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ERIC G. SUDER, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
1 Cases of the following petitioners are consolidated herewith: Eric G. Suder, docket Nos. 14435-09 and 6183-10, and Douglas J. Boyd and Karen B. Boyd, docket Nos. 14460-09 and 6210-10.
Docket Nos. 14435-09, 14460-09, 6183-10, 6210010.
UNITED STATES TAX COURT
T.C. Memo 2014-201; 2014 Tax Ct. Memo LEXIS 196

October 1, 2014, Filed


DISPOSITION: Decisions will be entered under Rule 155.
SYLLABUS

E designs telephone systems for small and midsize businesses. E claimed research tax credits under I.R.C. sec. 41 for 2004-07 on Forms 1120S. In computing the credits, E claimed qualified research expenses (QREs) for 76 projects. The parties stipulated 12 of these projects as being a representative sample for purposes of determining whether E's employees performed qualified research during the years at issue. Most of E's QREs are attributable to the wages of S, E's CEO and most highly compensated employee.

Held: Eleven of the twelve projects satisfy the four-part test for qualified research. See I.R.C. sec. 41(d).

[*2] @Held, further, Ps have substantiated the QREs that E claimed.

Held, further, S's wages were unreasonable under I.R.C. sec. 174(e). Reasonable wages determined.

Held, further, Ps are not liable for accuracy-related penalties for 2004-07.
COUNSEL: [**1] Jeremy M. Fingeret, John H. Dies, and Robert G. Wonish II, for petitioners.
Julie Ann P. Gasper, Lauren Laravia, and Duy P. Tran, for respondent.
JUDGES: VASQUEZ, Judge.
OPINION BY: VASQUEZ
OPINION
MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: In 1987 petitioner Eric Suder found himself unemployed when his employer, Candela Electronics (Candela), went out of business. As he searched for a new job, an opportunity presented itself. He recalled that Candela had sold a large volume of its private branch exchanges (PBXs) to Radio Shack, and that Radio Shack had little success in reselling them. He contacted Radio Shack and succeeded in negotiating the purchase of Candela PBXs for cents on the dollar.

Mr. Suder started a company out of his garage called Estech Systems, Inc. (ESI), through which he tested, repackaged, and resold the Candela PBXs at a profit. That provided some income in the short term, but supply of the Candela [*3] PBXs was limited. Mr. Suder recognized that he needed a steady stream of products for the long term. His vision was to design his own innovative, full-featured telephone systems for small and midsize businesses.

Through hard work and ingenuity, Mr. Suder gradually turned his vision into reality. [**2] In 1988 he hired his first employee at ESI.2 In 1989 he designed ESI's first product--an embedded system called "Phone Bill" which approximated the cost of a long-distance telephone call using bands instead of rate tables. He marketed Phone Bill to motels that could not afford a system that operated on the more expensive rate tables. A year or so later, he moved ESI from his garage into an office building, hired five or six additional employees, and spearheaded the design of ESI's second product--an embedded system called "Roll Call" which automated wake-up calls for motels through their phone systems.
2 It appears from the record that Mr. Suder had also been an employee of ESI since its inception. The parties have stipulated that Mr. Suder was an employee of ESI during the years at issue.

The success of Phone Bill and Roll Call prompted Mr. Suder to take on increasingly sophisticated projects. He pioneered the development of an auto-attendant circa 1990, an auto-attendant with voice mail storage circa 1990-91, an automated voice mail system circa 1992-94, and ESI's first phone system circa 1996. By 2004 he had grown ESI into a thriving company with approximately 125 [*4] employees, including [**3] a team of roughly 40 engineers, and gross revenues of approximately $38.5 million.

These cases concern tax years 2004 through 2007. For each of those years, ESI timely filed a Form 1120S, U.S. Income Tax Return for an S Corporation, in which it claimed a credit for increasing research activities under section 41 (research tax credit).3 Mr. Suder, who owned 90% of the shares of ESI, claimed flowthrough research tax credits of $445,987 for 2004, $440,306 for 2005, $454,526 for 2006, and $442,557 for 2007 on Forms 1040, U.S. Individual Income Tax Return. Petitioner Douglas Boyd, who owned the other 10% of the shares, claimed flowthrough research tax credits of $46,748 for 2004, $46,624 for 2005, $48,870 for 2006, and $48,378 for 2007 on Forms 1040.
3 Unless otherwise indicated, all section references are to the Internal Revenue Code (Code) in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. All monetary amounts are rounded to the nearest dollar.

On March 19, 2009, and January 25, 2010, respondent mailed notices of deficiency to Mr. Suder and Mr. Boyd disallowing the research tax credits they claimed for 2004-05 and 2006-07, respectively, and [**4] determining accuracy-related penalties.4 Mr. Suder and Mr. Boyd, both of whom resided in Texas, timely filed [*5] petitions with this Court. We consolidated their cases for trial, briefing, and opinion.
4 Respondent determined deficiencies in, and penalties on, petitioners' Federal income tax as follows:

Eric G. Suder, docket Nos. 14435-09 and 6183-10:


________________________________________________________________________________


Year

Deficiency

Penalty

2004

$445,987

$89,197

2005

440,306

88,061

2006

454,526

90,905

2007

442,557

88,511

________________________________________________________________________________


Douglas J. & Karen B. Boyd, docket Nos. 14460-09 and 6210-10:


________________________________________________________________________________


Year

Deficiency

Penalty

2004

$46,748

$9,350

2005

46,624

9,325

2006

48,870

9,774

2007

48,378

9,675

________________________________________________________________________________


In July 2013 we held a three-week special trial session in Dallas, Texas. We heard more than 3,500 pages of testimony and received into evidence more than 170,000 pages of exhibits. On the basis of this substantial record, there is no doubt that ESI conducted significant research and development activities throughout the years at issue. The threshold question in these cases is whether these activities constitute "qualified research" within the meaning of section 41(d). [*6] If so, we must decide whether ESI adequately substantiated its "qualified research expenses" (QREs) and whether Mr. Suder's wages were reasonable QREs within [**5] the meaning of section 174(e). Lastly, we must decide whether Mr. Suder or Mr. Boyd is liable for penalties under section 6662(a).
FINDINGS OF FACT
I. ESI's Senior Management

During the years at issue Mr. Suder served as the chief executive officer (CEO) of ESI. However, he did not perform the typical duties of a CEO. He spent most of his time brainstorming ideas for new products and ways to improve existing products. The inspiration for his ideas came from various sources, including reseller feedback, online research, trade publications, and alpha testing of ESI's products, which he personally performed. His coworkers thought of him as the "chief idea guy" and the "product visionary".

He is named as an inventor on 13 patents, the applications for which predate or postdate the years at issue, and one patent reissuance, the application for which was filed on June 3, 2005.

Mr. Suder spent little time managing the day-to-day operations of ESI's business. He left that task primarily to Mr. Boyd, who was ESI's president and chief operating officer at the time. Mr. Boyd was in charge of, among other [*7] things, the manufacturing, tech support, sales, finance, and human resources departments of ESI. He spent much of his time [**6] dealing with money matters, but because ESI's focus was on product development, he felt it was important to devote part of his time to that as well.

The other two key players at ESI were Harvey Wende and Buzz Hansen. Mr. Wende reported to Mr. Boyd, but he spent much of his time working directly with Mr. Suder on product development. Mr. Wende's official titles were senior vice president of product operations from 2004 to 2006 and senior vice president of product development in 2007. His functional role in both positions was to lead the product development teams at ESI, including the engineering groups, the product assurance lab, and the test technicians.

Mr. Hansen was ESI's chief technology officer. He had more technical expertise than any other member of ESI's senior management. His job was to design the architecture of new products.5 This entailed researching new technologies, deciding what technologies to incorporate into ESI's products, selecting appropriate electronic components, and writing high-level concept diagrams (known as block diagrams). As time permitted, Mr. Hansen also helped [*8] ESI's engineers in implementing his architecture. Mr. Hansen is also named as an inventor on [**7] the 13 patents and the reissued patent mentioned supra p. 6.
5 Mr. Hansen described the architecture of a product as the way the different components that make up that product interact with one another to achieve some kind of functionality.
II. ESI's Product Development Process

ESI became ISO-9000 certified in 2000. ISO-9000 is a series of quality management standards promulgated by the International Organization for Standardization. These standards are designed to ensure quality and consistency in a company's internal processes. As part of its ISO-9000 certification, ESI created a systematic product development process, which remained in place during the years at issue.
A. Concept Development

The process began with senior product strategy meetings. These meetings were held weekly and generally lasted between 1-1/2 and 2 hours. ESI's senior management, comprising Mr. Suder, Mr. Boyd, Mr. Wende, and Mr. Hansen, attended the meetings. The purpose of the meetings was to cultivate new ideas and assess their feasability at the macro level.

Senior management, and Mr. Suder in particular, had no shortage of great ideas. The challenge was figuring out how to transform these ideas into viable products. [**8] Senior management conducted followup meetings and consulted with senior engineers within ESI to determine the major components for each new [*9] product. The goal was to select components that could achieve the desired functionality of the new product in the most cost efficient manner.

Once the components had been selected, Mr. Hansen drafted the block diagram for the new product, which would show how the major components interacted. Senior management assigned a product manager to the new product. The product manager worked closely with Mr. Wende and ESI's engineers to draft specifications for the new product. The specifications often went through multiple iterations. Senior management remained very involved in this process and provided feedback to the product managers along the way. A new product was given a codename and the green light for hardware and/or software development only after Mr. Suder, Mr. Boyd, Mr. Wende, and Mr. Hansen had each signed off on the specifications.
B. Hardware and Software Development

Many product development projects had both a hardware and a software component. Hardware development always preceded software development because hardware involved additional cost [**9] considerations and was harder to change than software. Both the hardware and the software in ESI's products were (and still are) proprietary. The hardware was designed in-house by ESI's hardware engineers, and the software was written in-house by ESI's software [*10] engineers. The hardware and software functioned as an integrated system. As a general matter, neither the hardware nor the software of a competitor would work with ESI's products.

When the hardware engineers began working on a new project, the engineers were generally given the block diagram and the specifications for the product being developed. The block diagram showed only the major components; it generally would not show smaller components such as resistors, capacitors, and transistors, or the traces between them. One of the first tasks for the hardware engineers was to create a schematic from the block diagram.6 This process generally took two to six weeks, depending on the complexity of the product.
6 A schematic is a detailed, graphic layout for a circuit that shows the components on the circuit and the connections between them.

Creating the schematic involved a lot of research. The hardware engineers looked at written materials [**10] such as data sheets, design manuals, and application notes, consulted with field service engineers, and searched online for examples of how others have used the same or similar components. Because ESI's hardware was all proprietary, the engineers could not just copy the schematic from somewhere else and expect it to work with ESI's products. The engineers instead [*11] gathered general design information and used this information and their engineering expertise to create the schematic.

ESI contracted with an outside company called Alta Via to create electronic fabrication and assembly drawings (gerber files) for each schematic. The gerber files showed the physical placement of the components and the connections between them on a circuit board. Hardware engineers at ESI worked closely with Alta Via in a back-and-forth process that often took as long as creating the schematic itself.

The next step in the hardware design process was to manufacture physical prototypes from the gerber files. ESI contracted with GTECH, another outside company, to manufacture around 20 of each prototype for testing.7 After receiving the prototypes from GTECH, the hardware engineers at ESI carefully inspected the [**11] prototypes to verify that they were manufactured according to the specifications. They then performed a number of tests to verify that the prototypes were functioning correctly, including tests using oscilloscopes to measure signals and frequencies and tests using volt meters to measure voltages.
7 The number of prototypes varied from project to project.

If the prototypes passed all of the hardware engineers' tests, the prototypes were then transferred to ESI's software engineering group. ESI's software [*12] engineering group was divided into three specialities: (1) firmware, (2) call processing, and (3) graphical user interface (GUI). Firmware engineers wrote low-level code that allowed the hardware components to recognize each other and communicate with one another. Call processing engineers wrote low-level code that gave the hardware its intended functionality. GUI engineers wrote high-level code for PC-based applications.

The firmware engineers were generally the first software group to receive the prototypes. They did part of their coding in assembly language and part in C. Assembly language is essentially the native language of hardware. C is a computer programming language that more [**12] closely resembles English. One of the major challenges for the firmware engineers was to get the timing right on components such as microcontrollers and DSPs. Steven Wootton, a digital signal processor (DSP) and firmware engineer at ESI during the years at issue, described firmware coding as an iterative process involving a lot of testing and retesting. He used logic analyzers to test snippets of code and build on or modify the code on the basis of the test results until the timing was right within milliseconds.

The call processing engineers wrote application code, generally in C, that gave the prototypes their intended functionality. The code controlled what happened, for example, when a user pressed a certain key or accessed a certain [*13] feature. The call processing engineers generally layered their code on top of the firmware code. Unlike the firmware code, which was specific to each individual component, the call processing code often affected the system as a whole. The call processing engineers extensively tested their code and fixed the bugs that they spotted.

The GUI engineers wrote code for PC-based software that was used in conjunction with ESI's phone systems. During the years [**13] in issue, they worked primarily on two types of projects: (1) projects to configure the operation of the switch in ESI's phone systems (i.e., to customize the behavior of the phone systems) and (2) projects that added features and/or flexibility for end users. Project requirements were generally defined by senior management and passed along to the GUI engineers through their product managers. The GUI engineers were tasked with implementing the interface design described in the project requirements. Like ESI's other engineers, they also spent a significant amount of time fixing errors and bugs that arose.
C. Testing

After ESI's hardware engineers created a prototype of a new product and ESI's firmware and call processing engineers wrote code for the prototype, it was sent to ESI's in-house product assurance lab for further testing. If the prototype [*14] was an addition to an existing phone system, such as a port card or handset, it was tested both on its own and in the phone system. GUI applications were also tested by the product assurance lab.

The lab performed a number of tests, including smoke tests, basic tests, and regression tests. Smoke tests were short tests that were used to identify [**14] any major failures in the prototype. Basic tests were extended tests that were used to examine the functionality of the prototype. Regression tests were the most thorough tests run by the product assurance lab and generally took four to six weeks to complete. As part of a regression test, the product assurance lab tested a prototype extensively for the existence of any defects.

The product assurance lab generated a bug report for each problem that it identified. ESI kept a searchable database of these bug reports. Product managers reviewed the bug reports and prioritized them for repair. ESI's engineers reproduced the bugs in the bug reports, fixed them in order of priority, and returned the prototypes to the product assurance lab for further testing. Every once in a while, the product assurance lab discovered a serious bug that required ESI's engineers to redesign the prototype.

After the product assurance lab had finished its testing, the prototype was alpha tested by ESI's engineering department. ESI's engineering department [*15] installed the prototype in its phone system (or if the prototype was itself a phone system, replaced its phone system with the prototype) and used it in ESI's [**15] business. Mr. Suder was actively involved in the alpha testing process. There was not a single prototype that Mr. Suder had not personally "touched, played with, and blessed" during the alpha testing process.

The last stage of testing before commercial production was beta testing. ESI solicited its resellers to find beta testers for a new product. The beta testers were offered the product at a discount in exchange for agreeing to test the product in their businesses and to provide feedback on its performance. While the number of beta testers varied from product to product, ESI tried to find a minimum of 20 to 25 beta testers for each new product. ESI's engineers continued to fix bugs in the product during the beta testing process and after the product was available for sale to the public.
III. The 12 Stipulated Projects

ESI claimed QREs for 76 projects during the years at issue. The parties selected 12 of the 76 projects and stipulated that these 12 projects are representative of the 76 projects for purposes of determining whether ESI performed qualified research under
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