Eric G. Suder, et al. v. Commissioner of Internal Revenue

October 1, 2014 | Vasquez, United States Tax Court Judge | Docket No. 14435-09, 14460-09, 6183-10, 6210-10

 

Short Summary

This case involves Eric Suder and his company, Estech Systems, Inc. (ESI), who claimed federal research tax credits for developing new telephone systems and related technology. The IRS challenged whether ESI’s projects truly qualified as research activities under the tax law, and whether the expenses, especially the CEO’s high wages, were reasonable for the credit. After reviewing the evidence, the Tax Court ruled that most of ESI’s projects did meet the requirements for the research credit, but found that the CEO’s wages were excessive and needed to be reduced for tax purposes. No penalties were imposed on the company or its owners. 

Key Issues

• Did ESI’s projects qualify as “research” for the federal research tax credit? 

  The court needed to decide if the work ESI did, such as designing new phone systems and adding features, truly counted as qualified research under the strict requirements of the tax code. This involved looking at whether their projects involved technical uncertainty, used scientific methods, and aimed to create new or improved products. 

• Were the claimed research expenses, especially employee wages, properly documented and reasonable? 

  A big part of ESI’s tax credit claim came from employee wages, with a large portion going to the CEO, Eric Suder. The court had to determine if these expenses were backed by good records showing who did what, and whether the CEO’s very high compensation was reasonable and related to research work, as required for the tax credit. 

• Should ESI or its owners face penalties for how they claimed the credit? 

  The IRS had proposed penalties because they believed ESI might have claimed credits they weren’t entitled to, either by mistake or carelessness. The court had to decide if ESI acted reasonably and in good faith, or if penalties should be applied for errors in their tax reporting. 

Primary Holding

The court decided that most of ESI’s projects did qualify for the federal research tax credit because they met the legal requirements for qualified research such as solving technical challenges and following a systematic development process. The court also found that ESI provided enough documentation to back up most of its claimed research expenses. However, the court ruled that the CEO’s wages were unreasonably high and had to be reduced when calculating the credit. Finally, the court determined that ESI and its owners acted in good faith and did not owe any penalties, since their credit claims were largely reasonable and well-documented. 

Specific Rulings 

1. Whether ESI’s projects qualified as research for the tax credit: 

   • Ruling: The court decided that 11 out of 12 of ESI’s projects met all the requirements for the research tax credit.
   • Reasoning: The court found that these projects involved real technical challenges, relied on engineering or computer science, and followed a systematic, step-by-step process to solve problems or create new products. The only project that didn’t qualify was one that focused solely on changing the “look and feel” (style) of the software, which Section 41 rules specifically excludes.
     
     

2. Whether ESI’s research expenses were supported and reasonable: 

   • Ruling: The court ruled that ESI had good enough records to back up most of its claimed research expenses. However, the court also decided that the CEO’s wages were unreasonably high and could not be fully counted toward the tax credit.
   • Reasoning: The court was convinced that ESI kept detailed records of who worked on what projects and for how much time. But when it came to the CEO’s compensation, the court found that his salary was far higher than what would be considered reasonable for his role and actual hours worked, so it had to be reduced for tax purposes.
     

3. Whether penalties should apply for the credit claims: 

   • Ruling: The court found that no penalties were owed by ESI or its owners.
   • Reasoning: The court believed that the company made a good-faith effort to follow the rules, kept thorough documentation, and relied on professional advice when preparing their tax returns. As a result, any mistakes were not due to negligence or intentional disregard of the law.

Helpful Takeaways For Taxpayers

• Document your research activities thoroughly. 

  Keep organized and detailed records of what your team is working on, including project descriptions, development timelines, employee roles, and how much time each person spends on research activities. Good documentation not only makes tax filing easier, but also gives you a strong defense if the IRS reviews your claim. In this case, the court gave credit to ESI’s careful recordkeeping, which helped support their research credit claims. 

• Focus on the substance of your projects, not just cosmetic changes. 

  To qualify for the research tax credit, your work needs to involve solving technical problems, overcoming uncertainty, or creating something genuinely new or improved. Changes that are only about looks or style, like adjusting colors or layouts, won’t qualify. The court in this case specifically denied the credit for a project that was only about changing the visual design, not the underlying technology. 

• Be realistic and reasonable with employee wage claims. 

  When including employee wages as part of your research expenses, make sure you are accurately reflecting the time employees spend on qualified research. This is especially important for high-paid employees or executives, whose roles may include a mix of research and other business duties. Overstating these wages can lead to part of your credit being denied, as happened with ESI’s CEO. 

• Seek expert advice and act in good faith. 

  Working with experienced tax professionals and following their advice shows that you are making a genuine effort to comply with the law. This can be crucial if there are questions about your claims. In this case, the company’s use of a tax consultant and its honest approach helped them avoid penalties, even though some claims were challenged.