A recent court case provides guidance on owner compensation and when it qualifies as a research expense under §174. This qualification under §174 then dovetails with the §41 research and development (R&D) tax credit calculation and can have a huge impact. Many companies are led by entrepreneurs who spend significant time developing or improving the company’s products and processes rather than managing day-to-day operations. These qualifying activities can have a substantial impact on the size of a company’s credit.
In Eric G. Suder vs. Commissioner, Mr. Suder claimed that 75 percent of his time was devoted to research activities. Mr. Suder was the creative genius behind the company’s products, spending most of his time guiding product development from idea generation through testing. As a result, the company grew from a one-man, garage-based startup to a thriving 125-person organization. Like many entrepreneurial CEOs, Mr. Suder spent very little time managing day-to-day operations. Instead, his time was spent contributing to senior product strategy and follow up product meetings, reviewing product specifications, and researching networking technology that could be incorporated into the company’s products.
However, the IRS disallowed Mr. Suder’s R&D credits and also challenged whether the compensation paid to Mr. Suder was reasonable under §174. Mr. Suder argued that engineering’s role was to execute on his innovative ideas, and that his compensation was based on his creative contributions. Mr. Suder’s total compensation package during the period in question ranged from ~$8-11 million and was comprised of a base salary and bonuses, with bonuses based on growth, overall value and cash flow.
After a thorough analysis by the court, 75 percent of Mr. Suder’s salary was confirmed as qualified. Mr. Suder was able to convince the court through documentation and oral testimony that he participated heavily in research. Mr. Suder provided credible documentation supporting his research efforts.
With respect to his compensation, according to the law, “Under §174(e) a taxpayer may deduct a research and development expenditure only to the extent that the amount thereof is reasonable under the circumstances.” The amount of an expenditure is considered reasonable if “the amount would ordinarily be paid for like activities by like enterprises under like circumstances.” The court addressed the issue of “reasonable” with respect to how much of an owner’s compensation can be included in the credit computation. The court evaluated eight factors including the employee’s qualifications, the nature, extent and scope of the employee’s work, the size and complexities of the business, and the prevailing rates of compensation for comparable positions in comparable concerns.
After evaluating these factors and hearing from expert witnesses for Mr. Suder and the IRS, both of whom compared Mr. Suder’s wages to those of other CEOs performing similar services in similar companies, the court determined that while they agree with Mr. Suder’s high compensation as a CEO, the amounts were unreasonable under §174. The court determined that reasonable wages under §174 would be $2.3-2.6 million. These wage amounts represented base salary, annual incentive and long-term incentive. The court confirmed that wage comparison should be to that of other CEOs not to that of other employees within a company or other engineers or researchers.
The Suder case highlights that owners and other highly compensated executives who participate in R&D activities can be included in calculating the R&D credit. It also highlights the importance of supporting documentation as evidence of participation in qualified research activities.
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