Tax Court continues to evaluate experimentation test process

 

The Tax Court recently denied the IRS’s motion for summary judgment in Intermountain Electronics Inc. v. Commissioner (Docket No. 11019-19), holding that material facts remain in dispute regarding whether the taxpayer’s production activities constituted a process of experimentation.

 

The taxpayer designs, engineers, manufactures and services custom electrical distribution and control equipment for various applications, including underground and surface mining, power generation, oil and gas refineries, and federal and state governments. Its business activities include custom equipment fabrication, transformer fabrication and proprietary product development.

 

The taxpayer claimed research credits under Section 41 related to manufacturing custom product pilot models. The research credits were computed based on qualified research expenses relating to non-production and production employees and associated supplies. The IRS disallowed the research credits, arguing that the pilot models failed the “substantially all” test. In accordance with Section 41(d)(1)(C) and Treas. Reg. Sec. 1.41-4(a)(6) taxpayers must establish that “substantially all” (i.e., 80% or more) of their research activities constitute a process of experimentation to claim a research credit.

 

The “substantially all” test can be expressed as a fraction for purposes of evaluating whether the test is met. The numerator of the fraction includes only those expenses associated with activities that constitute a process of experimentation. In Little Sandy Coal Co. v. Commissioner (T.C. Memo. 2021-15) the Tax Court ruled in favor of the IRS, finding in part that production activities (e.g., fabricating a physical component) do not constitute a process of experimentation. On appeal, the Seventh Circuit upheld the Tax Court’s ultimate conclusion (62 F.4th 287, 7th Cir. 2023) but nonetheless ruled that production activities may constitute a process of experimentation.

 

In the Intermountain Electronics case, the IRS cited the Tax Court’s previous decision in Little Sandy, proposing that production expenses are categorically excluded from the numerator of the substantially all equation and that the taxpayer could not mathematically pass the “substantially all” test if production expenses were excluded from the numerator. The Tax Court disagreed with this interpretation of its prior ruling, stating that the precedent established does not foreclose production expenses from being included in the numerator of the “substantially all” equation. As a result, the Tax Court concluded that disputes of material fact remain.

 

The Tax Court’s interpretation of its own recent Little Sandy decision is unexpected and could indicate that the Tax Court may be leaning towards applying a more taxpayer-friendly interpretation of the process of experimentation, the “substantially all” test, which better aligns with the interpretation of the Seventh Circuit’s appeal of Little Sandy. Notably, the Tax Court did not address the Seventh Circuit ruling as part of its finding.

 

Although this case is pending litigation, it serves as another example where the IRS is challenging research credit claims on the basis of the process of experimentation “substantially all” test. 

 

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