More positive news for taxpayers with pilot model supply expenses

By Debbie Shi, CPA, Washington; Kevin Benton, EA, Dallas; and Mark Andrus, CPA, Dallas

Editor: Greg A. Fairbanks, J.D., LL.M.

Although one data point does not make a trend, recent Tax Court filings indicate that taxpayers with pilot model expenses continue to benefit. Two filings will be of interest to taxpayers with pilot model expenses. The IRS conceded the pilot model costs in TSK of America Inc., No. 4766-17 (Tax Ct. 8/13/18) (stipulated decision), and Shiloh Industries Inc. has filed a similar claim (Shiloh Indus., Inc., No. 20802-18 (Tax Ct. 10/22/18) (petition filed)). These events are positive data points in the complex history of R&D credits.

As a stand-alone event, TSK is not very significant because the IRS conceded the case, so there is no court opinion that can be referred to by other taxpayers. However, when evaluated in the context of related cases and regulations under Sec. 174 issued in 2014, the IRS's concession in the case is a positive development for taxpayers.

Background

Generally, Sec. 174(a) allows a deduction for qualifying research or experimentation expenditures and does not require those costs to be capitalized. However, the acquisition and improvement of certain property that is not made upon a taxpayer's order and at its risk may be subject to depreciation under Sec. 167 and therefore, under Sec. 174(c), not allowable as a current expense deduction. Whether certain costs qualify as deductible Sec. 174 research expenditures may also have implications for whether they may be treated as "supplies used in the conduct of qualified research" under Sec. 41(b)(2)(A)(ii) for purposes of the research credit. The treatment of pilot model costs may be particularly significant for tooling manufacturers, such as auto parts makers, that design and engineer tools necessary to manufacture parts or components, because tooling costs constitute a large part of their expenses.

TG Missouri Corp., 133 T.C. 278 (2009), contemplated whether production molds sold to customers are deductible under Sec. 174(a) or are required to be capitalized and depreciated under Sec. 174(c). TG Missouri was in the business of manufacturing injection-molded products, such as steering wheels, air bags, and body side molding for customers in the automotive industry. TG Missouri received requests for quotation from its customers and developed designs for the requested injection-molded products. However, TG Missouri was entitled to payment only if it successfully designed and built a mold capable of producing a sample product and the customer accepted the products produced using the mold. TG Missouri either constructed the production mold in-house or contracted with a third-party toolmaker to make it.

Although the third-party toolmakers constructed the molds according to TG Missouri's design specifications, TG Missouri bore the ownership rights and the economic risk of whether the produced mold would in fact meet the required specifications. The IRS argued that the tooling costs were property of a character subject to the allowance for depreciation subject to Sec. 174(c) because the molds were used in the same manner as production molds sold to customers. Ultimately, the Tax Court ruled that the taxpayer's tooling costs for molds purchased from third-party toolmakers were not subject to depreciation and were deductible Sec. 174 costs.

Prop. Regs. Sec. 1.174-2 (REG-124148-05), published on Sept. 6, 2013, and Regs. Sec. 1.174-2 (T.D. 9680), published on July 21, 2014, supported the conclusion reached in TG Missouri. The regulations provided that the ultimate success, failure, sale, or other use of the research or property resulting from the research or experiment is not relevant to a determination of eligibility under Sec. 174 (Regs. Sec. 1.174-2(a)(1)). Furthermore, the regulations defined the term "pilot model" as any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. This term includes a fully functional representation or model of the product or a component of a product (Regs. Sec. 1.174-2(a)(4)).

The final regulations include an example with facts similar to those in TG Missouri, where a tool manufacturer develops a tool design that is ordered to be built by a third party. In the example, there is uncertainty regarding the appropriate design of the machine, and the tool manufacturer bears the risk of the machine production, not the third party. The example states that the tool manufacturer may deduct amounts for engineering and design labor as well as materials and supplies used to develop the appropriate design (Regs. Sec. 1.174-2(b)(5), Example (1)).

Current developments

In TSK, the taxpayer challenged the disallowance of tooling costs, which the IRS conceded. The facts in the TSK petition are similar to those in TG Missouri — so similar, in fact, that the reader may question why the matter was not settled during exam. TSK is an automotive supplier, and automotive parts manufacturers often incur substantial tooling costs. TSK filed a petition in the Tax Court in February 2017 after the IRS issued a notice of deficiency for the 2013 tax year. TSK treated approximately $9.3 million paid to acquire tools for metal stamping or plastic injection molding to a third-party vendor as qualified research expenditures (QREs). The IRS contended that there was insufficient uncertainty around the tool's technology and that the costs were incurred primarily for production purposes rather than research.

The parties were scheduled to go to trial on Aug. 14, 2018; however, prior to the trial, the IRS conceded the case and agreed that the company had no tax deficiency. While the IRS's concession is not binding, it may be considered as a hazard of litigation for taxpayers with similar fact patterns.

Shortly after TSK was conceded, another automotive parts supplier, Shiloh Industries Inc., filed a Tax Court petition on Oct. 22, 2018, disputing the IRS's assertion that none of the $24.5 million of tooling expenses the company claimed in 2012 and 2013 could be treated as QREs. This makes Shiloh at least the third automotive parts supplier with a similar fact pattern to file a petition with the Tax Court.

TG Missouri was a win for taxpayers, and the Sec. 174 pilot model regulations broadened the TG Missouri result. The IRS's concession in TSK appears to be in line with the TG Missouri holding and the application of the Sec. 174 pilot model regulations. Now, Shiloh has filed a similar petition with the court. These recent events should give taxpayers greater confidence to include pilot model expenses as Sec. 174 expenses and R&D supply costs.

EditorNotes

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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