Tax Court determines no qualified research in judgment sample

 

The Tax Court issued an opinion on Dec. 23 in Phoenix Design Group Inc. (T.C. Memo 2024-113), related to research credits claimed by the taxpayer during 2015–2019.

 

Based on the Tax Court’s recommendation in a prior order (T.C. 8/29/2023), Phoenix Design Group and the IRS agreed to have the Tax Court evaluate three research projects (trial projects) based on whether there was qualified research (i.e., not evaluating the related expenditures). The Tax Court concluded that there was no qualified research for the three trial projects and that, while it was non-binding to the remaining 235 research projects, the decision would help the taxpayer and the IRS find a mutual resolution.

 

Grant Thornton Insight:

 

It is unclear how the trial projects were identified and other than whether the project contained qualified research, what the underlying technical positions in dispute were during the audit process. Taxpayers should proceed with caution when considering the use of judgment sampling to substantiate research credit claims. This approach could introduce potential bias in evaluating the credit claim and result in a disproportionate adjustment if the sampled projects are not substantially similar in fact to the entire pool of projects.

 

Phoenix Design Group is an engineering and consulting firm focused on designing mechanical, electrical, plumbing and fire protection (MEPF) systems. The taxpayer follows a six-stage process for designing MEPF systems and provided the Tax Court with project overviews, customer agreement terms and hours sheets which contained short narratives about the activities performed. Phoenix Design Group described each of the trial projects from the perspective of the related discipline (i.e., mechanical, electrical, or plumbing).

 

To evaluate the qualification of the trial projects, the Tax Court focused on the: (1) technical uncertainty at the outset, (2) process of experimentation to eliminate the uncertainty, and (3) project contemporaneous documentation. Regarding the technical uncertainty, the taxpayer stated that it faced uncertainty about the appropriate design of each of the MEPF systems even beyond the delivery of stamped construction documents because the appropriate design of the MEPF systems could not be established until construction was complete. Phoenix Design Group engineers could revise and alter the design through construction. However, the Tax Court rejected the taxpayer’s position and clarified that the mere possibility of altering the design in later stages does not itself establish that the appropriate design remained uncertain.

 

The Tax Court was also skeptical as to whether the Phoenix Design Group employees followed the six-step design process based on the narratives in the hours sheets. Specifically, the Tax Court pointed out that the employees did not categorize any of their hours based on the design phase, and the descriptions did not align with the work completed in each stage. Therefore, based on these inconsistencies, the Tax Court could not determine that Phoenix Design Group followed a process of experimentation by merely relying on the description. The Tax Court performed a more granular review of the three trial projects and concluded that relying on preliminary computations and the utilization of professional expertise to make determinations was not a process of experimentation. Furthermore, based on the information provided, the Tax Court was not able to apply the shrink-back rule to evaluate if portions of the project included qualified research. 

 

The Phoenix Design Group case emphasizes the importance of documenting the technical uncertainty of a project (business component) and demonstrating the specific activities that were performed to evaluate one or more alternatives and eliminate that technical uncertainty. 

 

Grant Thornton Insight:

 

The IRS continues to focus on the requirement of substantiating qualified research activities at the project (business component) level. Taxpayers should regularly review their methodology for identifying and analyzing qualified projects as well as ensure that contemporaneous documentation clearly connects the underlying facts with the Section 41 requirements.

 
 

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