R&D Tax Credit – Field Attorney Advice (FAA) on Reasonable Compensation under Section 174

In a recent Field Attorney Advice (FAA) memo 20154501F, the IRS took a different approach to auditing this R&D tax credit claim. In this case, a CEO in charge of a group of companies was claimed at 60% qualified in supporting the companies’ R&D activities and hence 60% of his compensation (box 1 W-2) was included in the R&D tax credit computation. This compensation included base salary and bonus.

The IRS approach was to employ an outside expert on compensation in determining that the issue was whether the CEOs value of services he performed was commensurate with the amount paid for his services (comparing his compensation with a valuation of those R&D services). The IRS developed this position in disallowing the R&D credit based on a requirement that research costs have to pass the Section 174 test, and Section 174(e) which requires that for an expense to be a deductible R&D expense, that expense must be ‘reasonable under the circumstances.’

The IRS then utilized an expert in compensation to determine whether the CEO’s comp was reasonable under the circumstances. However, it should be noted in reviewing the legislative history, this requirement under Section 174(e) is intended to simply exclude from R&D eligibility items such as disguised dividends, gifts, loans and other payments to executives. If the compensation paid to the CEO doesn’t include any of these other forms of payment, the actual amount of Box 1 W-2 wages should not be the subject of 174(e). Nevertheless this is the IRS position at least in this case, via the Field Attorney Advice issued by a local District Counsel attorney who prepared the FAA.

It remains to be seen whether the IRS has the resources to hire an outside expert on numerous cases to go after this reasonable compensation issue.

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