The Unwritten Rule That Can Make or Break Your R&D Credit Claim: Understanding Nexus

The research credit under Section 41 of the Internal Revenue Code is widely recognized as one of the most complex provisions in U.S. federal income tax law, demanding significant examination and taxpayer resources. A key, yet uncodified, challenge taxpayers face is the Internal Revenue Service's (IRS) requirement to demonstrate "nexus". Nexus, in this context, refers to establishing a clear link, relation, or connection between qualified research activities (QRAs) and business components, as well as between qualified research expenditures (QREs) (like wages, supplies, and contract research) and those business components.

Historically, the IRS has evolved its stance on documentation for the research credit:

• Early Stages (1995 Audit Plans): The groundwork for the nexus concept was laid, instructing agents to request workpapers identifying cost center, department, or project approaches, and documentation proving Section 41(d) requirements at the business component level.

• Fluctuating Documentation Requirements: While 1998 proposed regulations and a 1999 committee report indicated an intent not to force taxpayers to create new records or incur "unnecessary and costly taxpayer record keeping burdens", the 2001 final regulations introduced a stricter requirement for taxpayers to prepare documentation "before or during the early stages of the research project". Significant pushback led to the 2004 final regulations, which granted "reasonable flexibility" in substantiating credits, asserting that "failure to keep records in a particular manner... cannot serve as a basis for denying the credit". This flexibility, however, did not diminish the IRS's focus on nexus.

IRS Scrutiny and Amended Returns: The IRS has historically applied heightened scrutiny to research credit claims, particularly those filed on amended returns, often focusing on a "lack of nexus" or "inadequate contemporaneous documentation". In 2007 and 2009, directives designated research credit claims for refund as a Tier I issue, requiring mandatory information document requests (IDRs). While the Tiered Issue program was retired in 2012, the IRS continues to target areas of higher risk.

In October 2021, the IRS further clarified that for a research credit refund claim to be valid, taxpayers must provide five items of information with their amended tax returns. Although two requirements were later eliminated (including the controversial one mirroring 2001 regulations about describing information sought), the process is still in effect, though it "may sunset because of the new reporting requirements on Form 6765".

New Form 6765 Reporting for 2024 and 2025: Notably, the Form 6765, "Credit for Increasing Research Activities," now includes elements of the nexus concept for the first time, both quantitative and qualitative, by business component. These new reporting requirements are applicable for taxpayers claiming a research credit on their 2024 and 2025 tax year returns.

Importance of Documentation and Case Law: Courts, while not always using the term "nexus," emphasize the need for a documented relationship between QRAs and QREs.

• Moore Case: This case highlights the crucial role of documentation. The Tax Court disallowed a significant portion of a company president's wages as QREs due to a "total lack of written records demonstrating Robert’s use of time". Even if the Cohan rule (allowing estimation when exact amounts cannot be substantiated, if there's a reasonable basis) was considered, the absence of any general documentation prevented its application.

• Fudim Case: In contrast, Fudim was the first case where the Tax Court used the Cohan rule to estimate QREs. Despite a lack of contemporaneous time logs, testimony, technical documentation, patent activity, and scientific publications provided a "factual basis" for estimation.

• Shami and Suder Cases: Shami demonstrated that vague, contradictory testimony and uncorroborated allocations by executives without scientific backgrounds are insufficient. Conversely, Suder reinforced that detailed records and credible employee testimony can successfully demonstrate nexus.

• Little Sandy Coal Case: This case further affirmed that reliance on "after-the-fact estimates and generalized descriptions" or "arbitrary estimates and broad assertions rather than detailed records, time tracking, or other adequate documentation of specific employee activities" is insufficient to establish nexus.

Practical Considerations for Taxpayers (Especially for Amending Returns): Given the ongoing scrutiny, taxpayers should strategically develop and use a method to establish nexus. This includes:

• Anticipating Challenges: Evaluate prior tax positions based on current facts, case law, and technical guidance.

• Leveraging Documentation: Identify how existing documentation can demonstrate nexus. While time tracking is ideal, smaller taxpayers may not have such systems. Other valuable documents include:

  • Issue logs: Identifying technical uncertainties and participating employees.

  • Job descriptions: Explaining roles and how departments perform qualified services.

  • Organizational charts: Identifying employees performing QRAs.

  • Testing documents: Identifying employees, nonroutine tests, and alternatives evaluated.

  • Credible oral testimony can supplement documentation, but some documentation basis is required.

• Developing a Nexus Method: Systematically demonstrate the nexus of the research credit claim by incorporating various data sources from the organization. This detailed analysis helps prevent misapplication of research credit requirements.

In conclusion, while the "nexus concept" is not explicitly in the Code or regulations, the IRS has operationally established it, and the courts have largely adopted it. Taxpayers, especially those considering amending returns for prior years to claim R&D credits, must proactively document the nexus between qualified activities and expenditures and be prepared to robustly substantiate their claims during an examination. The new Form 6765 requirements for 2024 and 2025 further solidify the importance of this concept in current and future tax filings.