On December 23, 2024, the U.S. Tax Court sided with the Internal Revenue Service (IRS) in Phoenix Design Group, Inc. v. Commissioner (T.C. Memo 2024-113). Phoenix Design Group (PDG) is an engineering firm, that is taxed as a C-Corporation. PDG is focused on the mechanical, electrical, plumbing and fire protection (MEPF) systems of buildings.
All of PDG’s projects followed a six-stage design process:
- Basis of Design Stage: Requirements gathering.
- Schematic Design Stage: Creating of gross block diagrams.
- Design Development Stage: The architect provides PDG with plans that incorporate PDGs initial locations for the MEPF systems.
- Construction Document Stage: The building owner determines final equipment selection and PDG so that the MEPF systems can support the equipment.
- Bidding Stage: Building owner and architect solicit bids from construction contractors to complete the work.
- Construction Administration Stage: Actual construction begins.
Prior to this litigation, the IRS disallowed Internal Revenue Code (IRC) Section 41 Credits for Increasing Research Activities (R&D Tax Credits) claimed for the tax years ended December 31, 2013, through December 31, 2016, which were utilized in the 2015 through 2019 tax years, and assessed accuracy-related penalties.
The amounts in dispute were:
| Tax Year | R&D Credit Generated | R&D Credit Utilized | Penalty Assessed |
|
2013 |
$138,205 |
||
|
2014 |
$158,031 |
||
|
2015 |
$138,334 |
$55,504 |
$11,101 |
|
2016 |
$128,228 |
$47,811 |
$9,021 |
|
2017 |
$219,177 |
$43,835 |
|
|
2018 |
$68,147 |
$13,629 |
|
|
2019 |
$71,102 |
$14,220 |
R&D Tax Credit Study Methodology
Between 2013 and 2016, PDG conducted 409 research projects related to its business. To assess eligibility for R&D Tax Credits, PDG engaged a third-party consultant. The consultant identified 238 of these projects as potentially qualifying for the tax credits. Employing a sample methodology, the consultant selected 24 projects for detailed investigation and determined that 20 of them qualified for R&D Tax Credits. This sample analysis was then extrapolated to the 238 research projects to estimate the total R&D Tax Credits. PDG utilized the findings of this study in the preparation of its tax returns.
Tax Court Analysis
PDG and the IRS agreed to try a sample of the sampled research projects, which would not be binding on the remaining research projects. It would, however, establish a framework to enable the parties to resolve their differences regarding the remaining projects.
The three projects considered by the Court were:
- Gerald Champion Military Psychiatric Unit
- Baptist Memorial Health North Mississippi Oxford (BMHNMO)
- Vanderbilt University Engineering and Science Building (VUESB)
If the Court were to determine that one or more of the above-listed projects involved qualified research, the IRS would concede that PDG would not be liable for any accuracy related penalties for any of the credit years.
Summary of Applicable Law
To constitute qualified research, the Court cited IRC Section 41(d), which specifies that credit-eligible research must:
- Contain expenditures that may be treated as expenses under IRC Section 174 Amortization of Research and Experimental Expenditures (Section 174).
- Be undertaken for the purpose of discovering information that is:
- Technological in nature; and
- The application of which is intended to be useful in the development of a new or improved business component of the taxpayer.
- Substantially all the activities must constitute a process of experimentation.
Taken together, this is colloquially known as the Four-Part Test.
The Section 174 Test
The Tax Court noted that, to qualify for the R&D Tax Credit, the qualified wage expenditures associated with the above-listed projects had to be eligible to be treated as expenses under Section 174:
- The claimed research expenditures had to be eligible for a deduction under Section 174 (for tax years beginning before December 31, 2021); and
- The claimed research activities (that were funded by such qualified wage expenditures) constituted R&D within the meaning of Section 174.
- PDG would have to show that the information available to it did not establish the appropriate design of the product.
- If such information was not available to PDG with respect to establishing the capability, the method, or the appropriate design, then uncertainty existed.
- If the Court concluded that that PDG failed the Section 174 Test at the level of a product, PDG could still satisfy the test at the level of the component or subcomponent.
- If uncertainty existed, PDG would have to show that it undertook investigative activities that were intended to discover information that eliminated the uncertainty.
- Performing basic calculations on available data is not an investigative activity because the taxpayer already has information necessary to address that unknown.
- A taxpayer may not carry its burden to show it engaged in investigative activities merely by presenting an eventual solution to an issue.
The Process of Experimentation Test
The Court further noted that Section 41 requires that the Process of Experimentation Test had to be satisfied. Specifically, the substantially all the research activities, the constitute elements of a process of experimentation and be for a qualified purpose.
A qualified purpose includes research that is related to the development of new or improved functions, performance, reliability or quality. The substantially all requirement is met if 80% or more of the taxpayer’s research activities constitute elements of a process of experimentation for a qualified purpose.
The Shrinking Back Rule
The Court noted that if a business component fails any part of the Four-Part Test, it may apply the test to a subset of the product. This is known as the shrinking back rule which allows the Four-Part Test to be re-applied to the business component at its most significant subset of elements.
If that subset of elements again fails the Four-Part Test, the Court must drill down to a more granular subset of the business component until a subcomponent satisfies the test or the most basic level of the component fails to satisfy the test. Finally, the Court noted that when a component fails, it has previously applied the shrinking back rule to an issue that the taxpayer encountered in the design process.
The Court indicated that if the business component failed, it could shrink back into the specific discipline of plumbing, mechanical or electrical. It would not, however, shrink back into a specific design phase nor would it shrink back to the activities of specific employees.
The Tax Court Finding
The Tax Court ruled that uncertainty did not exist merely because there was a possibility of revising the design of the MEPF systems before construction was complete. Furthermore, the court found that the six-stage design process employed by PDG was not an adequate process of experimentation. Specifically, the activity descriptions in the employee time tracking system did not align with what was supposed to occur during the six-stage design process. As a result, the court had to apply a more detailed approach to determine whether the activities of specific employees were part of a process of experimentation for the three trial projects.
Gerald Champion Project
In the Gerald Champion project, PDG failed to identify specific information that was not available to its engineers at the outset. Additionally, PDG could not demonstrate that the information in the gross-block diagram and the schematic design diagram did not establish the appropriate basic design of the systems.
The company also failed to show how uncertainty in one element of the MEPF systems created uncertainty throughout the entire systems. PDG's mechanical engineers calculated the approximate size of the systems needed by referencing historical data provided at the start of the project, and reported this to an architect, which was not an evaluative process reflecting the scientific method.
BMHNMO & VUESB Projects
For the BMHNMO and VUSB projects, not knowing the footprint of the new construction building was insufficient to demonstrate design uncertainty. Similarly, the lack of knowledge regarding the final equipment chosen for a hybrid operating room did not create uncertainty for the entire system. The court noted that uncertainty in a component does not lead to uncertainty for the entire project or business component. PDG did not explain why the inclusion of a hybrid operating room would render the entire MEPF system uncertain.
Furthermore, PDG provided no evidence that any investigative activities occurred before the schematic block diagram and preliminary plan were provided by the architect. The timesheets submitted by PDG did not support the existence of qualified research, and the company again failed to demonstrate how uncertainty in one element of the MEPF systems created uncertainty throughout the entire systems.
Cherry Bekaert Insights
In the case against PDG, the Tax Court ruled unfavorably for the taxpayer, but several factors could have improved their position. First, PDG should not have relied solely on its six-stage development process as an automatic process of experimentation. The Court observed that the activities conducted during certain development stages did not align with what was expected at those stages. Additionally, PDG should have specifically identified and documented the information that was unavailable at the start of each project.
Furthermore, the taxpayer should have supplemented its time tracking with relevant documentation to link specific activities performed by its engineers to qualified activities. PDG also needed to demonstrate both qualified and non-qualified wage costs for each of the three projects under scrutiny. This would have shown the IRS or the Court that it was conducting its own shrink-back analysis on the business components.
Lastly, compliance with building codes does not establish a process of experimentation, nor do basic engineering calculations meet the requirements set by IRC Sec. 41(d). Instead, PDG should have provided documentary evidence to demonstrate a systematic evaluation of alternatives.
Your Guide Forward
Taxpayers in the Architectural & Engineering industry should not be deterred from claiming R&D Tax Credits, but it's crucial to provide proper documentation to support these claims. With stricter documentation standards anticipated for the 2025 tax year, an assessment by Cherry Bekaert is advisable. For questions or more information about R&D Tax Credits, Section 174, or related Congressional actions, contact Cherry Bekaert’s Tax Credits & Incentives Advisory practice.
