documentation challenges, taxpayers face another fundamental obstacle: the definition of “qualified research” has evolved significantly since the 1980s through legislative changes, regulations, and court decisions. The Tax Reform Act of 1986 substantially narrowed the definition of qualified research. Subsequent Treasury regulations, IRS Office of Appeals decisions, and court cases have further refined which activities qualify. This creates a troubling question: Should companies apply the definition that existed during the 1980s or the current definition when calculating their fixed-base percentage?
For consistency, most practitioners advocate applying current definitions to both the base period and the credit year. However, this approach requires companies to retroactively analyze 1980s activities under current standards—a difficult task when documentation was created under different legal frameworks. The evolving nature of qualified research definitions means companies must apply present-day standards to historical activities for which contemporaneous documentation was likely created under entirely different standards.
The Burden of Proof Hurdle
As the Sixth Circuit emphasized in the Audio Technica case, “taxpayers carry the burden of proving that they are entitled to tax deductions and credits.” This burden extends to establishing the correct fixed-base percentage. The court noted that “federal statutes that grant tax deductions and credits are matters of legislative grace and are strictly construed in favor of the government.” This strict construction means taxpayers must provide substantial evidence to support their claimed fixed-base percentage, even when documentation from the 1980s is difficult to obtain.
In practice, this creates a significant challenge: the IRS often demands contemporaneous documentation from the base period, while acknowledging that such documentation may no longer exist. This leaves taxpayers in the difficult position of developing reasonable reconstruction methodologies that will withstand IRS scrutiny. The absence of guidance regarding acceptable reconstruction methods further complicates taxpayers’ efforts to satisfy their burden of proof.
Strategies for Addressing Documentation Challenges
Given these difficulties, businesses claiming the research tax credit should consider several strategies. Companies should preserve any available documentation from the 1984-1988 period, including tax returns, financial statements, payroll records, project files and research notes, product development documentation, patent applications, engineering drawings and specifications, lab notebooks, and contracts with research partners.
For companies with incomplete records, reconstruction methods may include interviewing former employees who were involved in research activities during the base period, using industry standards or statistical sampling to estimate research time percentages, extrapolating from partial records, analyzing patent applications and technical publications from the base period, and using subsequent-year documentation to support the existence of earlier research activities.
While the Audio Technica case shows that prior settlements don’t create binding precedent, maintaining consistent positions can strengthen a taxpayer’s case if challenged by the IRS. Courts may view inconsistent positions skeptically, even if judicial estoppel doesn’t formally apply. Documenting the methodology for fixed-base percentage calculations and applying it consistently across tax years helps build credibility during audits and potential Tax Litigation. Sudden changes in methodology without clear justification may invite increased scrutiny.
The Alternative Simplified Credit
For many companies, the base period documentation issues have become too burdensome. Recognizing this problem, Congress created the Alternative Simplified Credit (ASC) method. The ASC eliminates the need to calculate a fixed-base percentage based on 1980s research activities. Instead, the credit amount is based on qualified research expenses over the previous three years. Specifically, taxpayers can claim a credit equal to 14% of the amount by which current-year qualified research expenses exceed 50% of the average qualified research expenses for the three preceding tax years. For companies without qualified research expenses in all three prior years, the credit rate is 6% of current-year qualified research expenses.
The ASC offers several advantages: it eliminates the need to document research activities from the 1980s, requires only three years of historical documentation, simplifies compliance by focusing on more recent records, and provides a viable path forward for companies with missing base period records. However, the ASC also has potential drawbacks. For companies with a very low fixed-base percentage under the regular method (like Audio Technica’s claimed 0.92%), the ASC may result in a smaller credit. Companies must weigh these factors when deciding which method to use.
It is worth noting that once a taxpayer elects the ASC method, they generally cannot switch back to the regular method in future years without IRS consent. This makes the decision to use the ASC a significant one that requires careful consideration of both short-term and long-term implications. Companies should perform a thorough analysis comparing the potential credit under both methods before making this election.
The Takeaway
The fixed-base percentage documentation requirement presents unique challenges for taxpayers claiming the research tax credit. Companies must locate and preserve decades-old records of qualified research expenses and gross receipts from the 1984-1988 period, often with limited guidance on how to address missing or incomplete documentation.
The Audio Technica case establishes that prior settlements with the IRS do not establish binding precedent for fixed-base percentage calculations in future tax years. Each tax year stands on its own, with the taxpayer bearing the burden to substantiate its claimed fixed-base percentage.
For businesses investing in research and development, understanding these documentation challenges is essential for maximizing and defending research tax credits. While the fixed-base percentage requirement creates significant burdens, proper planning, thorough documentation, and careful consideration of the Alternative Simplified Credit can help overcome these obstacles and secure this valuable tax benefit.
