A process of experimentation: Production expenses for the R&D tax credit

Editor: Rochelle Hodes, J.D., LL.M.

The Sec. 41 research and development (R&D) tax credit can provide a lucrative benefit for taxpayers, yet it carries the risk of intense scrutiny from the IRS. Moreover, the credit has been subject to myriad court rulings over the years that have critically shaped its application and interpretation.

Recently, in Intermountain Electronics, Inc., No. 11019-19 (T.C. 3/14/24) (order), the Tax Court denied an IRS motion for partial summary judgment. The court evaluated whether a pilot model meets the definition of a process of experimentation under Sec. 41(d)(3)(A) and whether production expenses incurred in developing a pilot model qualify as R&D credit. Eligible expenses under Sec. 174. The court’s order provides insights into the “substantially all” test under Sec. 41(d), the treatment of production costs incurred to develop a pilot model, and the importance of documentation to support qualified research activities.

Background

Intermountain Electronics Inc., a Utahbased C corporation, specializes in designing, engineering, manufacturing, and servicing custom electrical equipment for various industries, including mining, oil and gas, power generation, and government sectors. The taxpayer’s operations encompass three primary areas:

• Custom equipment fabrication;
• Transformer production; and
• Proprietary product innovation.

Intermountain Electronics’ products include specialized controls, switchgears, e-houses, and other electrical components. Their development lifecycle involves a multistage process from initial design to in-house part manufacturing, assembly, and final product testing before obtaining customer approval. For tax years 2012 through 2015, Intermountain Electronics claimed R&D tax credits for the expenses related to the development and manufacturing of its custom products, in which qualified costs included expenses for both nonproduction and production staff as well as for supplies. Intermountain Electronics claimed that each design of custom electrical distribution and control equipment is a unique and nonrepeatable finished design and thus considered them pilot models meeting the definition under Regs. Sec. 1.174-2(a)(4). The IRS denied the taxpayer’s claimed R&D tax credits for the expenses, based on the following arguments:

• Intermountain Electronics’ pilot models did not meet the “substantially all” test for R&D activities under Sec. 41(d); and
• The pilot model production expenses were not for eligible research and development under Sec. 174, which requires that an activity must relate to research and development in the experimental or laboratory sense (Regs. Sec. 1.174-2(a)(1)).

The ‘substantially all’ test

Sec. 41(d) defines qualified research for purposes of the R&D credit as research that is not an excluded activity under Sec. 41(d)(4) and that meets all of the following criteria:

1. Costs for the activity are treated as research or experimental expenditures under Sec. 174;

2. The activity is undertaken for the purpose of discovering information that is technological in nature;

3. The activity is intended to be useful in the development of a new or improved business component of the taxpayer; and

4. Substantially all of the activities constitute elements of a process of experimentation for a qualified purpose. In general, a qualified purpose relates to a new or improved function, performance, or reliability or quality (Sec. 41(d)(3)(A)).

For purposes of the “substantially all” requirement under Sec. 41(d)(1)(C), Regs. Sec. 1.41-4(a)(5)(i) provides that:

a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).

Regs. Sec. 1.41-4(a)(5)(i) further provides that:

[a] process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. A taxpayer may undertake a process of experimentation if there is no uncertainty concerning the taxpayer’s capability or method of achieving the desired result so long as the appropriate design of the desired result is uncertain as of the beginning of the taxpayer’s research activities. Uncertainty concerning the development or improvement of the business component (e.g., its appropriate design) does not establish that all activities undertaken to achieve that new or improved business component constitute a process of experimentation.

Under Sec. 41(d)(1) and Regs. Sec. 1. 41-4(a)(6), in order for activities to constitute qualified research, substantially all of the activities must constitute elements of a process of experimentation that relates to a qualified purpose. The “substantially all” test requires that 80% or more of a taxpayer’s research activities, measured on a cost or other consistently applied reasonable basis, constitute elements of a process of experimentation. Accordingly, if at least 80% of a taxpayer’s research activities constitute elements of a process of experimentation for a qualified purpose, the “substantially all” test is satisfied even if the remaining 20% or less of a taxpayer’s research activities do not constitute elements of a process of experimentation, as long as these remaining research activities satisfy the requirements of Sec. 41(d)(1)(A) and are not otherwise excluded under Sec. 41(d)(4). The “substantially all” requirement is applied separately to each business component.

Determining whether the 80%-or-more requirement is satisfied is based on a ratio as follows: costs satisfying elements of a process of experimentation ÷ overall costs eligible for the R&D tax credit.

Whether costs are properly included in the numerator and denominator of the fraction has been a point of dispute with the IRS. In determining which costs can be included in the fraction, it is helpful to understand the types of services (commonly referred to as “activity levels”) that qualify for the R&D tax credit. Under Sec. 41(b)(2) and Regs. Sec. 1.41-2(c), costs attributable to the following activity levels qualify for the credit:

• Direct engagement in qualified research: Involvement of individuals in the actual conduct of qualified research.
• Direct supervision of qualified research: Involvement of individuals in supervision of qualified research, such as a research scientist who directly supervises laboratory experiments but who may not actually perform experiments.
• Direct support of qualified research: Involvement of individuals who support the research activities or supervision of research activities. For example, direct support of research includes the services of a secretary for typing reports describing laboratory results derived from qualified research, of a laboratory worker for cleaning equipment used in qualified research, of a clerk for compiling research data, and of a machinist for machining a part of an experimental model used in qualified research.

In the motion for summary judgment in Intermountain Electronics, the IRS relied on Little Sandy Coal Co., T.C. Memo. 2021-15, to argue that production expenses should be omitted from the “substantially all” fraction. In Little Sandy Coal Co., the Tax Court gave two reasons for upholding the IRS’s disallowance of the taxpayer’s research credit claim: (1) Production costs were excluded from the numerator of the “substantially all” fraction, and (2) the taxpayer did not provide sufficient evidence to establish the factual basis or provide sufficient evidence for claiming those costs. Regarding the second point, most of the substantiation the taxpayer provided at trial was oral testimony, which the court found did not convincingly demonstrate that production expenses should be included in the fraction.

On appeal, the Seventh Circuit in Little Sandy Coal Co. Upheld the Tax Court’s ultimate conclusion that the taxpayer did not substantiate that the activities conducted by both the production and nonproduction employees were elements of a process of experimentation (Little Sandy Coal Co., 62 F.4th 287 (7th Cir. 2023)). However, the Seventh Circuit disagreed with what appeared to be the Tax Court’s categorical exclusion of direct support and direct supervision activities, ruling that production activities may constitute a process of experimentation. While the Tax Court’s order in Intermountain Electronics did not specifically address the Seventh Circuit’s decision in Little Sandy Coal Co., the order aligns with the Seventh Circuit’s decision in stating that it is possible for production expenses to be included in the numerator of the “substantially all” fraction.

A silver lining

The Tax Court’s Intermountain Electronics order presents some hope to taxpayers regarding the treatment of production costs. In denying summary judgment to the IRS, the court explicitly stated that Little Sandy Coal Co. “does not foreclose production expenses from being included in the numerator of the substantially all equation,” explaining that in Little Sandy Coal Co., it found that the taxpayer had not established that the production expenses could be included in the numerator.

This ruling is significant and favorable for taxpayers seeking to claim the R&D tax credit, as it leaves the door open for production expenses to potentially qualify as part of the R&D credit computation.

The Tax Court specifically rejected the IRS’s narrow interpretation and stated that production costs can be included in the numerator of the “substantially all” fraction if the taxpayer establishes that such costs constitute elements of a process of experimentation. One caveat remains: Intermountain Electronics still must establish at trial that it has production expenses that qualify to be included in the “substantially all” calculation. To do this, the taxpayer’s evidence will have to include a detailed analysis of R&D activities and associated costs, as well as substantiation of qualified activities.

Against the recent backdrop of more rigorous examinations of R&D tax credit claims and increased reporting on an upcoming revision of Form 6765, Credit for Increasing Research Activities, taxpayers should sharpen their focus on compliance and substantiation. While one common challenge by the IRS is now a question of fact and not law, Intermountain Electronics and prior cases are reminders that sufficient documentation supporting the R&D tax credit, including how qualified research expenses meet the process-of-experimentation requirement, is essential for overcoming an IRS challenge.

Editor notes

Rochelle Hodes, J.D., LL.M., is principal with Washington National Tax, Crowe LLP, in Washington, D.C.

For additional information about these items, contact Hodes at Rochelle.Hodes@crowe.com.

Contributors are members of or associated with Crowe LLP.