Indiana is at it again
Another one bites the dust
Indiana released a letter ruling concerning the state’s R&D credit. While not a court case, this document gives insight into what taxpayers can expect from the state’s Department of Revenue. I’ve written about Indiana’s treatment of R&D credits before. In that case, the taxpayer was compared unfavorably to the taxpayer in the Union Carbide case and ultimately lost. Here, the taxpayer loses again, but the reasoning and authority that the Department of Revenue uses are questionable at best.
Photo by Tom Fisk.
The R&D Claim
The taxpayers owned a pool contracting and consulting business focused on commercial companies, including swimming pools, water parks, and water treatment systems. Their clients included municipalities, non-profit organizations, and schools. The company claimed the R&D credit for two years, totaling $153,272 in credit. Indiana decided to audit both years.
During the audit, ten projects were selected for review. The Department of Revenue determined that the taxpayer was unable to substantiate the credit related to these projects and disallowed the credit in full. The study was based on estimates rather than time tracking. Of the ten selected projects, two were located outside of Indiana. Additionally, the taxpayer did not classify any expenses as § 174 expenses for tax or book purposes.
“Authority” for the denial
The letter ruling spends a substantial amount of time on the “Applicable Law” used to come to its conclusion. In this section, the DOR examines the relevant state law and state court cases. Then, it moves on to federal authority, including the language in statutes, regulations, and court cases, such as Little Sandy Coal. But then, without much fanfare, the DOR cites the IRS’s Audit Technique Guide, giving it more coverage than it did any other single source outside of the long quote from the Little Sandy case.
It is from the audit technique guide that the DOR finds the “requirement” that “[e]stimation methods are permitted only in cases where the sole issue is the exact amount paid or incurred in the qualified research activity. Accordingly, taxpayers must have factual support for every assumption underlying their estimates to meet their burden of proof.” The Department of Revenue proceeded to disallow the use of estimates based on this language. This is very similar to the argument that CA used to disallow an R&D claim recently.
Here in lies the issue. The IRS’s audit technique guide is not an authority that can or should be relied upon. Even if you assume that the Chevron standard still applies, that does not give the guide any authority. The IRS does not subject its audit guides to public notice and comment. It is an internal document used by examiners to bring themselves up to speed on a specific issue quickly. It is an internal training guide and nothing more. It does not have the force of law. It does not even have the authority that you would see from a letter ruling, advice memo, or other item issued by the IRS. It should not be used as authority for any disallowance. Indiana seems to have missed this point entirely.
In using a training manual as the basis for denial, all other arguments fail.
Indiana used the training manual to claim that time tracking is required and mandatory for the credit.
Indiana used the training manual to claim that estimates cannot be used for the credit without documentation that ties the expenses to qualified activity. But even setting aside the reliance on the training manual, this argument is not internally consistent. As I said about the CA case, “If you have to have detailed time tracking to establish the substantially all test, there is no reason to rely on estimates for the credit amount.”
Final thoughts
While there are other issues with this case, they cannot be addressed without correcting the fundamental flaw of the state’s argument. While I would love to see this corrected by the Indiana court system, I suspect this case will not be litigated, given the industry and flaws with the study, such as the inclusion of out-of-state projects. However, as more states adopt the premise that estimates are fundamentally not allowed in the use of the R&D credit, this creates more problems for taxpayers and their credit providers.
Wrap-up
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The content of this article is for informational purposes only and should not be taken as tax, legal, benefits, financial, or HR advice. I am a lawyer, but receiving this newsletter does not mean I am your lawyer. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.