Comment

Following the Seventh Circuit’s affirming of the Tax Court’s decision in Little Sandy Coal Co. v. Commissioner, Betz serves as yet another caution to taxpayers both in limiting credits taken for so-called “pilot models” and clarifying the standard that taxpayers must meet for substantiating their claimed qualified research expenses.

In more detail

In Betz, the petitioners co-owned Catalytic Products International, Inc. (CPI), an S corporation that designed and supplied custom-built air pollution control systems, primarily catalytic and thermal oxidizers, and that claimed USD 501,531 in credits for the expenses associated with designing and installing 19 projects for the 2014 tax year. The petitioners claimed a flow through of the credit on their personal federal income tax returns for 2014, and carried forward remaining portions of the credit in their 2015 and 2016 tax returns.

The court focused initially on substantiation principles, acknowledging that taxpayers need not necessarily maintain contemporaneous time-tracking records for its employees. But the court stated that the taxpayer must make a threshold showing that a particular employee performed activities that constitute qualified services with respect to a business component and that the court does not apply the Cohan rule to estimate wages paid in the absence of such a showing. Referencing the Seventh Circuit’s recent decision in Little Sandy Coal Co. v. Commissioner, the Tax Court concluded that “shortcut estimates of experimentation-related activities will not suffice,” and that “something more, such as documentation of time spent on such activities, is necessary.” In Betz, petitioners relied largely on trial testimony to carry their substantiation burden, and the court found their testimony to be vague at times, in conflict with the record, and lacking in credibility in some instances.

The vast majority of the court’s opinion focused on the requirement that expenditures may be treated as qualified research or experimental expenditures under section 174 (the “Section 174 Test”), one part of the four-part test for “qualified research” in section 41.

The court first analyzed whether the claimed supply expenses for all 19 products could be eligible for a deduction under section 174. Although deductions under section 174 are generally not available for costs of production, the Tax court explained that one exception was for costs incurred in constructing a prototype or “pilot model.” To qualify for the pilot model exception, the taxpayer must show that its purpose in constructing the representation or model was to evaluate and resolve uncertainty about capability, method or appropriate design. The court found that petitioners never made such a showing. Based on the dictionary definition of a representation or model to generally mean “an accurate stand-in for something else,” the court found that CPI’s subcontractors and suppliers were not constructing stand-ins to discover information about whether a design was appropriate. Instead, they were constructing the final product itself. CPI did not conduct early-stage testing to determine if the design of the product was appropriate and then modify the design as necessary, as one might expect if the products had been pilot models. Instead, the court noted that the testing of the oxidizers happened either at the subcontractor’s facility before shipping or at the customer’s facility after installation—that is, at a late stage when CPI’s design drawings were already finalized.  

The court then turned to the issue of whether the claimed wage expenses satisfied the Section 174 Test. Under Treas. Reg. § 1.174-2(a)(1), petitioners were required to show that information was not available to CPI establishing the appropriate design of the oxidizers and that CPI undertook investigative activities intended to discover such information. The court rejected petitioners’ blanket assertions that uncertainty existed with respect to the products as a whole simply because of the mere prospect of revising or altering the design before completion of onsite testing. The court noted that failure of an oxidizer system to pass testing might have resulted in some additional information-discovering activities with respect to a redesign of a particular component or subcomponent, but would not have required CPI to scrap the entire oxidizer and start over. The court ultimately concluded that petitioners failed to meet their burden of demonstrating that each of the 19 projects constituted qualified research under section 41. For many of the projects, the court determined that CPI simply already had “considerable” or “extensive” or “a plethora of” information available to it that established the appropriate design of the oxidizer as a whole. For others, the court found that any design uncertainty that did exist was resolved before 2014, the tax year at issue. The court warned taxpayers: “Merely identifying a project difficulty and the eventual design solution, without bridging the gap with evidence as to what investigative activities were performed, does not satisfy petitioners’ burden.”

Finally, the court also addressed the “funded research” exclusion to the section 41 credit. Section 41(d)(4)(H) excludes from the definition of qualified research any research to the extent funded by any grant, contract, or otherwise by another person. The court followed its prior approach of considering whether a taxpayer has substantial rights in research by looking to the terms of the parties’ contract. After reviewing each of the eight contracts at issue, the court found that the research performed by CPI for five of the eight projects was funded because CPI either fully assigned to the other party all intellectual and tangible property rights in the work product resulting from the research performed under the contract, or CPI was required to ask permission from the other party to retain and use any information or work product generated in performing the contract. 

The Tax Court’s opinion in Betz is a cautionary tale against trying to use the “pilot model” exception too liberally. According to the Tax Court, a pilot model is meant to be a representation or a stand-in (of the eventual product) that the taxpayer uses to evaluate and resolve uncertainty about the product, and the regulations require a taxpayer to show how it used the pilot model to evaluate and resolve uncertainty about the product. 

With respect to wage expenses, the Tax Court clarified the burden that taxpayers must carry in order to satisfy the Section 174 Test. Taxpayers must first identify an uncertainty by showing that 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. With uncertainty established, the taxpayer must next show that it undertook investigative activities that were intended to discover information that would eliminate that uncertainty. Finally, the taxpayer must substantiate the related wage expenses by tying those investigative activities to the specific wage expenses claimed, and to the employees who performed the activities.