Pilot models can help tax savings soar

Pilot Models Tax SavingsTaxpayers that have designed new equipment in the past few years can turn those pilot models into tax savings. Full-scale pilot models now meet the definition of research supply cost, even if the pilot model was a success and was placed in service or sold to a customer.

Some regulations have more impact than others, and the final
Section 1.172-2 regulations defining qualified pilot models fall into the big impact category. The regulations broaden the definition of qualified supplies and allow taxpayers to both deduct the costs and include them as qualified supply costs in the R&D credit computation.

2 major changes
The first major area of change is the definition of a pilot model. A pilot model can now include a fully functioning, full-scale model of the product, process, equipment and so on. As long as there's uncertainty regarding the development or improvement of a component, the costs to construct and test a model of the component can be a qualified Section 174 cost. These Section 174 costs include indirect and ancillary costs, as well as direct costs.
A second major change is that the ultimate success, failure, sale or use of the pilot model, including the capitalization and depreciation of the item, doesn’t affect whether the pilot model is qualified. Again, as long as there's uncertainty and the pilot model is used to resolve the uncertainty, the direct, indirect and ancillary costs to construct and test the pilot model can be qualified.  

Although these new regulations fall under Section 174, many of these additional costs may also qualify as supply costs under Section 41.

Businesses can benefit twice:
  1. The final regulations are under Section 174, so businesses can elect to expense all pilot model costs in the year the expense is incurred.  
  2. Many of these supply costs will also qualify for a tax credit under Section 41.  

A benefit as big as the uncertainty
To understand the potential scale of the tax benefit, let’s look at two examples from the regulations. One describes a taxpayer developing a new compressor blade to be used in an aircraft engine. The taxpayer faces uncertainties regarding the design of the blade. To resolve them, the taxpayer builds a prototype blade, installs it in an engine and tests the blade. The pilot model is the blade, and the costs to install it in the engine and test it are qualified costs.

Another example describes a taxpayer designing a new aircraft. The uncertainties relate to the aircraft’s overall capabilities. To test the design, the taxpayer builds a working aircraft and tests it. In this case, the pilot model is the entire aircraft.

One common element of these examples is an aircraft engine. We can assume that the engine is the same engine in both examples. In the first example, the taxpayer’s uncertainty was limited to the design of the blade. Only a portion of the engine (the blade) was a qualified pilot model. However, in the second example, the taxpayer’s uncertainty encompassed the design of the entire aircraft. The engine became a component of the larger, full-scale aircraft pilot model.

The determining factor in these two examples is uncertainty. Since a pilot model is qualified if it's used to resolve uncertainty, the scope of the uncertainty will dictate the scale of the pilot model. In the second example, the uncertainty encompassed the entire aircraft. Taxpayers need to carefully evaluate and consider the scope of the uncertainties related to each pilot model.

Stay on your toes
Taxpayers need to be aware of potential pitfalls in these three areas.

  1. Vendor contracts — If you hired a vendor to build equipment for you, you can include those costs as supply R&D costs as long as you retained the risk of failure. Check your contracts carefully. Vendor guarantees and warranties may shift the risk of failure from you to them. This shift of risk may preclude you from taking the associated pilot model costs.
  2. Documentation — This is as important as ever. In a major case last year, Eric G. Suder et al., v. Commissioner of Internal Revenue, a Tax Court judge stated that the R&D tax credit is one of the most complicated areas of tax law, particularly because the rules are subjective. It can be difficult to document technical uncertainties, the thought process or each issue evaluated.  However, each taxpayer needs to have documented evidence that supports pilot model qualification. That can be tricky. Taxpayers should gather and evaluate available documentation and determine the strength of the documentary evidence.  
  3. Technical memos — These regulations introduce new terms and new issues. Many taxpayers have memos in work paper files that outline legal positions on supply costs. Take the time now to update technical memos regarding supply costs. Because the regulations include new terminology, you need to incorporate those changes in your old analyses, memos to the file for auditors and work paper files addressing the issue of supply costs under both Sections 174 and 41.

These are big regulatory changes. Taxpayers have the opportunity to include the costs of full-scale models as pilot models. This results in accelerated deductions and increased R&D tax credits. That said, it’s important to carefully analyze the documented facts to make full use of the opportunity.



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