The research credit: Adaptation exclusion

A recent Tax Court case concerning a taxpayer’s eligibility for Sec. 41 research credits, Betz,¹ provides insights regarding the IRS’s and the court’s recent interpretation of the Sec. 41(d)(4)(B) adaptation exclusion and its relationship with the Sec. 174 uncertainty test provided in Sec. 41(d)(1)(A). Although the IRS and Tax Court independently analyzed the adaptation exclusion and the uncertainty test, the case opinion makes it clear that technical uncertainty factors into both analyses. It is important for taxpayers to be mindful of the adaptation exclusion and how the Service may use it to challenge a research credit claim. This awareness is particularly crucial for taxpayers that perform development activities to meet customer specifications.

Qualified research

Sec. 41(d)(1) provides four requirements that research activities must satisfy to constitute qualified research, the expenses of which may be eligible for the research credit:

1. The expenditures are eligible for treatment as specified research or experimental expenditures (SREs) under Sec. 174;
2. The activities must be undertaken to discover information that is technological in nature; 
3. he activities must be intended to be useful in the development of new or improved business components (i.e., any product, process, computer software, technique, formula, or invention) intended for sale, lease, licensing, or use in one’s trade or business; and
4. Substantially all of the activities must constitute a process of experimentation related to a new or improved function, performance, reliability, or quality.

In accordance with Sec. 41(d)(2), the four-part test must be applied to each individual business component separately.

Among the requirements for SREs under the first test above are that they be incurred during the tax year in connection with the taxpayer’s trade or business and represent research and development costs “in the experimental or laboratory sense.”² To be incurred “in the experimental or laboratory sense,” the SREs must be intended to discover information that would eliminate uncertainty concerning a product’s development or improvement (the uncertainty test). Uncertainty for this purpose exists if the information available to the taxpayer does not establish the capability or methodology for developing or improving the product or its appropriate design.³

The adaptation exclusion

Besides the four-part test, Sec. 41(d)(4) provides several exclusions from the definition of “qualified research.” One such exclusion is the adaptation exclusion under Sec. 41(d)(4)(B), which states, “Any 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. Thus, any activities related to adapting an existing business component to fulfill the specific needs or requirements of a particular customer fall outside the purview of qualified research and therefore do not qualify for the research credit. Importantly, Regs. Sec. 1.41-4(c)(3) clarifies that the adaptation exclusion does not apply solely because a business component is intended for a specific customer. Rather, as discussed in greater detail below, development activities associated with business components intended for a specific customer can qualify for the research credit.

Betz and the adaptation exclusion

The petitioners in Betz were shareholders of Catalytic Products International Inc. (CPI), an S corporation that designed and supplied custom-built air pollution control systems, including catalytic and thermal oxidizers that eliminate harmful airborne manufacturing pollutants. These 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 research credit was allocated to the shareholders of CPI and used during the 2014, 2015, and 2016 tax years.

The Tax Court ruled in favor of the IRS, holding that the taxpayers were not entitled to a research credit under Sec. 41 because the costs associated with the development activities did not meet the Sec. 174 uncertainty test and certain projects constituted funded research, which is also excluded from qualified research under Sec. 41(d)(4)(H). The court also concluded that the petitioners were liable for Sec. 6662(a) accuracy-related penalties on the basis of negligence and substantial understatements of income tax for the tax years at issue. The following discussion focuses on the court’s analysis of the Sec.174 uncertainty test, as applicable to CPI’s development activities and the associated expenditures, and its relation to the adaptation exclusion.

The petitioners argued that uncertainty existed as to the appropriate design of each system because the appropriate design could not be established until after each system cleared on-site testing.

The court rejected the petitioners’ assertion, stating that conducting postproduction testing on a product does not establish that its appropriate design as a whole remained uncertain before the testing was successfully completed. The court analyzed employee activities for all 19 projects at issue and generally found that the employees had sufficient details from the projects’ onset to establish the oxidizers’ appropriate design. Importantly, the court appears to have applied in its analysis an obsolete “discovery test” from 2001 final regulations, ⁴ which requires that research undertaken for discovering information that is technological in nature “exceeds, expands, or refines the common knowledge.” In so doing, the court failed to acknowledge that “[a] taxpayer may employ existing technologies and may rely on existing principles.”⁵

The court also addressed the adaptation exclusion in its analysis. Notwithstanding its conclusions with respect to the Sec. 174 uncertainty test, in a footnote of the opinion, the court determined that expenditures incurred associated with one of the projects were excluded from qualified research under the adaptation exclusion because, in some instances, comparable systems were previously designed and supplied to the same customers, such that the appropriate design of the systems was already known. The court’s analysis demonstrates that the existence of technical uncertainty at the outset of the development is important for a project not to be disqualified by the adaptation exclusion.

For example, CPI’s M&W Ireland project (No. 14-07718) required CPI to develop a wastewater treatment system for a European subcontractor of an existing customer. The project’s proposal noted that CPI would deliver an exact copy of a wastewater treatment system that it had previously provided to the same customer but with minor, site-specific changes to meet European Standards. The court found that the petitioners did not establish that the Sec. 174 uncertainty test was satisfied because CPI did not establish that the information about the European standards was unavailable to CPI or that CPI employees conducted any relevant investigative activities. Based on this, the court held that the information available to CPI from its previous project established the project’s basic design specification.

In an independent analysis, the court also concluded that the M&W Ireland project was excluded from qualified research through application of the adaptation exclusion. The court reasoned that an exact copy of a previous product with minor, site-specific modifications falls within the plain meaning of the word “adaptation.” The court cited Trinity Industries, Inc.,⁶ which held that the adaptation exclusion applied to a taxpayer’s “refinement of a preliminary design” provided by the customer.

The court also analyzed the extent to which the 19 projects constituted pilot models to evaluate CPI’s claimed supply QREs. The court concluded that because the petitioners failed to show that the purpose in producing the oxidizers was to evaluate and resolve uncertainty about the product, they failed to establish that the oxidizers were pilot models. The court stated that in some of the projects evaluated, CPI had finalized the appropriate design during the proposal process before the onset of production of the oxidizers, noting that because CPI entered key information and specifications into its spreadsheets and the output dictated the design choices, there was no uncertainty or investigative activities. Further, CPI did not perform design testing during the fabrication process, only quality control testing afterward.

In making its determination, the court acknowledged the possibility that certain wages and supplies related to other pilot models may constitute qualified research at the component or subcomponent level through application of the “shrinking-back” rule provided in Regs. Sec. 1.41-4(b)(2). However, the court noted that the taxpayer failed to provide information and documentation to substantiate application of the shrinking-back rule.

The analysis in Betz is significant to the adaptation exclusion because it emphasizes that the existence of technical uncertainty at the outset of the development that requires investigative activities to resolve is critical for demonstrating that development activities are not a mere adaptation of an existing business component, particularly for taxpayers that perform development activities to meet customer specifications. As part of substantiating the qualification of development activities, taxpayers should distinctly identify the technical uncertainties that existed at the outset of the development.

Taxpayers should also identify the elements that make the current project a new or improved business component, which may include added functionalities, measurable improvements, or a new application that requires certain enhancements to meet that purpose. As evidenced by the pilotmodel analysis in Betz, to substantiate the qualification of pilot models, it is important for taxpayers to demonstrate that technical uncertainty is not resolved until the final unit or system testing is performed, by documenting that a systematic process of experimentation was required throughout the development process.

Preceding case law

Other case law preceding Betz indirectly addresses application of the adaptation exclusion. In Eustace,⁷ the taxpayers owned an S corporation, Applied Systems Inc., which developed and sold software that independent insurance agencies used to manage their businesses. During the early 1990s, the taxpayers sought to claim a research credit associated with activities that Applied Systems undertook to improve its software package, such as those to manage additional ratings computations resulting from transactions between insurers and agencies and to enable multiple people to work on the same customer file simultaneously without corrupting or overwriting each other’s changes.

On appeal, the Seventh Circuit held that none of the activities described in Eustace were “pioneering” but instead “entailed variations on themes long used by other developers,” concluding that the activities did not constitute qualified research. Although the substantive analysis in Eustace is outmoded (the court’s analysis relied upon the discovery test and other requirements that were not adopted in the 2003 final regulations in T. D. 9104) and not directly applicable, the court in Betz asserted that “Sections 41(d)(1) and (d)(4) are independent rules, which deserve, and have received, independent constructions.” Indirectly, the court’s reasoning can be interpreted such that the adaptation exclusion under Sec. 41(d)(4)(B) requires an independent analysis from the general qualification requirements under Sec. 41(d)(1), which is consistent with how the court analyzed the adaptation exclusion.

In Davenport,⁸ the taxpayers were shareholders in Burly Corp., which owned a subsidiary, Mueller Supply Co. Inc., that manufactured residential metal roofing and stand-alone metal Buildings. The taxpayers filed amended tax returns for their 2002 and 2003 tax years to claim research credits associated with software developed to manage, automate, and integrate all aspects of Mueller’s business, including integration of manufacturing, design, sales, accounting, and shipping (what the taxpayers called the “OneWorld Project”). The OneWorld Project was developed using a J.D. Edwards OneWorld software application suite that was commercially available and used for enterprise resource planning.

In this case, the IRS contended that the OneWorld Project involved mere adaptation of existing commercially available software and quality control–type testing, while the taxpayers argued that the project involved a complex process of custom software design, customization, and testing. The court ruled in favor of the IRS, finding no evidence that the development activities included a process of experimentation. The court concluded, “More importantly, the evidence establishes that any uncertainty that existed as to the ‘capability or the method of achieving that result, or the appropriate design of that result’ occurred during the Project, not at the outset of the Project or ‘as of the beginning of the [Davenports’] research activities.’ ” Although the court did not directly address the IRS’s position with respect to the adaptation exclusion, the court’s findings suggest that demonstrating the existence of technical uncertainty at the outset of a project is central for distinguishing qualified research activities from activities that are a mere adaptation of existing products.

Adaptation exclusion examples

Regs. Sec. 1.41-4(c)(10) provides illustrative examples regarding the application of the adaptation exclusion. The taxpayer in Example 3 is a software development company that offers a general ledger accounting software program to its clients. The taxpayer incurs expenses to customize the core software platform to meet the unique requirements of a specific customer. Example 3 concludes that the taxpayer’s activities are excluded from qualified research under the adaptation exclusion because its activities relate to adapting an existing software program to align with a particular customer’s need.

In Example 6, the taxpayer is a rail car manufacturer. The rail cars that it manufactures come with a range of specifications concerning performance, quality, and reliability that require extensive testing procedures. A customer places an order for a passenger rail car with design specifications that differ from those of other existing customers only in that the customer wants fewer seats and a higher quality of seat material and carpet than what is currently available in the market. This example concludes that these activities are excluded from the definition of “qualified research” because the rail car does not represent a new business component for the taxpayer and instead is an adaptation of an existing business component that did not necessitate a process of experimentation.

In Example 7, a valve equipment manufacturer engages in activities to design an improved manufacturing process that requires the use of specialized robotic equipment that is not readily available in the commercial market. The taxpayer acquires preexisting robotic equipment, and the taxpayer’s engineers identify technical uncertainty concerning how to modify the equipment to meet the taxpayer’s specific needs. The engineers perform extensive scientific and laboratory testing to evaluate design alternatives and ultimately develop a design to meet the taxpayer’s needs. It is concluded that the research activities are not excluded from qualified research under the adaptation exclusion, provided that the research satisfies the requirements under Sec. 41(d)(1).

There is a clear distinction between the development activities in Examples 3 and 6 and those in Example 7. The efforts in Example 3 and Example 6 are associated with business components that have limited or no unique design specifications to distinguish them from previous business components. In contrast, the development activities in Example 7 are associated with a business component with unique design requirements evidenced by clear technical uncertainties that exist at the outset of the development. These examples further emphasize the importance of documenting technical uncertainties that exist at the development’s outset to substantiate qualified research activities and the inapplicability of the adaptation exclusion.

In addition, the business component in Example 7 was developed to meet the taxpayer’s specific needs, which underscores that the adaptation exclusion does not apply solely because a business component is intended for a specific customer. Interestingly, the conclusion In Example 7 could be interpreted such that the analysis of the adaptation exclusion under Sec. 41(d)(4)(B) is not independent of the four-part test analysis under Sec. 41(d)(1), which conflicts with the courts’ interpretation in Betz and Eustace. For additional context, a House conference report on the Tax Reform Act of 1986⁹ stated, “The conference agreement specifies that expenditures incurred in certain research, researchrelated, or nonresearch activities are excluded from eligibility for the credit, without reference to the requirements described above relating to technological information, process of experimentation, and functional purposes.”¹⁰ This appears to suggest that Congress intended the independent application of the Sec. 41(d)(4) exclusions.

However, compare that to the preamble of T.D. 9104,¹¹ in which the government explained:

Some commentators requested additional clarification regarding the scope of the research after commercial production, adaptation, and duplication exclusions set out in section 41(d)(4)(A), (B) and (C), and §1.41-4(c)(2), (3) and (4) of the 2001 proposed regulations. After consideration of these comments, the Treasury Department and the IRS believe that the multitude of factual situations to which these exclusions might apply make it impractical to provide additional clarification that is both meaningful and of broad application. The Treasury Department and the IRS believe these three specific exclusions do not cover research activities that otherwise satisfy the requirements for qualified research. Taxpayers, however, should carefully review (including, as appropriate, the application of the shrinking-back rule) research activities that might otherwise fall within these exclusions to ensure that only eligible activities are being included in their credit computations.

Thus, it is clear from the preamble that the IRS and Treasury do not believe that the adaptation exclusion independently excludes otherwise qualifying research activities.

Importance of technical uncertainties

Taxpayers that perform development activities for customers under an agreement to meet those customers’ specifications should distinctly identify the technical uncertainties that exist at the outset of the development for each business component and clearly document the new or improved aspects of each business component that give rise to the technical uncertainty. It is important for taxpayers to substantiate these technical uncertainties and improvements to business components through adequate documentation and analysis to demonstrate the inapplicability of the adaptation exclusion to their development efforts.

Footnotes

¹ Betz, T.C. Memo. 2023-84.

²Regs. Sec. 1.174-2(a)(1).

³Id.

⁴T.D. 8930, 66 Fed. Reg. 280 (Jan. 3, 2001).

⁵Regs. Sec. 1.41-4(a)(4).

⁶Trinity Industries, Inc., 691 F. Supp. 688, 697, n.11 (N.D. Tex. 2010).

⁷Eustace, T.C. Memo. 2001-66, aff’d, 312 F.3d 905 (7th Cir. 2002).

⁸Davenport, 897 F. Supp. 2d 496 (N.D. Tex. 2012).

⁹Tax Reform Act of 1986, P.L. 99-514.

¹⁰H.R. Conf. Rep’t No. 99-841, 99th Cong., 2d Sess., vol. II, p. 74 (Sept. 18, 1986).

¹¹69 Fed. Reg. 22, at 25 (Jan. 2, 2004).

Contributors

Pinky Shodhan, CPA, J.D., LL.M., MBA, is a senior tax associate; Samantha Joost, CPA, is a senior manager; Dennis St. Martin, CPA, is a senior manager; Monica Bambury, J.D., LL.M., is a senior manager; and Kevin Benton, E.A., is a managing director, all with Grant Thornton LLP. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA RESOURCES

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Frost et al., “The Research Credit: Documenting Qualified Services,” 55-3 The Tax Adviser 12 (March 2024) 

Koch, “R&D Tax Credits: A Valuable Cash Infusion for Businesses,” Tax Insider (Aug. 13, 2020)

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