Tax Court opines on qualified research expenses

The Tax Court recently issued a partial summary judgment in Gale E. Stephens & Anne M. Stephens v. Commissioner of Internal Revenue (Docket No. 9920-21), permitting the taxpayer to treat supply expenses as qualified research expenses.

In Stephens, the court examined Controlled Environmental Systems, Inc. (CESI) and Quality Air Services, Inc. (QASI), which design and sell custom air flow systems. After developing a design that CESI and QASI believed would meet a customer’s specific needs, CESI and QASI would contract with third parties to build and install the systems at the customer's site. CESI and QASI also would purchase supplies to fabricate pilot models that were used in a process of experimentation to develop new products that would be sold to customers.

CESI and QASI claimed research credits under Section 41 for aspects of designing and building these air flow systems.

The IRS argued that because the supplies would have been purchased regardless of whether qualified research was being conducted, they cannot qualify as supplies used in the conduct of qualified research. The IRS pointed to Union Carbide Corp. & Subsidiaries v. Commissioner (T.C. Memo. 2009-50), in which the Tax Court disallowed production supplies consumed during process-related research activities.

One process-related research activity in Union Carbide involved creating a revised method to produce ethylene — a substance used to manufacture plastics. During production, the taxpayer in the case was forced to regularly suspend its ethylene manufacturing furnaces to rid the furnaces of harmful byproducts created during the production process. Looking for ways to mitigate this problem, the taxpayer conducted several tests, incorporating and experimenting with new chemicals to insert into the furnaces in hopes of reducing the byproduct. The court reasoned that because the taxpayer sought to improve its production process rather than the product — i.e., plastic —the supplies were, at best, indirect research costs. The court further reasoned that the taxpayer must show the amount of raw materials costs that were purchased in excess of what would have been purchased in the ordinary course of business to capture these supply costs.

The Tax Court in Stephens disagreed with the IRS’ reliance on Union Carbide, based on the nature of how the supplies were being used in the performance of research. While the taxpayer in Union Carbide used its pilot model supplies to develop a new or improved manufacturing process, CESI and QASI used the supplies to develop products (i.e., custom air flow systems) that were sold to customers.

Another distinction between these two cases was the initial intent of the supplies. In Union Carbide, the raw materials used by the taxpayer in the performance of trial runs were initially treated as inventory (i.e., raw materials used to make finished goods that would have been purchased regardless of whether a taxpayer was engaged in qualified research). In contrast, CESI and QASI purchased the supplies specifically to build and test air flow systems pursuant to customer contracts and not for another reason. Thus, the precedent established in Union Carbide does not prevent CESI and QASI from treating its supplies as qualified research expenses. It is important to note, however, that in this partial summary judgment, the Tax Court did not express an opinion as to whether CESI's and QASI's activities constituted qualified research (i.e., whether the supplies were used in a process of experimentation defined in Section 41(d)).

The IRS in Stephens further argued that because the supplies were used by CESI and QASI to build air flow systems under contractual arrangements, the supplies were not used in an “investigative nature” pursuant to Section 174. The court disagreed, however, stating that a contractual obligation to build a product does not preclude the possibility that, in developing the product, the taxpayer is also resolving uncertainty. To support its position, the court cited TG Missouri v. Commissioner (Docket No. 8333-06) — a case that is quite similar to the Stephens case — in which a taxpayer performed design work for customer-specific molds and then contracted with a third party to build a final mold. The court concluded that the purchase of the mold from a third party constituted a qualified supply expense.

The Stephens case provides taxpayers with more clarity surrounding supply costs for the Section 41 research credit. In the context of product-related research activities, taxpayers should take care in separately documenting these research activities and their underlying costs. Furthermore, the IRS will likely increase their focus on how taxpayers used supplies in a process of experimentation to develop products for customers pursuant to contractual agreements.