in-20250430-IR-045250179NRA: DEPARTMENT OF STATE REVENUE

DEPARTMENT OF STATE REVENUE LETTER OF FINDINGS: 01-20241466 and 01-20241467 Income Tax For the Years 2019, 2020, and 2021 HOLDING Shareholders of an Indiana S Corporation failed to substantiate that they were entitled to claim the pass-through Indiana Research Expense Credits (“RECs”) of S Corporation. ISSUE

I. Income Tax – Burden of Proof.

Authority: I.R.C. § 41; IC 6-3-2-1; IC 6-3-1-3.5; IC 6-3.1-4-1; IC 6-3.1-4-4; IC 6-3.1-4-5; IC 6-8.1-3-12; IC 6-8.1-5-1; IC 6-8.1-5-4; Dep’t of State Revenue v. Caterpillar, Inc., 15 N.E.3d 579 (Ind. 2014); Indiana Dep’t of State Revenue v. Rent-A-Center East, Inc., 963 N.E.2d 463 (Ind. 2012); Tell City Boatworks, Inc., v. Indiana Department of Revenue, 162 N.E.3d 603 (Ind. Tax Ct. 2020); Wendt LLP v. Indiana Dep’t of State Revenue, 977 N.E.2d 480 (Ind. Tax Ct. 2012); Scopelite v. Indiana Dep’t of Local Gov’t Fin., 939 N.E.2d 1138 (Ind. Tax Ct. 2010); Indiana Dep’t. of State Revenue, Sales Tax Division v. RCA Corp., 310 N.E.2d 96 (Ind. Ct. App. 1974); Suder v. Comm'r, T.C. Memo. 2014-201 (T.C. 2014); Little Sandy Coal Co., Inc. v. Comm’r of Internal Revenue, 62 F.4th 287 (7th Cir. 2023); United States v. McFerrin, 570 F.3d 672 (5th Cir. 2009); Stinson Estate v. United States, 214 F.3d 846 (7th Cir. 2000); Treas. Reg. § 1.41-4; Treas. Reg. § 1.6001-1; IRS, Audit Technique Guide, 2005 WL 4057831 (June 2005). Shareholders of an Indiana S Corporation argued that they were entitled to claim additional Indiana research expense credits pursuant to studies prepared by a third-party consulting firm. STATEMENT OF FACTS Individuals are Indiana residents and the shareholders of an Indiana S-Corporation (Company) (hereinafter collectively, “Taxpayers”). Since the 1980s, the Company has been a pool contractor and a pool consultant in the commercial pool business. The Company offers various commercial pool services; it designs, constructs, and services swimming pools, water parks and water treatment systems for facilities managed by others, including municipalities, not-for-profit organizations, and schools in Indiana and other states. Additionally, the Company offers classes to individuals for Certified Pool/Spa Operator certification. The Company’s income passes on to Individuals – its shareholders – who in turn report the flow-through income on their individual income tax returns. To claim Indiana RECs for income tax purposes, Taxpayers hired a third-party consulting firm (“Consultant”) to prepare two studies for 2019 and 2020 (“Studies”). Taxpayers claimed a total of $153,272 Indiana RECs attributable to a total of $2,661,695 research expenses on W-2 wages paid to their employees to conduct qualified research (“QREs”) for 2019, 2020, and 2021 based on the Studies. The Indiana Department of Revenue (“Department”) audited Taxpayers’ business records and tax returns. Taxpayers requested that the audit select ten projects – numbers 18023, 17018, 18028, 19029, 19015, 20005, 21011, 21001, 21002, 21013 – to be reviewed. The audit reviewed and determined that Taxpayers’ documents failed to substantiate their claimed QREs and Indiana RECs. The audit disallowed the claimed RECs, resulting in additional tax, interest, and penalty. Taxpayers protested. A hearing was conducted during which Taxpayers and their representatives explained the basis for their protest. Taxpayers asked for and were granted additional time to submit their supporting documents. This Letter of Findings results.

I. Income Tax – Burden of Proof.

DISCUSSION Pursuant to the audit, the Department found that Taxpayers did not (i) maintain adequate records and (ii) properly document expenses pertaining to their qualified research activities during the course of their business for these years as required under federal and Indiana tax law. Taxpayers argued that they were entitled to the claimed RECs, as estimated. The issue is whether Taxpayers provided sufficient documentation to support their protest. IC 6-8.1-5-4(a) provides, “[e]very person subject to a listed tax must keep books and records so that the [D]epartment can determine the amount, if any, of the person’s liability for that tax by reviewing those books and records. The records [] include all source documents necessary to determine the tax, including invoices, register tapes, receipts, and canceled checks.” The person also “must allow inspection of the books and records and returns by the [D]epartment or its authorized agents at all reasonable times.” IC 6-8.1-5-4(c). IC 6-8.1-3-12(b) further permits the Department to use statistical sampling. If both parties “agree to a sampling method to be used, the sampling method is binding.” Id. The Department “shall make a proposed assessment of the amount of the unpaid tax on the basis of the best information available to [D]epartment” if it “reasonably believes that a person has not reported the proper amount of tax due.” IC 6-8.1-5-1(b). Importantly, all tax assessments are prima facie evidence that the Department’s claim for the unpaid tax is valid; the taxpayer bears the burden of proving that any assessment is incorrect. IC 6-8.1-5-1(c); Indiana Dep’t of State Revenue v. Rent-A-Center East, Inc., 963 N.E.2d 463, 466 (Ind. 2012). The taxpayer is required to provide documentation explaining and supporting its challenge that the assessment is wrong. Poorly developed and non-cogent arguments are subject to waiver. Scopelite v. Indiana Dep’t of Local Gov’t Fin., 939 N.E.2d 1138, 1145 (Ind. Tax Ct. 2010). “[W]hen [courts] examine a statute that an agency is ‘charged with enforcing . . . [courts] defer to an agency’s reasonable interpretation of [the] statute even over an equally reasonable interpretation by another party.’” Dep’t of State Revenue v. Caterpillar, Inc., 15 N.E.3d 579, 583 (Ind. 2014). Indiana follows the federal tax system with certain modifications. IC 6-3-2-1(b); IC 6-3-1-3.5(b). Indiana provides certain tax credits which a taxpayer may claim to reduce its tax liability. One of the tax credits available for the tax years in question under Indiana tax law is the RECs for any “qualified research expense that is incurred for research conducted in Indiana” provided under IC 6-3.1-4-1. IC 6-3.1-4-4 incorporates applicable federal tax law and regulations. I.R.C. § 41(d)(1) defines “qualified research” as: In Tell City Boatworks, Inc., v. Indiana Department of Revenue, 162 N.E.3d 603, 612-13 (Ind. Tax Ct. 2020), the Indiana Tax Court explained that “[f]or purposes of the Indiana Credit, the term ‘qualified research expense’ has the same meaning as that defined under Section 41(b) of the Internal Revenue Code except that the qualified expense must be incurred for research conducted in Indiana.” The court explained further the four-part test: In Little Sandy Coal Co., Inc. v. Comm’r of Internal Revenue, 62 F.4th 287 (7th Cir. 2023), the United States Court of Appeals further addressed the application of the Section 174 Test and the Process of Experimentation Test under the federal statutory and regulatory framework, in part: Accordingly, “qualified research” is research that meets the above-mentioned requirements and cannot be excluded by activities outlined under I.R.C. § 41(d)(4). Exclusions include: research after commercial production, adaptation of existing business components, or funded research. No credit is allowed to taxpayers if their activities fall into those exclusions under I.R.C. § 41(d)(4). Only when taxpayers demonstrate and substantiate that their research activities in Indiana meet all of the four-part requirement to be considered qualified research activities and their activities are not excluded under I.R.C. § 41(d)(4), the taxpayers may be entitled to claim the RECs. Each of the above tests must be applied separately and first at the level of the discrete business component. If a business component as a whole fails one of the tests, the “shrinking-back rule” may be applied. Treas. Reg. § 1.41-4(b)(2). Only when the above requirements are satisfied, expenses such as in-house research expenses and contract research expenses may be considered as qualified research expenses. I.R.C. § 41(b)(2) and (3). In order to obtain the benefit of the credit, both federal and Indiana law require that taxpayers maintain and produce contemporaneous records sufficient to verify those credits. Specifically, “[a] taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. For the rules governing record retention, see § 1.6001–1. . . .” Treas. Reg. § 1.41-4(d). Importantly, “[t]ax credits are a matter of legislative grace, and taxpayers bear the burden of proving they are entitled to claim tax credits.” Suder v. Comm’r, T.C. Memo. 2014-201, *12 (T.C. 2014). Where such a credit is claimed, “the party claiming the same must show a case, by sufficient evidence, which is clearly within the exact letter of the law.” Indiana Dep’t of State Revenue, Sales Tax Division v. RCA Corp., 310 N.E.2d 96, 100 (Ind. Ct. App. 1974). Simply put, “[t]ax credits are a matter of legislative grace, are only allowed as clearly provided for by statute, and are narrowly construed.” United States v. McFerrin, 570 F.3d 672, 675 (5th Cir. 2009) (citing Stinson Estate v. United States, 214 F.3d 846 (7th Cir. 2000). The IRS’s Audit Technique Guide, 2005 WL 4057831 (June 2005) provides guidance in relation to the information necessary to verify research expense credits; it states, in relevant part: Thus, estimation may be permissible to calculate the amount of expense only when the taxpayers can substantiate their qualified research activities based on their verifiable, factual documents and the exact amount of expense is the sole issue. The taxpayers must have factual support for every assumption underlying their estimates to meet their burden of proof. The Department reviewed the Studies prepared by the Consultant and requested that Taxpayers provide factual, verifiable source documents to substantiate the credits they claimed. The audit report noted that Taxpayers, in response, stated they “did not maintain a time tracking system which tracked the employee’s time to specific projects” and that they “utilized estimations to determine the amount of Qualified Wages for each individual” as explained in their Studies. Importantly, Taxpayers “requested that a sample be selected of the projects to review in detail.” The Department selected ten (10) projects to be reviewed and found that two (2) out of the ten (10) projects were outside of Indiana. The audit reviewed the projects under the four-part test: The audit found that Taxpayers’ documents failed to identify and substantiate their research and development expenses, and “no research and development expenses either for book or for tax reporting purposes” were reported as required under I.R.C. § 174. Taxpayers further included “Construction: Labor – [Taxpayers]” and “Construction: Subcontracted” in the labor expense category of their RECs claim. The audit report, in part, noted: The audit noted that three executives – “President, Chief Financial Officer, and Vice President of Business Development – estimated the percentage of time of identified employees spent engaged in qualified services” and the Consultant “derived a percentage of each employee’s qualified R&D activity as compared to the employee’s total time spent working throughout the year” from the estimated information to complete the Studies. The audit found that “[t]he amount of the credit claimed could not be substantiated” because the documents submitted “failed to demonstrate how wages were associated with the project claimed.” The audit found that Taxpayers’ activities failed to meet the second test: research undertaken for the purpose of discovering information which is technological in nature. The audit report noted: In addition, Taxpayers’ Project Qualification Notes (“PQ Notes”), prepared by the Consultant, were incomplete. The audit noted that the Consultant reworded the PQ Notes the second time but failed to support their claim; the documentation provided contained a “[l]ack of available information as to the capability or method for developing or improving the business component or the appropriate design of the business component was not identified [] for any project.” The audit determined that Taxpayers’ activities did not meet the second test: research undertaken for the purpose of discovering information which is technological in nature because they failed to document the “projects were undertaken to discover information that is technological in nature and intended to eliminate uncertainty concerning the development or improvement of a business component.” The audit found that Taxpayers failed to meet the third requirement: Business Component Test. A “business component” is “any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, license” or used in Taxpayers’ trade or business. The Consultant, during the audit, stated that Taxpayers were engaged with their customers in one of two contractual relationships: (1) a pool consultant and/or (2) a pool contractor. The audit reviewed and determined Taxpayers’ documentation “failed to identify a business component of a project or identify contradictory business components in the separate records.” The audit noted, for example, the PQ Notes stated that the business component for the project number 18023 was “the construction method,” but “according to the scope and Study the business component [was] the design solution and construction method of the water slide and the mechanical components.” Further, the audit noted that Taxpayers have been working as a contractor, a subtractor, or a consultant in “constructing swimming pools, aquatic centers, [] and therapy pools.” Taxpayers had “no manufactured products” for sale. Because the documentation provided did not properly “identify the business component,” the audit found that Taxpayers did not meet the Business Component Test. As to the fourth requirement, the audit explained that “a process of experimentation must be an evaluative process and generally should be capable of evaluating one or more alternatives.” The audit noted that Taxpayers were engaged as a pool consultant or a pool contractor/subcontractor, which were to “furnish, design, and install swimming pools, pool equipment, water slides and mechanical systems.” The audit found that according to the Studies, Taxpayers’ uncertainties were uncertainties of “the turnover rates and the appropriate equipment required for the pool.” Taxpayers’ “uncertainties presented were not uncertainties in the research and development sense which required a process of experimentation,” and their “chosen solutions were normal practices in the swimming pool construction industry” – especially given that they were the experts in this business for more than thirty-eight years. The audit found that Taxpayers’ documentation “did not address the activities of which constitute elements of a process of experimentation for a permitted purpose,” and their supporting documents failed to meet the fourth requirement. Separately, the audit noted that the documentation submitted by Taxpayers was insufficient to establish that their projects met all the requirements of Indiana qualified research as a whole. The audit was not able to apply the shrinking-back rule because the documentation was insufficient to identify Taxpayers’ business component properly for the purposes of shrinking-back rule. Also, the audit determined that Taxpayers’ documents demonstrated that their research activities were excluded activities. Thus, no credit was allowed pursuant to I.R.C. § 41(d)(4). In short, the audit reviewed Taxpayers’ supporting documents, disallowed their claimed QREs, and denied all RECs for those years pursuant to IC 6-3.1-4-5 and the above-mentioned federal and Indiana tax law. Taxpayers argued that they were “not required to track expenses to specific accounts” and were entitled to claim the Indiana RECs because their activities met the requirements of four-part test. Taxpayers argued that their “business component as a new or improved pool that was designed and developed for a new or increased function,” and “simply extending the length of an existing product [] is sufficiently novel to classify as a new product.” Taxpayers also argued that their “expertise in designing and constructing new or improved pools does not preclude them from having uncertainty as to the appropriate design of the pools.” Taxpayers listed their uncertainties including: (i) method to construct the requisite design, (ii) design of the lighting system install, and (iii) design of the pump systems to satisfy the mechanical requirements and which would fit on the existing building space. Taxpayers offered email exchanges to support that they “needed to perform additional design drawings through AutoCAD to eliminate uncertainty as to the appropriate design of the pool.” Taxpayers claimed that they were “designing and constructing first in class pools that have never been built before” and the project number 21011, a “Park Aquatic Center, which won the Aqua Master Larger Commercial: Award of Distinction, is a one-of-a-kind waterpark.” Taxpayers argued that “substantially all of the claimed research activities constitute a process of experimentation” because their mechanical engineer “drafts and designs projects, draws the pool mechanical systems, engineers pool structures, and works with other consultants to ensure all components work together, as shown in the design drawings.” Those drawings were reviewed by their Vice President of Business Development. Taxpayers prepared a revised Excel table to summarize the claimed qualified wages for 2020 and 2021 by job title. That Excel table removed Service Technician, Assistant Service and Construction Manager, Director of Operations, and Logistics Manager/Inside Sales from the initial claim of qualified research activities. Taxpayers stated: To support their protest, Taxpayers offered drawings, emails, and reports on assessment of swimming pools. Taxpayers maintained that they were entitled to claim the Indiana RECs. As mentioned, the issue was whether Taxpayers provided sufficient factual, verifiable documents to substantiate their Indiana RECs. It should be noted that during the audit, Taxpayers requested and agreed to sample ten specific projects. Thus, documents not related to these sample projects, such as projects 19005, 17115, and 18015, were irrelevant and beyond the scope of this protest. It also should be noted that Taxpayers offered documents that did not match the projects listed in the Studies; their reliance on these misleading documents to support their protest is misplaced. This decision will address the following: To claim the Indiana RECs – an Indiana tax credit – Taxpayers were required to substantiate that they conducted qualified research activities in Indiana. The audit found that projects 20005 and 21001 were non-Indiana projects. But Taxpayers did not address those findings. Thus, Taxpayers were prohibited from claiming the Indiana RECs in that regard. Taxpayers were required to show that they performed qualified research activities in Indiana and their research activities in Indiana satisfied each and all of the four requirements under I.R.C. § 41(d)(1) and not excluded under I.R.C. § 41(d)(4): To qualify the research expenses under I.R.C. § 174, the expenses at issue must be costs incurred in connection with Taxpayers’ trade or business “which represents research and development costs in the experimental or laboratory sense.” Throughout the protest, Taxpayers claimed that their “expertise in designing and constructing new or improved pools does not preclude them from having uncertainty as to appropriate design of the pools.” Taxpayers argued that they were not required to track expenses to specific accounts. Referencing a POE Qualification summary (by job title in an Excel table) for 2020 and 2021, Taxpayers claimed that their estimations were sufficient to “substantiate[] that all of the activities that capture the wage QREs constitute elements of a process of experimentation.” Upon review, Taxpayers were mistaken. Without a time tracking system, Taxpayers’ Studies claimed that more than thirty individuals conducted qualified research activities in Indiana each year. Without factual, verifiable documents, Taxpayers simply relied on estimates from three executives to derive their QREs. But all the expenses claimed by Taxpayers as QREs were already reported and deducted as ordinary and necessary business expenses, and the QREs in question included “not only wages [and] cost of labor reported on job cost detail reports but also wages of the director of operations, president, and inside sales manager which were not on any of the job cost detail reports provided.” Without factual, verifiable documents to substantiate their claim concerning the QREs of their thirty employees, Taxpayers simply removed wages associated with job titles that the audit determined did not qualify, such as Service Technician, Assistant Service and Construction Manager, Logistics Manager/Inside Sales, and Director of Operations. Taxpayers were statutorily required to “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” The Department is not able to agree that Taxpayers met this requirement. “Estimation methods are permitted only in cases where the sole issue is the exact amount paid or incurred in the qualified research activity.” The Technological Information Test requires that Taxpayers’ research was undertaken for the purpose of discovering technological information and the research was intended to eliminate uncertainty concerning the development or improvement of a business component. Taxpayers argued that they were not “required to seek to obtain information that exceeds, expands or refines the common knowledge of skilled professional in the particular field of science or engineering in which [they were] performing the research.” Taxpayers claimed that they “utilized physics to evaluate the constructability and feasibility of the design, ensuring functional and efficient integration of the sub-components including the site, structural, mechanical, electronical, and plumbing systems.” Upon review, however, Taxpayers were mistaken. Taxpayers offered no hypothesis for each research project they undertook to discover the technical information, and the research was intended to eliminate uncertainty concerning the development or improvement of a business component. Taxpayers claimed that they utilized “physics to evaluate the constructability and feasibility of the design.” Without such hypothesis, the Department was not able to review their records concerning the steps or paths they undertook for each research project to discover the technological information to eliminate their uncertainties concerning the development or improvement of a business component. Specifically, as a pool consultant, Taxpayers must fulfill their fiduciary duty to their customers and provide their services: to inspect, assess, evaluate, advise, and recommend. To that end, Taxpayers inspected and assessed the conditions of existing pools, reported their findings, advised their customers, and recommended appropriate actions. Separately, Taxpayers’ documents showed that they were hired as a subcontractor for custom-built pools designed and certified by other professionals, including architects and engineers. Taxpayers’ drawings stated: Taxpayers’ documents further stated: Without any hypothesis to conduct their research, the Department does not agree that Taxpayers met the second test: documenting the research activities and discovering the technological information to eliminate their uncertainty concerning the development or improvement of their business component. Taxpayers must identify their business component for which they claim qualified research activities. To that end, Taxpayers were required to demonstrate that they intended that the information to be discovered during their research be useful in the development of a new or improved business component identified. Without an identifiable business component, any information discovered cannot be useful in the development of a new or improved business component identified to satisfy the requirements under I.R.C. § 41. A “business component” means any product, process, computer software, technique, formula, or invention which is to be (1) held for sale, lease, or license or (2) used by Taxpayers in their trade or business. The audit found that Taxpayers had no manufactured products for sale. Taxpayers did not own any patents and were not in the process of obtaining one. Verifiable information showed that Taxpayers were hired to inspect and assess conditions of existing swimming pools, to renovate swimming pools, or to construct new swimming pools to meet specifications of their customers, architects, or professional designers, and certified by the professional engineers. The supporting documents showed that Taxpayers used AutoCAD to produce two types of drawings: (1) drawings required to be reviewed by others, such as third-party architects and professional engineers and (2) drawings that were for “design development pricing package – not for construction.” Taxpayers argued that their business component was “a new or improved pool,” but they had (i) “no manufactured products” for sale, (ii) no prototypes to test, and (iii) no patents to use or license. Taxpayers failed to meet the third requirement. Under the fourth test, Taxpayers must show that “substantially all of their research activities constitute elements of a process of experimentation for the purpose of discovering a new or improved function, performance, reliability, or quality.” Taxpayers claimed that more than thirty employees conducted qualified research activities each year and “performed a qualified process of experimentation to resolve technical uncertainties during their design process” in Indiana by using AutoCAD drawings. Taxpayers claimed that they “can substantiate that substantially all of the activities that capture the wage QREs constitute elements of a process of experimentation.” Upon review, however, the Department is not able to agree. Taxpayers’ arguments were similar to the petitioner’s in Little Sandy Coal Company. The petitioner in that case argued that it was entitled to the research tax credit based on its “‘iterative process’ of designing and constructing vessels” which – in turn – relied on an “estimated portion of [petitioner’s] employee’s time spent on qualified research.” 62 F.4th at 295. The petitioner in that case asserted that its estimates were entirely “reasonable.” Id. The court in Little Sandy Coal Company disagreed and explained: The court affirmed the disallowance of the petitioner’s research tax credit and concluded: The Department’s own evaluation and verification standard is supported by the United States Court of Appeals’ decision in Little Sandy Coal Company. Taxpayers’ documents showed that their employees had “a drawing that needs corrections” as the “project [19005] is coming to an end soon.” That project was not listed in Taxpayers’ Studies, was not reviewed by the audit, and was beyond the scope of this protest. As the audit noted, Taxpayers’ “Studies did not address the activities of which constitute elements of a process of experimentation for a permitted purpose.” Taxpayers’ uncertainties presented were not uncertainties in the research and development sense which required a process of experimentation. Specifically, Taxpayers had no manufactured pool products for sale, no prototypes to test, and no patents to use or license. Since the 1980s, Taxpayers – a pool consultant and a contractor for custom-built commercial pools – had been working with various third-party professional designers, architects, and engineers on these projects. Without properly documenting their hypothesis of each research scope and objective, these activities of Taxpayers’ thirty plus employees each year could not be verified. As such, those activities could not constitute elements of a process of experimentation for the purpose of discovering a new or improved function, performance, reliability, or quality. Taxpayers’ claim to the Indiana RECs was predicated on “reasonable estimates,” an “Employee Variable Sample,” and the Consultant’s Studies. Taxpayers’ reliance is unfounded because their “estimates” are not based on “contemporaneous records” constituting evidence falling within the “exact letter of the law.” The Department does not agree that the estimates are sufficient to meet Taxpayers’ burden under IC 6-8.1-5-1(c) of establishing that the assessments were “wrong” and their claim to income tax credits was correct as called for under Treas. Reg. § 1.41-4(d), Treas. Reg. § 6001-1, and IC 6-8.1-5-4(a). In addition to the failure to meet the above requirements, the audit further found that Taxpayers’ activities were excluded from qualified research activities under I.R.C. § 41(d)(4). Taxpayers did not distinguish their projects, construction contract or otherwise, and were paid according to the terms and conditions of their contracts. As such, their activities were to fulfill their contractual obligations. Taxpayers also retained no substantial rights. Taxpayers thus were prohibited from claiming the RECs because their activities were excluded activities under I.R.C. § 41(d)(4). The shrinking-back rule is not applicable in this instance because Taxpayers did not offer any information to support the application of the shrinking back rule – shrinking back to the next available business component or components. To conclude, given the totality of the circumstances, in the absence of other verifiable supporting documentation, the Department is not able to agree that Taxpayers met their burden of proof demonstrating that the Department’s assessments were incorrect pursuant to IC 6-8.1-5-1(c). FINDING Taxpayers’ protest is respectfully denied. February 28, 2025 Replaces Finding Document at: New