Opinion
9920-21
12-05-2022
GALE E. STEPHENS & ANNE M. STEPHENS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Ronald L. Buch, Judge.
Before the Court is the Commissioner's motion for partial summary judgment, in which he asks us to find as a matter of law that the Stephenses are not entitled to research credits they claimed with respect to two entities they own.
Controlled Environmental Systems, Inc. (CESI) and Quality Air Services, Inc. (QASI) design and sell custom air flow systems. They contract with third parties to build and install the systems at the customer's site. CESI and QASI claimed research credits under section 41 for aspects of designing and building these systems.
Unless otherwise indicated, all statutory references are to the Internal Revenue Code, Title 26 U.S.C., in effect at all relevant times, all regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure.
The Commissioner filed a motion for partial summary judgment asking the Court to conclude that CESI's and QASI's supply expenses were not qualified research expenses as a matter of law. The Commissioner argues that because the supplies were used to construct the finished product and fulfill contractual obligations, they were not used in an investigative nature.
But the Court has previously found that supplies purchased from a third party to construct a product for resale were qualified research expenses. See TG Missouri Corp. v. Commissioner, 133 T.C. 278 (2009). Thus, the Commissioner has failed to establish that as a matter of law CESI's and QASI's supply expenses cannot be qualified research expenses. Therefore, the Commissioner's motion for partial summary judgment must be denied.
BACKGROUND
Gale and Anne Stephens are the sole shareholders of CESI and QASI, two S-corporations that are in the business of selling custom air flow systems. These air flow systems are built to meet the customer's specific needs.
Although each air flow system is unique, CESI and QASI generally follow the same development process when creating a custom air flow system. They begin by gathering all relevant preliminary information. Once that information is gathered, they develop an initial design for the system and all its component parts. The design is based upon what the customer plans to do in the space. When CESI or QASI believes it has developed a promising design that will meet the customer's needs, it provides a quote to the customer. If the customer decides to go forward with the project, the parties enter into a contract and CESI or QASI makes the necessary refinements to the design.
After the design and price are agreed, the project moves to the fabrication phase, in which a third party manufactures the components of the air flow system. The third party builds the components based on specifications given by CESI or QASI. After all the components are completed and the system is built, it is installed by third-party contractors at the customer's site. CESI or QASI will then test the system to make sure that it functions as intended. If CESI or QASI determines that the system works properly, then a third party will test the system to validate CESI's or QASI's determinations.
CESI and QASI both claimed research credits based on the air flow systems they developed. They each specifically claimed research credits for (1) wages paid to employees that directly engaged in or directly supervised qualified research activities, and (2) supply expenses used by third-party manufacturers to build air flow systems. The supplies included panels, hinges, screws, nuts, valves, monitors, and ducts.
The Commissioner selected CESI's and QASI's 2015, 2016, 2017, and 2018 tax returns for examination. The Commissioner disallowed all research credits claimed for both businesses for the years examined. Because the Stephenses are the sole shareholders of both S corporations, the adjustments flowed through the corporations to them.
On March 8, 2021, the Commissioner sent the Stephenses a notice of deficiency for 2015, 2016, and 2017, and a separate notice of deficiency for 2018, determining deficiencies of $32,561, $195,105, $289,626, and $489,868, respectively. The Commissioner also determined accuracy-related penalties for 2016, 2017, and 2018.
While residing in Michigan, the Stephenses timely petitioned the Tax Court to challenge the Commissioner's determinations. In the petition, the Stephenses allege that CESI and QASI substantiated all elements of the research credits claimed and that the Commissioner erred in disallowing those credits.
On March 22, 2022, the Commissioner filed a motion for partial summary judgment. In his motion, the Commissioner asks the Court to determine as a matter of law that the supplies used to build air flow systems are not supplies used in qualified research because they would have been purchased in the ordinary course of business, regardless of whether qualified research was being conducted.
DISCUSSION
Before the Court is the Commissioner's motion for partial summary judgment, in which he asks us to determine as a matter of law that he properly disallowed credits for the claimed supply expenses. Although the Commissioner denied research credits claimed for wages and supplies, his motion is only directed at the supplies.
I. Summary Judgment Standard
We may grant partial summary judgment when there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994). The moving party bears the burden of showing that there is no genuine dispute as to any material fact. Sundstrand Corp., 98 T.C. at 520 . When a motion for summary judgment is properly made and supported, an opposing party may not rest on mere allegations or denials. Rule 121(d). Rather, the party's response, by affidavits or declarations, or as otherwise provided in Rule 121, must set forth specific facts showing there is a genuine factual dispute for trial. Id. In deciding whether to grant summary judgment, we view the facts and make inferences in the light most favorable to the nonmoving party. Sundstrand Corp., 98 T.C. at 520. For purposes of this motion, we make factual inferences in the light most favorable to the Stephenses.
II. Summary of Parties' Arguments
The Commissioner provides two legal arguments in support of his position that the supply expenses of CESI and QASI cannot be qualified research expenses under section 41. First, the Commissioner argues that because the supplies were purchased to build air flow systems that CESI and QASI were contractually obligated to build, they were purchased regardless of whether qualified research was being conducted. Additionally, the Commissioner argues that because the supplies were not used in an investigative nature, and instead for the actual construction of products (i.e., the air flow systems) with the purpose of fulfilling contractual obligations, the section 174 test is not met.
The Stephenses disagree. They argue that there is no rule that precludes taxpayers from claiming supply costs if they are incurred in relation to a contract obligation if there is uncertainty in developing the product. They also argue that their air flow systems are pilot models, making their production costs qualified research expenses. They assert that a pilot model need not be created solely for the purpose of developing the concept of a product.
III. Section 41 Research Credit
Section 38 allows a taxpayer to take a general business credit for research credits determined under section 41(a). The credit is 20% of the excess of a taxpayer's qualified research expenses for the taxable year over the base amount. I.R.C. § 41(a)(1).
A taxpayer's qualified research expenses include any in-house research expenses or contract research expenses paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer. I.R.C. § 41(b)(1)(A). In-house research expenses can be either (1) wages paid to an employee for qualified services performed or (2) amounts paid or incurred for supplies used in the conduct of qualified research, which is the focus on this motion. I.R.C. § 41(b)(2)(A) (emphasis added).
An activity or project must meet four tests to constitute qualified research. I.R.C. § 41(d)(1). These four tests are (i) the section 174 test, (ii) the technological information test, (iii) the business component test, and (iv) the process of experimentation test. Id.; Siemer Milling Co. v. Commissioner, T.C. Memo. 2019-37, at *19. We are asked to determine whether the section 174 test was met.
The section 174 test requires research expenditures to be treated as specified research or experimental expenditures under section 174. I.R.C. § 41(d)(1)(A ); Siemer Milling Co., T.C. Memo. 2019-37, at *19-20. Section 174 allows taxpayers to treat specified research or experimental expenditures as expenses not chargeable to capital account and to deduct those expenses in the year they are paid or incurred, or to defer and amortize the expenses. Treas. Reg. § 1.174-1.
The regulations define specified research or experimental expenditures as "expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense. The term generally includes all such costs incident to the development or improvement of a product." Treas. Reg. § 1.174-2(a)(1). Product is defined to include "any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license." Treas. Reg. § 1.174-2(a)(3).
Expenditures are research and development costs in the experimental or laboratory sense if they are for "activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if 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." Treas. Reg. § 1.174-2(a)(1). We have previously construed this regulation "to limit deductions to those expenditures of an investigative nature expended in developing the concept of a model or product." Mayrath v. Commissioner, 41 T.C. 582, 590 (1964), aff'd, 357 F.2d 209 (5th Cir. 1966). While this Court's interpretation of Treas. Reg. § 1.174-2 was made prior to an amendment which later defined "costs in the experimental or laboratory sense" and "pilot model," our interpretation is consistent with the language added in the later amendments. See Mayrath, 41 T.C. at 590 n.4.
The Commissioner argues that because CESI and QASI purchased supplies to build air flow systems that they were contractually obligated to build, the supplies would have been purchased regardless of whether qualified research was being conducted and therefore cannot qualify as supplies used in the conduct of qualified research. This argument is based on this Court's analysis in Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo. 2009-50, 97 T.C.M. (CCH) 1207, aff'd, 697 F.3d 104 (2d Cir. 2012).
In Union Carbide Corp., the Court held that the Commissioner properly disallowed claimed research credits under section 41. Union Carbide Corporation (UCC) is a worldwide manufacturer and marketer of chemicals and plastics. Union Carbide Corp., 97 T.C.M. (CCH) at 1212. In analyzing whether supply expenses were correctly claimed for one of the projects under review, the Court stated, "[r]aw materials used to make finished goods that would have been purchased regardless of whether a taxpayer was engaged in qualified research are not 'used in the conduct of qualified research." Id. at 1273. The Court determined that because UCC used the supplies that were used in the project for normal operations outside of the project, and UCC sold the materials produced during the project in the ordinary course of its business, those supplies could not constitute qualified research expenses. Id. at 1217, 1273.
The Commissioner looks to Union Carbide Corp. as support in this case for disallowing as qualified research expenses the supplies used to build the air flow systems. The Commissioner argues that CESI's and QASI's contractual obligations to build air flow systems are analogous to the situation in Union Carbide Corp. in which the Court determined that the supplies would have been purchased regardless of any qualified research being conducted. However, Union Carbide Corp. is distinguishable. In Union Carbide Corp., the supplies were raw materials that previously had been treated as inventory and deducted as costs of goods sold. Id. at 1273. UCC's situation also differed in that the research credit claimed by UCC was for a process, not a product as in this case. Id. CESI and QASI bought supplies specifically to build air flow systems that they assert tested concepts. The supplies were not purchased for any other reason.
The precedent established in Union Carbide Corp. does not foreclose CESI and QASI from treating its supplies as qualified research expenses. We express no opinion as to whether CESI's and QASI's supplies in fact were used in qualified research.
The Commissioner further argues that because the supplies were used by CESI and QASI to build the actual air flow systems that were sold to customers, the supplies were not used in an investigative nature pursuant to the section 174 test. Furthermore, the Commissioner argues that the air flow systems were not pilot models because they were built to fulfill contractual obligations, not to resolve uncertainty.
To support this argument, the Commissioner primarily cites Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15. In Little Sandy Coal Co., the petitioner claimed research credits for developing vessels and the Commissioner denied those credits. Id. at *3. In that case, we noted that "[a]s a general rule, section 174 applies to the costs of developing the concept of a product but not the costs of building the product itself. But when a taxpayer constructs a physical product for the purpose of assessing the viability of its concept, the construction costs can be considered costs of developing the concept of the product and thus can be deducted under section 174." Id. at *38 (internal citations omitted). This passage describe why supplies for a pilot model, despite being production costs, may qualify for deduction under section 174 (provided that the purpose of building the product was to evaluate and resolve uncertainty). Id. at *39.
The Commissioner argues that the air flow systems were not pilot models that were built to resolve uncertainty, but rather for the purpose of fulfilling contractual obligations. But a contractual obligation to build a product does not preclude the possibility that in developing the product the taxpayer is also resolving uncertainty. See, e.g., Treas. Reg. § 1.174-2(a)(11), Ex. 3. Indeed, the outcome in Little Sandy Coal Co. did not turn on whether a tanker constituted a pilot model. Little Sandy Coal Co., T.C. Memo. 2021-15, at *41-42. The Court found that the process of experimentation test was not satisfied. Id. at *37, *43.
Perhaps a more fitting case to consider is TG Missouri Corp. In that case, TG Missouri Corporation (TG) claimed research credits based on costs paid to third parties for constructing molds that TG sold to customers. TG Missouri Corp., 133 T.C. at 281. The Court found that TG properly included the costs of the production molds it purchased from third parties as the cost of supplies in calculating its section 41 research credit. Id. at 297.
While the issue in TG Missouri Corp. was about whether the depreciation exclusion under section 41(d) or section 174(c) applied, the Court's holding is relevant here. Id. at 279. The process for developing the production mold in TG Missouri is similar to the process for developing air flow systems in this case. TG's process ordinarily began when it received a request for quote from a customer, and the request included general product specifications and requirements to build the mold. Id. After the request was received, TG would enter into a contract with the customer to develop the mold. Id. at 279-80. Next, TG would either construct the mold in-house or contract with a third party to construct it. Id. at 280. If TG contracted with a third party, after the third party completed the construction, TG would purchase the mold from the third party and resell it to its customer. Id. We held that TG correctly claimed credits for supplies that it purchased for the purpose of resale to its customers. Id. at 297. The holding in TG Missouri supports the conclusion that a contractual obligation to build a product does not preclude the product from being built to resolve uncertainty.
IV. Conclusion
The fact that supplies were purchased for the purpose of constructing a final product for delivery to a customer does not preclude those supplies from being qualified research expenditures. Whether they are, in fact, qualified research expenditures is a question to be resolved at trial. Accordingly, it is ORDERED that the Commissioner's motion for partial summary judgment filed March 22, 2022, is denied.