For practitioners advancing research credit claims, a recent Finance Court case is worrying as more has been said than was necessary to deny the taxpayer’s claim. The commissioner can use the dictation in the opinion to ban other taxpayers’ research credit claims.
In order to receive federal tax credits for research activities, a taxpayer must prove that he has carried out “qualified research”. Research is qualified if it passes a four-part test. In Part 1, the taxpayer has to prove that the proposed product design is technologically uncertain at the beginning of the research project. In the second part, the taxpayer is asked to prove that he has carried out his research activities for the purpose of discovering technological information in order to remove the technological uncertainties. Part three asks the taxpayer if they would like to use technological information they discover to develop or improve product design. In Part 4, the taxpayer must demonstrate that “essentially all” research activities are elements of an experimental process for certain technological purposes that relate to the function, performance, reliability or quality of the product. IRC §41 (d)) (1).
Leon Max, Inc., a suburban company, designs and sells women’s apparel for which it has applied for federal research tax credits. The taxpayer, the member of Leon Max, Inc., carefully considered all of the evidence needed to maintain a research loan claim. However, the tax court was not convinced that the taxpayer qualified for the loans. TC memo. 2021-37 (March 29, 2021). The opinion begins with a comment that “[b]Starting with hand-drawn sketches and using knowledge that is common to people in their field, designers, modelers, and pattern makers take great care to turn the sketches into clothes that people want to buy. “The use of ‘common knowledge’ is not a basis for scientists and engineers to use their common knowledge – their expertise and training – to conduct research. Eligibility for credit does not require scientists and engineers to expand common knowledge. A Reference to “common knowledge” enlivens a dispute that was settled long ago and is best left unsaid. Treas. Reg. §1-41-4 (a) ((3) (ii).
The court continued, “Designers, modelers, and pattern-makers often knew what threads were working with the fabric, but they tested thread thickness, needle size, and sewing machine adjustments through trial and error for garments with visible seams.” The sentence appears to disaggregate the design uncertainty by stating that the thread category to use was known, but not the thickness of the thread to be used. Construction uncertainty doesn’t work that way. The question is whether the information available to the taxpayer does not establish the ability or method to develop or improve the product or the appropriate design of the product. Sweetheart. Reg. §1.174-2 ((a) (1). If the thread thickness was unknown, the taxpayer was unsure.
In the court’s discussion of the need to provide evidence of “uncertainty”, a case from 1966 was cited for the suggestion that the costs incurred must be “investigative”. The court would have done better if it had relied on the language of the treasure. Reg. §1.174-2, which was passed in 1994, rather than the language of a 1966 opinion. “Investigative” and “Investigate” do not appear in Treas. Reg. §1.174-2. In addition, the court found that the investigative activities should be used to “develop” the concept of a model. But the sentence in Treas. Reg. §1.174-2, in which the term “develop” is used, also speaks of the “appropriate design” of the product, which is what Leon Max is about. At this point in the statement, the inclusion and discussion of an “appropriate design” would also have been appropriate.
The statement shifts gears to discuss the process to be used to remove uncertainty. This is where the statement could have started and ended. The difference between activities that allow tax credit for research spending and activities that allow only tax deduction for research spending is that creditworthy activities must involve an “experimentation process” while deductible research expenditures do not rely on conducting a process of experimentation. IRC §41 (d) (1). Here the court could possibly have ruled more firmly that the taxpayer was not engaging in a systematic activity that was an experimental process, but when it said this the court said a lot that was unnecessary and wrong. The court found that the taxpayer only ran uncreditworthy quality control tests because “[i]t developed [internal] Standards to meet your own needs, but also to comply with prescribed standards from recognized industry organizations. “The court confused experimental testing with quality control testing. Quality control testing takes place after a product is designed and after the production system used to make the product has been designed. Quality Control Tests are used to determine whether the taxpayer is making the product he is designing after all design uncertainties have been resolved The identity of the test source is immaterial. Engineers develop failure modes and effect analyzes in-house to design products. These tests are even experimental processes. Although they were developed in-house. Tests ordered by external organizations – for example the federal government – can also be experimental Processes, but none of it converts the tests from experimental tests to quality control tests.
An experimentation process must be based on principles of the physical or biological sciences, engineering or computer science. Finding that the taxpayer’s audit was not an experimental procedure, the court found that the audit did not result in the tests required for the “design and manufacture of complex products such as bridges, satellites, computers or other products for which that Expertise is required, is required. ” to be constructed by an engineer. “It doesn’t require the product to be” complex. “The court made this out of all the stuff. Also, the court relied on the language in a Congressional Committee report to request that the technology be” high. “It is not a legal or regulatory requirement that the technology be “high” and the court should not give the Commissioner a new, unsupported and vague reason to ban research credits.
The court eventually discussed Leon Max’s unqualified activities “relating to style, taste and seasonal design factors”. These activities are indeed not qualified, IRC §41 (d) (3) (B), but the court then determines that “even non-disqualified activities have not undergone any experimental process”. This statement makes no sense as style, taste, and seasonal design factors can never be experimented with. Why should it be said that the taxpayer did not conduct an experimentation process for activities for which an experimentation process can never be done? The court may have been confused about the circumstances under which the cost of these activities could qualify as qualified research costs, even though these activities themselves were not the subject of an experimental trial. Again, confusion in the court’s analysis can give the Commissioner new unsupported reasons not to allow research credits.
© 2021 Miller, Canfield, Paddock and Stone PLC National Law Review, Volume XI, Number 113