California OTA Rejects R&D Credit Where Taxpayer Lacked Contemporaneous Project Documentation
A recent California Office of Tax Appeals decision provides an important warning for businesses claiming California research and development tax credits: a retrospective R&D study, high-level cost estimates, and credible executive testimony may not be enough to establish entitlement to the credit when the taxpayer cannot produce contemporaneous evidence showing what research actually occurred.
In Appeal of Advanced American Laboratories, Inc., 2026-OTA-397P, the OTA upheld the California Franchise Tax Board’s denial of research credits claimed for the 2019 and 2020 tax years. The opinion is currently designated pending precedential. (Office of Tax Appeals)
The case is particularly significant for taxpayers that prepare R&D credit studies after the tax year has closed or after the research activities have already occurred. The decision does not suggest that taxpayers must maintain any particular form of documentation. It does, however, reinforce that taxpayers must be able to substantiate the underlying research activities in enough detail to demonstrate that the statutory requirements for qualified research were actually satisfied.
The Taxpayer Claimed Credits Through Amended Returns
Advanced American Laboratories was a California corporation that provided environmental testing services involving substances such as mold, asbestos, and lead. The company retained a CPA to conduct an R&D tax credit study covering its 2019 and 2020 tax years.
The study was completed in May 2022, several years after some of the claimed research activities occurred. It identified five projects involving technologies such as transmission electron microscopy, artificial intelligence-based microbiological analysis, automated microscope platforms, infrared technology, and DNA analysis. (Office of Tax Appeals)
The company subsequently filed amended California returns claiming R&D credits of $12,495 for 2019 and $11,924 for 2020 and requesting refunds of $11,022 and $10,518, respectively. FTB audited the amended returns and ultimately denied the credits after concluding that the taxpayer had failed to provide sufficient information supporting the claims. (Office of Tax Appeals)
The taxpayer appealed.
California's R&D Credit Requires More Than Showing That Technical Work Occurred
California's research credit is generally based on Internal Revenue Code section 41, subject to California-specific modifications under Revenue and Taxation Code section 23609. California currently describes the credit as available to businesses that engage in qualified research activities in California. (State of California Franchise Tax Board)
For the years at issue, OTA explained that a taxpayer seeking to establish qualified research had to satisfy the familiar four-part test:
The expenditures must satisfy the applicable IRC section 174 requirement.
The research must be technological in nature.
The information sought must be intended for use in developing or improving a business component.
Substantially all of the research activities must constitute a process of experimentation relating to function, performance, reliability, or quality. (Office of Tax Appeals)
The taxpayer bears the burden of proving its entitlement to the credit.
This distinction matters because conducting sophisticated technical or scientific work does not, standing alone, establish that the work constitutes qualified research under section 41.
The Central Problem Was the Lack of Supporting Project Evidence
At the OTA hearing, the taxpayer acknowledged that it had not submitted contemporaneous documentation supporting the claimed research activities.
The OTA emphasized that Treasury Regulation section 1.41-4(d) requires a taxpayer claiming the research credit to maintain records in sufficiently usable form and detail to establish that the expenditures qualify. At the same time, OTA recognized that taxpayers are not required to maintain their records in any particular prescribed format.
That is an important distinction.
The problem in Advanced American Laboratories was not simply that the company lacked a particular form, project log, or standardized R&D file. Rather, the evidentiary record did not contain the underlying materials necessary to demonstrate what occurred during the projects.
OTA specifically identified the absence of contemporaneous evidence such as:
email communications;
laboratory data;
project notes; and
monthly reports documenting the claimed research projects.
The taxpayer's CEO testified about uncertainty associated with the five projects, and OTA expressly found his testimony credible. Nevertheless, OTA concluded that the testimony, whether viewed alone or together with the retrospective study, lacked sufficient detail to establish several components of the qualified-research test.
That conclusion may be one of the most significant aspects of the case.
Credibility was not enough. The taxpayer still needed evidence demonstrating how the activities satisfied the statutory requirements.
A Retrospective R&D Study Did Not Cure the Evidentiary Problem
The taxpayer's R&D study was based substantially on a questionnaire completed by the CEO and an interview with him. The study stated that contemporaneous documentation existed, but the documents themselves were not placed into the record.
OTA also noted that the study's preparer apparently had not independently sampled the underlying documents. The taxpayer's qualified research expenses were instead calculated using a high-level estimate under which the CEO estimated R&D costs to be approximately 30 percent of certain direct costs. (Office of Tax Appeals)
OTA ultimately concluded that the worksheets supported the mathematical calculation of claimed QREs at a high level but did not corroborate the underlying research activity.
This is a critical distinction for businesses relying on third-party R&D credit studies.
An R&D study can be useful for identifying projects, organizing evidence, interviewing technical personnel, and calculating qualified research expenses. But a study generally cannot substitute for evidence demonstrating what employees actually did, what technological uncertainties existed, what alternatives were evaluated, what experimentation occurred, and how the work related to an eligible business component.
In a controversy, the study itself may be only one part of the evidentiary record.
OTA Rejected the Argument That Expenses Could Simply Be Estimated
The taxpayer relied in part on United States v. McFerrin, a Fifth Circuit case sometimes cited for the proposition that exact records of research expenses are not always necessary.
OTA rejected the taxpayer's interpretation.
The panel explained that McFerrin involved a situation in which the government had conceded that some qualified research occurred. Only after a taxpayer establishes that qualified research actually took place may a court potentially estimate the amount of associated qualified research expenses.
In Advanced American Laboratories, the taxpayer had not crossed that threshold.
Because it had failed to establish that the underlying activities constituted qualified research, OTA concluded there was no basis to estimate the associated QREs.
This distinction is highly relevant in R&D credit examinations. There are effectively two separate substantiation questions:
Did qualifying research activity occur?
And, only after that question is answered:
How much qualified research expense is attributable to that activity?
A taxpayer generally cannot use an estimation methodology to overcome a failure to prove the first element.
Adapting Existing Technology Can Present Additional Problems
OTA also observed that the record indicated some of the taxpayer's projects involved adapting existing technologies or techniques to the company's existing practices, procedures, or methods.
The panel noted that adaptation of an existing business component may fall within an exclusion from qualified research under IRC section 41(d)(4).
This presents another common R&D credit controversy issue.
Businesses frequently implement new software, laboratory equipment, automation platforms, artificial intelligence tools, or manufacturing technology. From the company's perspective, the implementation may involve significant technical effort.
But technical difficulty does not automatically produce a research credit.
The taxpayer must still establish, among other things, that qualifying uncertainty existed and that a qualifying process of experimentation occurred. Simply adapting or deploying commercially available technology may not satisfy those requirements.
A Federal Refund Did Not Establish Entitlement to the California Credit
The taxpayer also argued that its position should be accepted because the IRS had issued federal refunds associated with the 2019 and 2020 R&D credit claims.
OTA rejected that argument as well.
There was no evidence that the IRS had actually audited and affirmatively accepted the federal R&D credit. More importantly, OTA explained that FTB is not necessarily bound by an IRS determination it believes is incorrect.
This is an important point for taxpayers claiming parallel federal and California research credits.
The issuance of a federal refund does not necessarily mean the IRS substantively reviewed the credit. And even where a federal examination has occurred, California may conduct its own analysis under California law.
Taxpayers should therefore avoid assuming that federal processing or acceptance automatically establishes the validity of the corresponding California credit.
Document Retention Policies Can Create Unexpected Tax Exposure
The taxpayer's CEO testified that the company generally retained records for only three years. By the time the matter reached appeal, some relevant documentation was apparently no longer available.
That fact highlights a practical problem that extends well beyond this particular case.
The useful life of R&D documentation may be considerably longer than the company's ordinary operational document-retention period.
A credit may be generated in one year, carried forward into later years, claimed through an amended return, examined several years later, and then proceed through an administrative appeal. Documents generated during the original research project may therefore become relevant long after the project itself has ended.
Businesses claiming material research credits should consider whether their tax-document retention policies adequately preserve the technical and financial evidence that may later be required to defend those credits.
What Should Businesses Preserve?
There is no universal checklist, and OTA specifically recognized that taxpayers are not required to keep records in one particular format.
Nevertheless, a defensible R&D credit file will often include contemporaneous evidence connecting employees and expenses to particular business components and research activities. Depending on the business, useful evidence may include project plans, technical specifications, engineering or laboratory notes, testing results, design iterations, source-control records, internal emails, meeting notes, prototype records, unsuccessful testing, technical reports, employee time records, payroll information, vendor invoices, and interviews or memoranda prepared while personnel still have direct knowledge of the work.
The goal is not simply to accumulate documents.
The documentation should permit the taxpayer to explain the research at the project or business-component level: what uncertainty existed, what alternatives were considered, what experiments or evaluations were undertaken, who performed the work, and which expenses are attributable to that qualifying activity.
The Broader Lesson for California R&D Credit Claims
Advanced American Laboratories does not mean that an R&D credit fails whenever a taxpayer lacks perfect contemporaneous project files.
Nor does the decision establish that every taxpayer must use a particular time-tracking or project-documentation system.
The larger lesson is that a taxpayer claiming the credit must ultimately be able to prove the underlying research activity, not merely reconstruct a credit calculation.
A retrospective study may help organize and present that evidence. It may not be enough to create the evidence years later.
That distinction becomes especially important when businesses file amended returns seeking substantial refunds based on R&D studies commissioned after the tax years involved. Those claims may receive significant scrutiny, and taxpayers should evaluate the quality of the underlying project-level evidence before assuming that a study alone will withstand an FTB examination.
What Taxpayers Facing an FTB R&D Credit Examination Should Consider
Taxpayers already under examination should identify early whether their supporting evidence addresses both sides of the credit analysis: qualification of the research activities and substantiation of the associated expenses.
When responding to FTB information document requests, it may be useful to organize the evidence by business component or project rather than simply submitting large volumes of generalized technical and accounting records.
The taxpayer should also be prepared to demonstrate how each project satisfies the applicable four-part test and how the methodology used to identify wages, supplies, or other claimed QREs relates to the qualifying activities.
Waiting until an OTA appeal to reconstruct the evidence may be particularly difficult if employees have left the company, project records have been deleted, or ordinary document-retention policies have resulted in the destruction of relevant materials.
Conclusion
Appeal of Advanced American Laboratories, Inc. reinforces a basic but consequential principle of R&D credit controversy: the taxpayer must establish that qualified research actually occurred before the amount of the resulting credit becomes relevant.
The taxpayer in this case had a formal R&D study, expense worksheets, and credible testimony from its CEO. OTA nevertheless concluded that the record did not sufficiently establish the underlying qualified research and sustained FTB's denial of the refund claims. (Office of Tax Appeals)
For California businesses claiming material research credits, the decision is a reminder that the strongest defense is generally built while the research is taking place—not years later when an audit begins.
Disclaimer
This article is provided for general informational purposes only and does not constitute legal, tax, accounting, or other professional advice. The discussion is based on authorities and information available as of the date of publication. Appeal of Advanced American Laboratories, Inc., 2026-OTA-397P, is currently designated pending precedential, and its status should be confirmed before relying on the opinion as precedential authority. Application of the California research credit depends on the taxpayer's particular activities, documentation, expenditures, tax years, and applicable law. Taxpayers should consult qualified legal and tax advisers regarding their specific circumstances.
