Upon joining a Big Four firm in Washington, D.C.—then known as the Big Eight—I was introduced to the research credit, which had only recently been established. Its complexity led many attorneys and CPAs in my office to specialize in Internal Revenue Code Section 41, the Credit for Increasing Research Activities. At that time, the research credit represented one of the most valuable incentives available to corporate clients, and the necessity of conducting a thorough study became self-evident early in my career.
In the 1980s, providers commonly conducted research and development (R&D) studies using an interview approach. Providers traveled to client sites, toured facilities, and held multiple interviews with clients’ subject matter experts (SMEs) in conference settings. Senior partners posed questions while managers and associates compiled notes. Post-interview, junior staff would collect these notes, which a secretary in the office would then transcribe. These project write-ups typically were sufficient documentation for research credit claims. Although the Internal Revenue Service reserved the right to request further information, audits were generally resolved after reviewing the provider’s study. Such detailed write-ups met IRS expectations in most cases.
As the research credit matured through the 1990s and early 2000s, my role evolved into defending R&D studies rather than preparing them. The IRS began requiring more substantial contemporaneous documentation instead of relying solely on provider studies. This shift underscored the importance of improving R&D study methodologies to meet heightened IRS scrutiny.
A US Tax Court case is currently underway in which the IRS has challenged the validity of interview-based studies and the methods providers use to calculate credits. Given the implications for providers and taxpayers, it is essential to consider the question, Are research credit interviews and write-ups now obsolete? The current Tax Court dispute provides a useful case study for addressing this question.
Background: Origin of the Dispute
Kyocera, a prominent multinational corporation, differs significantly from the typical small taxpayer in research credit litigation. After initially claiming a $398,985 research credit for 2018, Kyocera worked with a Big Four firm on a comprehensive multiyear study and amended its return to claim approximately $1.7 million. The IRS denied this amended claim due to perceived deficiencies in documentation. Initially filed in district court, the matter was subsequently moved to the US Tax Court.
Although the case remains unresolved, its brief progression in district court offers valuable perspectives. The IRS submitted a summary judgment motion, asserting no genuine dispute regarding material facts and that the law supported its decision. Since Kyocera bore the burden of proof, the IRS argued that the absence of contemporaneous supporting documentation rendered the claim unsupportable. Specifically, the IRS regarded the Big Four firm’s study as hearsay, primarily due to credibility concerns, and determined that Kyocera failed to satisfy the burden of proof.
The key elements of the IRS’ motion highlighted what it considered the flaws in the Big Four firm’s methodology, specifically that the firm had:
- interviewed and surveyed thirty-six SMEs after the tax year ended to assess the activities of 1,200 individuals in the absence of time tracking;
- used estimated percentages to allocate expenses;
- relied exclusively on interviews without supporting documentation; and
- applied a comparable process to identify supply and contract research expenses.
Kyocera provided the Big Four firm’s study and engagement letter during discovery, but there was no record of retaining or storing contemporaneous documentation. The IRS noted that Kyocera did not keep time records, supply invoices, or contractor invoices, and neither the Big Four firm nor Kyocera produced source documents or survey responses when subpoenaed.
Seven Insights for Tax Professionals
Irrespective of the outcome of this case, it is imperative to examine the procedural shortcomings in Kyocera’s research credit study to better prepare for future examinations.
- Emphasize documentation over interviews. An adage heard at TEI conferences is, “Pave the road with documentation and fill the potholes with interview notes.” The IRS and courts require contemporaneous documentation; SME interviews may supplement, but not replace, primary records, time tracking, and technical documentation. The Kyocera dispute primarily reflects insufficient proof due to inadequate documentation.
- Select SMEs strategically. The IRS expressed concern that thirty-six SMEs were tasked with representing the work of 1,200 individuals, considering this excessive. SMEs should possess direct knowledge of research activities and personnel, limiting their testimony to areas within their expertise. Properly articulating the basis for selecting each SME and establishing credibility—“laying a foundation”—is essential.
- Be aware that the reliability of SME testimony diminishes over time. The IRS considered post-period SME interviews unreliable, particularly given the absence of documentation. Initiating studies in the same year as the researched activity enhances the reliability of SME responses.
- Record activity-level detail. Providers often ask SMEs to categorize projects and allocate participant involvement. However, the IRS requires granular descriptions linked to business components and compliance with the four-part test. Time allocations are insufficient without substantiating the nature of experimental activities involved.
- Preserve technical documentation. The lack of contemporaneous technical documentation significantly undermined Kyocera’s position. Companies should develop policies to preserve relevant emails, test results, design documents, and project logs for a minimum of seven years in alignment with internal retention guidelines.
- Define business components clearly. Ambiguous or broadly defined business components present defense challenges. Each component must be clearly delineated and demonstrate experimentation and uncertainty, bolstered by relevant documentation.
- Address high-risk job titles. Upper management and support roles are generally presumed to be nonqualifying unless compelling evidence demonstrates otherwise. Meticulous documentation distinguishing between qualifying research activities and nonqualifying supervision or support duties is critical. Consider executive-level surveys to substantiate claims involving these positions.
Key Lessons
Whether resolved by the Tax Court or settled beforehand, the Kyocera case imparts numerous lessons invaluable to those conducting research credit studies:
- Exclusive reliance on interviews is inadequate for meeting the burden of proof;
- Selection of SMEs should be strategic, involving individuals with firsthand knowledge restricted to reasonable groups;
- Delays in initiating studies may reduce the credibility of testimonies;
- Detailed activity-level information is essential;
- Documentation supporting each aspect of experimentation is indispensable;
- Preserving project-level information is necessary;
- Providers should clearly define and be prepared to defend each business component under the statutory four-part test; and
- Certain departments or job titles require particularly rigorous substantiation.
The Kyocera litigation serves as a crucial reminder for tax professionals regarding the risks of relying on outdated methodologies centered on interviews, write-ups, and estimates. Establishing a sound R&D credit process requires prioritizing documentation and aligning practices with current IRS standards. The outcome of this case is poised to influence the validation of R&D credits and procedures for addressing erroneous refunds in the future.
Jason Massie, CPA, Esq., is the founder of MASSIE R&D Tax Credits, LLC.
