Siemer Milling Company v. Commissioner of Internal Revenue

 April 15, 2019 | David Buch, Judge | United States Tax Court | Docket No. 21655-15

Short Summary

In the case of T.C. Memo. 2019-37, Siemer Milling Company v. Commissioner of Internal Revenue, the United States Tax Court examined whether Siemer Milling Company (Siemer) was entitled to research and development (R&D) tax credits under section 41 of the Internal Revenue Code (IRC) for its activities during the tax years ending May 31, 2011, and 2012. Siemer, an Illinois-based wheat milling company, claimed credits for various projects aimed at developing new processes and products. The primary question was whether the expenses claimed by Siemer qualified as research expenses under the IRC. The court ultimately decided that Siemer did not meet the necessary criteria to qualify for the R&D tax credits.

Key Issues

1. Qualification of Research Expenses: Whether the expenses Siemer claimed for its research activities met the definition of “qualified research expenses” under section 41 of the IRC.
2. Burden of Proof: Whether Siemer successfully proved that its expenses were indeed qualified research expenses, overcoming the presumption of correctness of the IRS’s determination.
3. Process of Experimentation: Whether Siemer’s activities constituted a “process of experimentation” as required by the IRC to qualify for the R&D tax credits.
4. Technological Information: Whether the research was conducted for the purpose of discovering information that is technological in nature and useful in the development of a new or improved business component.
5. Accuracy-Related Penalties: Whether Siemer was liable for accuracy-related penalties under section 6662 for negligence or disregard of rules and regulations, or for a substantial understatement of income tax.

Holding

1. Non-Qualification of Expenses: The court held that Siemer did not prove its expenses were qualified research expenses under section 41. Siemer failed to demonstrate that the activities met the required criteria for a process of experimentation, technological information, or a specific business component.
2. Failure to Meet Burden of Proof: Siemer did not provide sufficient evidence to overcome the IRS’s determination. The company’s documentation and testimonies were not enough to establish that their activities were qualified research under the IRC.
3. Rejection of Process of Experimentation: The court found that Siemer’s projects lacked the necessary methodical plans involving testing hypotheses, analyzing data, refining hypotheses, and retesting to constitute a scientific process of experimentation.
4. Technological Information Criteria Not Met: The court determined that Siemer did not adequately show reliance on principles of the physical or biological sciences, engineering, or computer science. The activities were more aligned with routine quality control and evaluation of existing products rather than technological innovation.
5. No Accuracy-Related Penalties: Despite the disallowance of the credits, the court found that Siemer was not liable for accuracy-related penalties. The company had reasonably relied on the expertise of its long-time accounting firm, CliftonLarsonAllen, LLP (CLA), demonstrating good faith and reasonable cause in its claims.

Specific Issues/Rulings

Qualification of Expenses for R&D Tax Credits

Court Ruling: The court ruled that Siemer Milling Company did not meet the requirements to qualify for R&D tax credits under section 41 of the IRC for the tax years ending May 31, 2011, and 2012.

Justification: The court found that Siemer failed to prove that its expenses were qualified research expenses. Despite Siemer’s arguments and the preparation of credit studies by its accounting firm, CliftonLarsonAllen, LLP (CLA), the court determined that the company’s documentation and evidence were insufficient. Specifically, the court noted that Siemer’s activities did not constitute a process of experimentation, a key requirement for qualifying research. The court found that the activities described by Siemer, such as mechanical maintenance and routine quality control, did not demonstrate a methodical plan involving scientific experimentation.

Compliance with Section 174 Test

Court Ruling: The court ruled that Siemer Milling Company did not satisfy the section 174 test, which requires that research activities be intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.

Justification: The court concluded that Siemer did not face sufficient uncertainty regarding its projects to meet the section 174 test. For example, Siemer claimed that it was unsure about the speed at which the Pulsewave machine could operate effectively. However, evidence showed that testing on similar machines had already been conducted at higher speeds, and the improvements Siemer made were more aligned with mechanical maintenance than genuine research aimed at resolving uncertainty. Additionally, the court found that Siemer’s documentation lacked details on the uncertainties faced and how its activities aimed to resolve these uncertainties, further failing to meet the section 174 criteria.

Technological Information Test

Court Ruling: The court ruled that Siemer Milling Company did not meet the technological information test, which requires that research be conducted for the purpose of discovering information that is technological in nature, relying on principles of physical or biological sciences, engineering, or computer science.

Justification: The court determined that Siemer did not adequately demonstrate reliance on principles of the physical or biological sciences, engineering, or computer science. Siemer’s projects, such as the Pulsewave and ozone projects, were described in general terms without clear references to specific scientific principles or methodologies. The court noted that Siemer did not employ individuals with relevant engineering or scientific degrees and failed to identify the precise technological principles underpinning its research. This lack of specificity and technical detail led the court to conclude that Siemer’s activities did not constitute technological research as required by section 41. The court emphasized that mere assertions of scientific reliance without substantive evidence and detailed documentation are insufficient to meet the technological information test.

Business Component Test

Court Ruling: The court ruled that Siemer Milling Company did not meet the business component test for the projects claimed for the tax years ending May 31, 2011, and 2012.

Justification: The court found that Siemer did not sufficiently establish that its research was aimed at developing a new or improved business component, such as a product or process used in its trade or business. The court noted inconsistencies in Siemer’s descriptions of the business components related to its projects. For example, during the trial, Siemer’s vice president, Mr. Tegeler, described the projects as “processes” aimed at developing products, while on brief, Siemer referred to them as either process or product improvements or a combination of both. This inconsistency weakened Siemer’s position. Furthermore, Siemer did not provide specific evidence or detailed documentation to clarify the precise business components involved. The lack of clear identification and focus on a specific product or process led the court to conclude that Siemer did not satisfy the business component test.

Process of Experimentation Test

Court Ruling: The court ruled that Siemer Milling Company did not meet the process of experimentation test for its claimed research activities.

Justification: The court determined that Siemer’s activities did not constitute a process of experimentation. To qualify, research activities must involve a methodical plan to evaluate alternatives to achieve a desired result, with substantial uncertainty as to the capability, method, or design of achieving that result. The court found that Siemer’s projects lacked evidence of a structured method involving a series of trials to test a hypothesis, analyze data, refine the hypothesis, and retest it. For instance, Siemer’s activities, such as adjusting the speed of the Pulsewave machine or introducing ozone into the milling process, were not supported by detailed documentation or a clear experimental plan. The court noted that the descriptions of the activities were general and lacked specifics about the scientific methods used. This absence of detailed, methodical experimentation led the court to conclude that Siemer did not engage in a true process of experimentation as required by section 41.

Substantially All Requirement

Court Ruling: The court ruled that Siemer Milling Company did not meet the “substantially all” requirement, which mandates that at least 80% of the research activities constitute elements of a process of experimentation.

Justification: The court found that Siemer did not provide sufficient evidence to demonstrate that substantially all of its research activities were part of a process of experimentation. Since Siemer failed to establish that its activities constituted a process of experimentation, it consequently could not show that 80% or more of those activities met this criterion. The court noted that Siemer’s assertions about meeting the “substantially all” requirement were largely conclusory and unsupported by detailed evidence or documentation. Without clear evidence showing that a significant portion of the activities were indeed part of a systematic experimental process, the court could not find in favor of Siemer on this issue. Thus, Siemer’s inability to substantiate its claims with robust evidence resulted in the failure to meet the “substantially all” requirement.

Documentation and Evidence

Court Ruling: The court ruled that Siemer Milling Company did not provide adequate documentation and evidence to support its claims that the activities met the requirements for qualified research expenses.

Justification: The court found that Siemer’s documentation was insufficient to substantiate its claims for the R&D tax credits. The credit studies prepared by CliftonLarsonAllen, LLP (CLA), were based on interviews and estimates rather than concrete, contemporaneous records. Many documents were undated, and their authors and sources were not identified. This lack of precise and detailed documentation made it difficult for the court to determine the exact nature and extent of the research activities. Furthermore, the court noted that Siemer did not call several key employees who could have provided firsthand testimony about the research projects. The reliance on hearsay evidence and general descriptions rather than specific, verifiable documentation led the court to conclude that Siemer failed to provide adequate evidence to support its claims.

Fixed-Base Percentage Calculation

Court Ruling: The court did not need to make a definitive ruling on the accuracy of Siemer’s fixed-base percentage calculation because the company failed to prove that its expenses were qualified research expenses.

Justification: Since Siemer did not meet the burden of proving that its research activities qualified for the tax credits, the issue of whether the fixed-base percentage was accurately calculated became moot. However, the court did note that Siemer’s fixed-base percentage had been adjusted based on estimates and interviews rather than solid historical data. This approach raised concerns about the reliability of the calculations. Siemer initially reported a fixed-base percentage of 3% but later amended it to 0.2% based on retrospective estimates. The lack of contemporaneous records to support these estimates further weakened Siemer’s position.

Eligibility for Accuracy-Related Penalties

Court Ruling: The court ruled that Siemer was not liable for accuracy-related penalties under section 6662 for negligence, disregard of rules or regulations, or substantial understatement of income tax.

Justification: The court found that Siemer acted with reasonable cause and in good faith by relying on the expertise of its long-time accounting firm, CLA. The penalties under section 6662 apply when there is a substantial understatement of income tax or negligence, which includes failure to make a reasonable attempt to comply with the tax code. Siemer demonstrated that it relied on CLA, a competent professional firm with a history of preparing Siemer’s financial audits and tax returns. CLA had “open access” to Siemer’s records and conducted interviews to gather information. The court concluded that Siemer’s reliance on CLA’s advice constituted reasonable cause and good faith, protecting it from liability for accuracy-related penalties.

Reasonable Cause and Good Faith Defense

Court Ruling: The court ruled that Siemer acted with reasonable cause and in good faith in relying on the advice of its accounting firm, CliftonLarsonAllen, LLP (CLA), thereby avoiding accuracy-related penalties.

Justification: The court applied a three-prong test to determine reasonable reliance: (1) the adviser must be a competent professional with sufficient expertise, (2) the taxpayer must provide necessary and accurate information to the adviser, and (3) the taxpayer must actually rely in good faith on the adviser’s judgment. The court found that CLA was a competent professional firm with substantial expertise in tax matters and credit studies. Siemer provided CLA with complete access to its records and facilitated interviews with key personnel. Additionally, Siemer’s chief financial officer, Mr. Brumleve, testified that the company relied on CLA’s expertise when preparing its tax returns and credit studies. There was no evidence to suggest bad faith or negligence on Siemer’s part. Consequently, the court ruled that Siemer’s actions met the criteria for reasonable cause and good faith, shielding it from accuracy-related penalties.

Key Takeaways for Taxpayers

The Siemer Milling Company v. Commissioner of Internal Revenue case highlights some key insights for taxpayers looking to successfully claim R&D tax credits. One of the main takeaways is the importance of keeping thorough and detailed documentation of research activities. This includes maintaining records of dates, objectives, methodologies, and results to clearly demonstrate the innovative work being conducted. It’s also beneficial to show a clear process of experimentation, where hypotheses are tested, data is analyzed, and improvements are made based on findings.

Additionally, clearly identifying the specific business components, such as new or improved products or processes, that are the focus of your research is essential. This helps in meeting the criteria for the business component test under section 41. While the case showed the importance of providing concrete evidence, it also demonstrated that relying on the expertise of a professional accounting firm can be very helpful. By working closely with knowledgeable tax professionals and giving them full access to relevant records, you can navigate the complexities of the R&D tax credit more effectively.

Overall, this case reinforces that with meticulous preparation and the right professional support, claiming R&D tax credits is very achievable and beneficial for businesses engaged in innovation and development. By following these guidelines, you can enhance your compliance with tax regulations while maximizing the benefits of the R&D tax credit.