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The research credit: Business-component requirement
The Fifth Circuit’s decision in Grigsby, 86 F.4th 602 (5th Cir. 2023), emphasizes the need for taxpayers to clearly define business components when preparing and documenting their Sec. 41 credit.

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A recent circuit court case, Grigsby,1 emphasizes the need for taxpayers to clearly define business components when preparing and documenting their Sec. 41 research tax credit. The Fifth Circuit determined that the taxpayer failed the business–component requirement and cited that failure as one of two reasons for disallowing the research credit.
This article focuses on the taxpayer’s approach to the business–component requirement in Grigsby, the significance of separately analyzing product development and process development, and considerations that taxpayers should make when defining and analyzing business components for the purposes of preparing research credit claims.
Background
Since being enacted through the Economic Recovery Tax Act of 1981, P.L. 97–34, the credit for increasing research activities (the research credit) has had a long history of uncertainty for taxpayers, due to several variables including the subjective nature of the requirements and the need for technical guidance during the early years of the credit. For example, the term “qualified research” for purposes of the research credit initially had the same meaning as the term “research or experimental” under Sec. 174. Consequently, Congress believed that the 1981 act was being applied too broadly, with some taxpayers claiming the credit for virtually any expense relating to product development.2
Additionally, in a hearing conducted by the Senate Finance Committee, John Chapoton, assistant secretary of the Treasury for Tax Policy, discussed the need to narrow the application of the research credit through the introduction of the business–component requirement:3
Taxpayers in other industries [outside of manufacturing and utility areas] also claimed the credit in 1981, businesses such as fast–food restaurants, baked goods, home building, publishing, banking, stock brokerage, and movie production. All claimed the credit. I think it is pretty clear that we have some cases far from the high technology research area. … We would focus on the business component, that is the most basic element or component part of a product or process, with respect to withdrawing the activities undertaken, to see if the required substantial technological improvement is found.
Additionally, there was ambiguity regarding the eligibility of process–related activities with respect to research beginning after the commercialization of a product.
As part of the Tax Reform Act of 1986, P.L. 99–514, Congress made changes to the research credit that included amending the definition of “qualified research” to add the business–component requirement and providing a related special rule for production processes that drew a distinction between product development and process development. Specifically, Congress clarified that process–related activities performed after the commercialization of a product may qualify for the credit only if the qualified research requirements were met for developing a new or improved process. These changes provided taxpayers with further guidance while also narrowing the credit’s scope to better achieve the tax policy of encouraging businesses to perform the research necessary to increase the innovative qualities and efficiency of the U.S. economy.4
Congress continued to pass a series of bills to extend the research credit while revising and providing clarifications around requirements to claim the credit. In 2001, Treasury issued final regulations addressing the qualified research and business–component requirements.5 In response to taxpayer concerns, Treasury suspended the 2001 final regulations and issued proposed regulations.6 Treasury subsequently issued final regulations in 2004,7 which adopted and revised portions of the proposed regulations.
Code and regulations
Sec. 41(d)(2)(B) defines a “business component” as any product, process, computer software, technique, formula, or invention that is intended to be held for sale, lease, or license, or used by the taxpayer in its trade or business. Sec. 41(d)(2)(A) further specifies that the “four–part test” for determining qualified research, as outlined in Sec. 41(d)(1), must be applied separately to each business component. For in–house and third–party expenditures to be eligible for inclusion in the research credit, these expenses must relate to a business component that individually meets the requirements of the four–part test. Additionally, Regs. Sec. 1.41–4(a) affirms the business–component requirement by stating that research activities related to the development or improvement of a business component must meet all the requirements of Sec. 41(d)(1) to be treated as qualified research.
Additional guidance regarding the qualification of business components is provided in Sec. 41 and the underlying regulations. Specifically, Sec. 41(d)(2)(C) requires that any plant process, machinery, or technique used for the commercial production of a business component be treated as a separate business component from the business component being produced. Therefore, the costs associated with developing production processes, machinery, or techniques are separately analyzed for qualification. Additionally, Sec. 41(d)(4) lists exclusions from the definition of qualified research that are expanded upon in the regulations and are generally applied at the business–component level. For example:
- Post-commercial production: Activities conducted after the beginning of commercial production generally do not qualify as research for purposes of the research credit.8
- Adaptation: Activities related to adapting an existing business component to meet a particular customer’s requirements or needs are not qualified research.9 The adaptation exclusion ensures that only efforts intended to develop new or significantly improved business components are eligible for the research credit.10
- Duplication: Activities related to duplicating or reproducing an existing business component are not qualified research.11 This exclusion applies if the taxpayer reproduces an existing business component, in whole or in part, from a physical examination, plans, blueprints, detailed specifications, or publicly available information.
It is critical that business components are clearly established and that the analysis of each business component (including application of any relevant exclusions) is adequately documented to substantiate a research credit claim.
Grigsby case
In Grigsby,12 the IRS sought to recover a tax refund that it issued to the defendants as shareholders of Cajun Industries LLC, an S corporation. Cajun amended its 2012 tax return to include $1.3 million in research credits based on its determination that various projects met the Sec. 41 criteria. Representative projects included infrastructure improvements such as flood control structures and site preparation for industrial plants. After initially approving the credit and issuing the refund, the IRS determined that the refund was erroneous because the claimed activities did not align with the requirements for qualified research under Sec. 41.
In its decision, the district court determined that Cajun did not meet the Sec. 41 requirement to develop a business component for two reasons. The first reason was procedural, with the court finding that the taxpayers failed to supplement their discovery responses to include new assertions that the business components were processes instead of products, as the business components were originally defined. In its second reason, the court cited a lack of specificity in the taxpayers’ description of Cajun’s business components and noted the taxpayers’ descriptions were merely “vague” references to new construction processes that related to Cajun’s “methods of construction.” Without identifying specific processes or methods of construction, the taxpayers made a general statement that “Cajun performed engineering analyses that fundamentally relied on engineering principles, which allowed Cajun to determine the proper method of construction.” The court concluded the taxpayers did not identify a single new or improved construction process, and their vague and conclusory statements could not create an issue of fact to withstand summary judgment. The district court granted summary judgment to the government based on its determination that Cajun did not meet the business–component requirements of Sec. 41 and that the work performed by Cajun would be considered funded research under the funded–research exclusion provided in Sec. 41(d)(4)(H).
On appeal, the Fifth Circuit affirmed the district court’s decision.13 The Fifth Circuit noted that two of the three reasons the district court relied upon to grant summary judgment were based on the business–component requirement. First, the taxpayers failed to properly disclose their arguments related to product vs. process business components, and the process arguments failed for lack of specificity. Second, the taxpayers separately failed to offer any evidence establishing any new or improved products.
In its decision, the Fifth Circuit stated the four–part test must be applied separately to each business component. As such, evidence provided by the taxpayers regarding Cajun’s processes could not be applied to its products. After determining the only evidence provided by taxpayers related to its process development and not its product development, the court evaluated the taxpayers’ business–component process claims. The Fifth Circuit determined the change from a product to process argument was an entirely new basis to claim the credit. This meant that, regardless of how intertwined the two types of business components may have been, each product and process required a separate evaluation to qualify for purposes of the research credit. The court also noted the district court’s determination that even if the construction process evidence was allowed, it was vague and conclusory and did not identify a single new or improved process that resulted from Cajun’s work on the projects.
The Fifth Circuit concluded that the projects “yielded no viable business components and were funded,” and, as such, the taxpayers were ineligible to claim the research credit. The Fifth Circuit affirmed the district court’s grant of summary judgment, and the taxpayer subsequently filed a certiorari petition with the U.S. Supreme Court.
Though the Supreme Court refused to hear the taxpayers’ case,14 their petition contained several arguments regarding the business–component requirement. First, the taxpayers argued that the categorization of a business component as a process or product is not mutually exclusive, based on the definition of a “product” in Regs. Sec. 1.174–2(a)(3), which provides that it includes “any pilot model, process, formula, invention, technique, patent or similar property.” Second, the taxpayers asserted that the business components were correctly identified and defined within the government’s proposed statement of facts, which stated that Cajun built the new structures for each project. The taxpayers claimed their identification of the business component was sufficient without having to categorize them as either products or processes.
Preceding case law
In addition to the recent decision in Grigsby, other cases involving the research credit have further demonstrated the importance for taxpayers to substantiate the business–component test and clearly define the business component associated with their research activities.
In Siemer Milling Company,15the taxpayer was in the business of milling and selling wheat flour. The taxpayer claimed research credits for the tax years ended May 31, 2011, and May 31, 2012, associated with seven projects, some of which occurred over both credit years. At trial, the IRS asserted that all seven of the taxpayer’s projects were not qualified research because they did not satisfy any of the four tests. The IRS made several arguments that it claimed were broadly applicable to all the projects and other arguments that were applicable to specific projects.
The IRS contended that each of the taxpayer’s projects failed the business–component test under Secs. 41(d)(1)(B)(ii) and (d)(2)(B) because the taxpayer was inconsistent in its description of the business component to which each project related. The IRS noted that the taxpayer’s expert witness described all the business components as “processes” during testimony, but on brief, the taxpayer represented that the business components were “either process improvements, product improvements, or some combination of both.” The Tax Court found this argument unpersuasive, reasoning that the expert witness’s description of the projects was not at odds with the taxpayer’s representations on brief. Still, the court concluded that the taxpayer’s wheat hybrids project did not meet the business–component test because the taxpayer failed to establish what business component it sought to develop with this project. During this project, the taxpayer performed testing on new varieties of wheat that it collected from breeders, and the court found that the taxpayer was simply determining what was available from wheat breeders and growers rather than developing a new or improved product or process.
Notably, the court did not address the special rule in Sec. 41(d)(2)(C) that requires production processes to be treated as a separate business component from the business component being produced. Although the Tax Court rejected its arguments, the IRS’s challenge of the research credit claim based on inconsistent business–component descriptions emphasizes the significance of establishing clearly defined business components.
In Stephens,16 the Tax Court denied the IRS’s motion for partial summary judgment, ruling that the Service failed to establish that, as a matter of law, the supply expenses at issue could not be qualified research expenses. The taxpayers owned two S corporations, Controlled Environmental Systems Inc. (CESI) and Quality Air Services Inc. (QASI), that were in the business of selling custom airflow systems. CESI and QASI contracted with third parties to build and install the systems at their customer’s site and claimed research credits for aspects of designing and building these systems. The research credits included employee wages and supply expenses used by third–party manufacturers to build airflow systems (e.g., panels, hinges, screws, nuts, valves, monitors, and ducts).
In its motion, the IRS argued that CESI’s and QASI’s contractual obligations to build airflow systems were analogous to the facts in Union Carbide Corp.,17 where the Tax Court determined that supplies were not qualified research expenses because they would have been purchased regardless of any qualified research being conducted. The Tax Court in Stephens held that the precedent established in Union Carbide Corp. did not foreclose CESI and QASI from treating their supplies as qualified research expenses. According to the court, Union Carbide Corp. was distinguishable, in part, because the research credit claimed by the taxpayer in Union Carbide Corp. was for a process, whereas the research credits claimed by the taxpayers in Stephens were for airflow systems products. The Tax Court’s analysis in Stephens makes clear that a taxpayer’s business–component definition (e.g., product vs. process) is critical to not only substantiating whether a business component meets the definition of qualified research but also in determining the amounts that may be includible as qualified research expenses.
Considerations
As emphasized by Grigsby and the preceding case law, business components are a fundamental concept for the research credit, as illustrated by the requirement under Sec. 41(d) that research activities are only qualified to the extent they are related to a business component. Therefore, it is critical to sufficiently memorialize the analysis at the business–component level and provide contemporaneous documentation to corroborate the qualified research. One challenge that taxpayers face is that this analysis is driven by facts and circumstances, and, given the subjective nature of the definition of qualified research, two substantially similar taxpayers may apply the Sec. 41 requirements to their specific facts and arrive at different conclusions regarding business–component qualification or even defining the business component.
The IRS continues to focus on auditing research credit claims at the business–component level. In a recent news release,18 the IRS explained that Form 6765, Credit for Increasing Research Activities, will require many taxpayers to provide business–component information for the 2025 tax year, while taxpayers have the option of voluntarily providing that information for the 2024 tax year. Form 6765 now includes specifically establishing the business–component type under Sec. 41(d)(2)(B) for each business component required to be reported. In a subsequent news release that accompanied the draft instructions for Form 6765,19 the IRS encouraged taxpayers and their representatives to review and consider using the form’s new format when preparing their tax–year 2024 return. Without sufficiently analyzing the qualified research expenditures and activities at the individual business–component level to document how the requirements under Sec. 41 are met, taxpayers will encounter significant challenges when claiming and defending research credit claims.
Footnotes
1Grigsby, 86 F.4th 602 (5th Cir. 2023).
2See S. Rep’t No. 99-313, 99th Cong., 2d Sess., at 694—95 (1986).
3S. Hearing 98-843, at 74—76 (1984).
4S. Rep’t No. 99-313, 99th Cong., 2d Sess., at 694 and 698 (1986).
5T.D. 8930.
6REG-112991-01.
7T.D. 9104.
8Regs. Sec. 1.41-4(c)(2).
9Regs. Sec. 1.41-4(c)(3).
10See Shodhan, Joost, St. Martin, Bambury, and Benton, “The Research Credit: Adaptation Exclusion,” 55-6 The Tax Adviser 38 (June 2024).
11Regs. Sec. 1.41-4(c)(4).
12Grigsby, No. 19-596-BAJ-SDJ (M.D. La. 2022).
13Grigsby, 86 F.4th 602 (5th Cir. 2023).
14Grigsby, No. 24-40 (U.S. 10/7/24) cert. denied.
15Siemer Milling Company, T.C. Memo. 2019-37.
16Stephens, No. 9920-21 (T.C. 12/5/22) (order).
17Union Carbide Corp., T.C. Memo. 2009-50.
18News Release IR-2024-171, June 21, 2024.
19News Release IR-2024-313, Dec. 20, 2024.
Contributors
Dennis St. Martin, CPA, is a senior manager in Raleigh, N.C.; Nick Wasielewski, CPA, is a senior manager in Minneapolis; Ami Norton, J.D., is a senior manager in Houston; Monica Bambury, J.D., LL.M., is a managing director in Bellevue, Wash.; and Kevin Benton, E.A., is a managing director in Dallas, all with Grant Thornton LLP. For more information about this article, contact thetaxadviser@aicpa.org.
Articles
Shodhan, Joost, St. Martin, Bambury, and Benton, “The Research Credit: Adaptation Exclusion,” 55-6 The Tax Adviser 38 (June 2024)
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)
Comment letter
AICPA comments on proposed changes to Form 6765, Credit for Increasing Research Activities
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