IRS wins R&D credit case on insufficient uncertainty test

The Tax Court recently ruled in favor of the IRS in Mark Betz and Christine Betz v. Commissioner and Dennis Lincoln and Julia Lincoln v. Commissioner (T.C. Memo 2023-84), holding that the taxpayers could not claim a research credit under Section 41 based on a lack of technical uncertainty and because certain projects constituted funded research. The court also upheld accuracy-related penalties under Section 6663(a) on the basis of negligence and substantial understatements of income tax.

The taxpayers were shareholders of Catalytic Products International, Inc. (CPI), an S corporation that designed and supplied custom-built air pollution control systems. The systems were generally designed to meet customer specifications, and CPI often purchased components of the systems from third-party suppliers and engaged third-party subcontractors to construct the systems. CPI reported a research credit on its 2014 federal income tax return related to 19 projects, and calculated the credit based on wage and supply qualified research expenditures (QREs).

The court first evaluated the extent to which CPI’s development activities and associated research expenditures met the Section 174 uncertainty test. Under Section 41(d)(1)(A), expenditures associated with qualified research must be considered research or experimental (R&E) expenditures under Section 174. In general, Section 174 R&E expenditures are associated with activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Under Treas. Reg. Sec. 1.174-2(a)(1), uncertainty exists if the information available to the taxpayer does not establish the capability or methodology for developing or improving the product or the appropriate design of the product.

With respect to wages claimed as QREs, the petitioners argued that uncertainty existed because the appropriate design of each system could not be established until after the system cleared onsite testing. The court rejected the petitioner’s assertion, stating that conducting post-production testing on a product does not establish that its appropriate design as a whole remained uncertain before the testing is successfully completed. The court analyzed employee activities for all 19 projects at issue and generally found that employees had sufficient details of the design of the systems at their disposal from the onset of the projects to establish the appropriate design of the oxidizers, in part because many of the project proposals were issued prior to the credit year and included detailed design specifications. In some instances, comparable systems were designed and supplied to the same customers previously.  Section 41(d)(4)(B) states that “[a]ny research related to the adaptation of an existing business component to a particular customer’s requirement or need” is excluded from the definition of qualified research.

The court also analyzed the extent to which the 19 projects constituted pilot models to evaluate whether the supply costs could be claimed as QREs. In accordance with Treas. Reg. Sec. 1.174-2(a)(4), the costs associated with a representative model of a product qualify as a Section 174 expenditure to the extent they are related to pilot models produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The taxpayer asserted each oxidizer was a pilot model because it was “uniquely designed for the particular application on which it is being designed.” However, the court concluded that petitioners failed to establish that the oxidizers at issue were pilot models because petitioners failed to show that the purpose in producing the oxidizers was to evaluate and resolve uncertainty about the product. In reaching its conclusion, the court observed that testing of the oxidizers as a whole occurred late in the development process and CPI often incurred significant expenditures ordering specially sized components prior to testing, suggesting that it would be economically irrational to incur such costs if CPI still lacked information as to the appropriate design of the oxidizer as a whole.

The court acknowledged the possibility that certain wages and supplies related to the pilot models may constitute qualified research at the component or sub-component level through application of the “shrink-back” rule provided in Treas. Reg. Sec. 1.41-4(b)(2). However, the court noted that the taxpayer failed to provide information and documentation to substantiate application of the shrink-back rule.

Next, the court evaluated the extent to which eight of the 19 projects constituted funded research, which does not qualify for the research credit under Section 41(d)(4)(H). In part, Treas. Reg. Sec. 1.41-4A(d)(1) provides that research performed for another person in which the taxpayer retains substantial rights is not considered funded. The court analyzed the terms and conditions of relevant agreements for each of the eight projects and found that CPI retained incidental benefits but did not retain substantial rights in five of the eight projects.  Accordingly, the court concluded that the QREs associated with those five projects were incurred in connection with funded research and not eligible for the research credit.

The Tax Court’s analysis of the Section 174 uncertainty test and its application to development efforts undertaken pursuant to customer contracts provides helpful insight regarding the court’s interpretation of the adaptation exclusion under Section 41(d)(4)(B) and the interplay between the adaptation exclusion and the Section 174 uncertainty test. Furthermore, the court’s disallowance of the research credit based on a product “as a whole” analysis, and lack of documentation to substantiate a shrink-back analysis, emphasizes the importance of documenting the technical uncertainty at the appropriate level and maintaining documentation to substantiate a shrink-back application.