April 27, 2021
The court ruled that the taxpayer failed three elements of the four-part test: the section 174 test; the technological in nature test; and the process of experimentation test. In addition, the court ruled that the taxpayer’s activities fell within the exclusion under I.R.C. section 41(b)(3)(B) for research undertaken for style, taste, cosmetic, or seasonal design factors.
A. Section 174 Test
The Tax Court observed that uncertainty may not require experimentation and that the taxpayer must show it has experimental expenditures because (1) the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product, and (2) its activities were meant to eliminate these uncertainties.
The court found that the taxpayer’s claimed uncertainties including: how to cut and drape printed fabrics; fabric choices; thread sizes; details such as twists, pintucks, and pleating in the fabric; modifying patterns for plus-size garments; fabric shrinkage; and the final fit of the garment are not uncertainties under I.R.C. section 174.
The court reasoned that for an uncertainty to exist under section 174, a taxpayer must be uncertain about whether it can achieve its objective through research. Here, the taxpayer had the requisite information to resolve issues as they arose. Thus, the proper thread size to use with a particular fabric and the proportions of a garment are well known and understood by the designers and patternmakers. How to drape a particular fabric to achieve the desired aesthetic may be unknown, but the taxpayer’s garment makers already had the information necessary to address that unknown.
The court also found that the taxpayer’s activities, such as testing fabric shrinkage by washing it, were not investigative. These activities were “common solutions to common problems.”
B. Technological in Nature
The taxpayer argued that fit testing relies on engineering, fabric draping and fabric print alignment activities rely on material sciences, and fabric shrinkage and colorfastness tests rely on principles of chemistry.
Using a plain meaning analysis, the court rejected the taxpayer’s arguments stating fit testing does not constitute engineering, fabric draping and fabric print alignment do not rely on principles of material science, and fabric shrinkage and colorfastness related activities do not rely on principles of chemistry.
C. Process of Experimentation
The court provided several reasons to conclude the taxpayer failed to meet this requirement. First, the taxpayer did not face uncertainty for purposes of the process of experimentation test.
Second, to conduct a process of experimentation, a taxpayer must also use hard sciences to achieve a business’s goal. The regulations provide a process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science. The taxpayer did not fundamentally rely on science or engineering in its product development process.
Third, according to the court, the taxpayer did not employ a process akin to the scientific method to address issues. Per the court, “to be a true process of experimentation, the project must use the scientific method.” This means “the project must involve a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.”
D. Research falls under 41(b)(3)(B) exclusion
Section 41(b)(3)(B) provides, “[R]esearch shall in no event be treated as conducted for a purpose described in this paragraph if it relates to style, taste, cosmetic, or seasonal design factors. Here, the court concluded “many of LMI’s activities were not for a qualified purpose because they related to style, taste, and seasonal design factors.”
The court provides a well-reasoned analysis of why the taxpayer’s activities did not meet the four-part test. Its reasoning of why the research was not technological in nature, and why the purported research activities fall within the exclusion for research undertaken for style, taste, and seasonal design factors are difficult to challenge.
While we believe the case was correctly decided, the court’s interpretation of the applicable standards for technical uncertainty under section 174, and what constitutes elements of a process of experimentation raise issues requiring additional clarification.
Regarding the 174 test, the court concluded that the taxpayer’s development team knew how to solve the issues characterized as technical uncertainties at the outset of the project, and therefore there was no technical uncertainty. Clearly, the technical uncertainty requirement is not met if a taxpayer knows at the outset how to solve the technical uncertainty.
However, the fact that developers may employ “common solutions to common problems” should not be interpreted as establishing a de facto rule for concluding no technical uncertainty exists. Congress has stated that “employing existing technologies in a particular field or relying on existing principles of engineering or science is qualified research if such activities are otherwise undertaken for purposes of discovering information and satisfy the other requirements under I.R.C. § 41.”
In addition, such an interpretation would be inconsistent with the Tax Court’s decision in Suder v. Commissioner. In Suder, the court held the taxpayer met the section 174 test for all 12 projects under consideration. Many projects were for incremental product improvements, and often the engineers did rely on common solutions and existing principles of engineering to resolve the technical uncertainty. Yet, the court sided with the taxpayer rejecting the IRS’s argument that no technical uncertainty existed because the taxpayer’s research and development activities were routine.
As the court’s statement in Leon Max is dicta, it likely did not intend to set any precedent that would conflict with Congress’s statement above, or cases like Suder. Rather, the court concluded that based on the facts of the case before it, the taxpayer simply knew how to resolve the issues it identified at the outset of the project, and therefore there was no technical uncertainty.
Regarding the process of experimentation requirement, not surprisingly, the Tax Court concluded the taxpayer failed to meet this element as any process of experimentation was not undertaken to resolve a technical uncertainty.
In addition, since the court had concluded the taxpayer did not meet the technological in nature test, the taxpayer would also fail the process of experimentation test because a process of experimentation “must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.”
What requires clarification is the court’s assertion, “[t]o be a true process of experimentation, the project must use the scientific method,” and whether this interpretation impermissibly narrows the types of activities constituting elements of a process of experimentation.
Treas. Reg. section 1.41-4(a)(5)(i) provides a taxpayer’s research includes “elements of a process of experimentation” if it is “designed to evaluate one or more alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology) 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.”
Applying this standard, the Suder court held the taxpayer’s formal product development process constituted elements of a process of experimentation because it enabled the taxpayer to identity uncertainty concerning the development of a product, and enabled the taxpayer to identify and evaluate potential alternatives to resolve those uncertainties, through a systematic trial and error methodology.
Based on a plain reading of the statute and regulations, the scientific method is not a pre-requisite to meeting the process of experimentation” test. As Suder makes clear, all that is required is that the taxpayer employ a systematic process capable of identifying alternatives to resolve technical issues that existed at the outset of the project (i.e. through modeling, simulation or systematic trial and error).
Finally, section 41(d)(1)(C) does not talk about “a process of experimentation,” but rather activities constituting “elements of a process of experimentation.” Thus, a process need not include nor be limited to, all the steps of a systematic trial and error process (or the scientific method) so long as the process employed includes the core elements of a systematic trial and error process.
Ramifications to Taxpayer’s Reporting Apparel R&D Credits
Leon Max has major implications for companies claiming R&D credits in the fast fashion industry. (We do not believe this decision has any significant impact to companies that develop performance or functional apparel.)
The IRS is on very solid ground disallowing the credits based on the 1) the technological in nature test, and 2) the exclusion for research related to style, taste, and seasonal design factors. While Leon Max raises some issues regarding applying the section 174 and process of experimentation requirements, the IRS also has a strong position denying the credits based on the failure of the taxpayer to meet these tests (e.g., the taxpayer per se fails the process of experimentation test if the research is not technological in nature).
Leon Max follows two other recent Tax Court cases — Siemer Milling v. Commissioner and Little Sandy Coal v. Commissioner – in attempting to narrow the definition of what constitutes elements of a process of experimentation. These cases highlight the importance of having a robust methodology to substantiate the process of experimentation requirement. Those that fail to address the issues raised by these cases face a tougher time attempting to sustain their credits on audit.