One of the top priorities for the Trump administration and Congress this year will be passing a massive tax bill to extend the Trump tax cuts. It’s also a perfect opportunity to correct a major problem in the tax code that threatens America’s economic competitiveness.
Two days before Christmas, a ruling was handed down by the United States Tax Court (T.C. Memo 2024-113) that threatens to punish the innovators who drive America’s economic dominance. Congress and the incoming presidential administration must work together to fix this problem, or the U.S. economy will lose the dynamism that enables us to remain the most technologically advanced country in the world.
The ruling, issued in a case pertaining to tax credits claimed by an engineering firm, is so broadly written that it threatens to make whole industries ineligible for research and development (R&D) tax credits, which are fundamental to President Trump’s vision for our economic renaissance.
For example, the IRS has a four-part test to determine whether a company is eligible to claim R&D tax credits for a project. Part four of the test states the project “must rely on principles of the physical or biological sciences, engineering, or computer sciences.” The tax court ruling, however, sets a new precedent that could make engineering projects ineligible for R&D credits.
Similarly, the ruling states that engineering calculations do not qualify for the credit, even though “calculations” are explicitly cited in the regulations as an example of qualifying activities. Moreover, the ruling rejected the use of time sheets to account for the hours spent on research projects, instead calling for unrealistic levels of documentation, leaving companies with no realistic alternative for tracking this crucial component.
The danger goes far beyond the ruling’s impact on engineering firms. Many U.S. companies that claim the R&D credit rely on the same methods used in this case to validate their claims.
In its efforts to comply with the ruling, the IRS may feel compelled to narrow its guidance on R&D tax credits significantly — and many businesses may determine that claiming those credits is too risky. Research investment will decline, particularly with respect to high-risk/high-reward projects that offer the greatest benefits for the overall economy.
The U.S. is already operating at a disadvantage compared to countries like Ireland, which offers a 30% refundable R&D tax credit that dwarfs the credit offered by the U.S. tax code. Restricting eligibility for the R&D tax credit is exactly the opposite of what our economy needs.
Fortunately, the solution is straightforward. It requires political will. Indeed, this exact problem has been encountered and overcome in the past.
Prior to this ruling, the IRS at one point issued guidance to its auditors instructing them to reject R&D tax credit claims from architecture and engineering firms. Members of Congress — including members of the House Ways and Means Committee, which writes tax laws — bluntly informed the IRS that they never intended such a strict and exclusive interpretation of the law, and the IRS dutifully withdrew its guidance.
Now, the tax court has created an even more restrictive interpretation, which as a matter of law the IRS is now bound to adhere to.
There are three ways out of this: either the case is reversed on appeal by the Sixth Circuit Court of Appeals or another tax court judge must issue a contradictory ruling in a separate case, or Congress must update the law to clarify its intent. Fortunately, the new Congress has a golden opportunity to address this issue when they take up must-pass legislation extending the Tax Cuts and Jobs Act (TCJA) this year.
In fact, Congress could use this opportunity to address the current confusion and misinterpretation of the four-part test for R&D credits to make it clearer for businesses and IRS auditors alike to understand which activities qualify.
Eliminating duplicative language, defining terms more clearly, and giving taxpayers more flexibility to justify their claims using business records would all help to make R&D credits more accessible to America’s innovators.
In the meantime, Trump’s new IRS Commissioner, former Congressman Billy Long, can take administrative steps to mitigate the impact of the tax court’s ruling, such as instructing auditors to adopt a more objective and reasonable approach when considering R&D credit claims that align with Congressional intent of law.
This should be an easy decision. We simply can’t risk discouraging innovation, especially now, with China and others trying to challenge our technological dominance. Our economy has become less competitive over the past four years, burdened by the Biden administration’s heavy-handed approach to regulation. Reversing that trend requires loosening the reins on America’s entrepreneurs.
The next few years under President Trump could — and should — be the start of another golden age for the U.S. economy. But that won't happen without the private sector innovation that has always set America apart.
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Julio Gonzalez is the founder of Engineered Tax Services.