Tax Court Denies R&D Tax Credit for Expenditures Related to Designing Clothes

May 2021

BY

Lisa Keith, Managing Director, R&D

The U.S. Tax Court on March 29, 2021 ruled in favor of the IRS in Max v. Commissioner, finding that the petitioner’s research tax credit (RTC) claim failed under Internal Revenue Code (IRC) Section 41 because the business’s activities for which it claimed the RTC (1) lacked the requisite uncertainty, (2) were not “technological in nature” and (3) failed to meet the “substantially all” requirement with respect to the “process of experimentation” test.
 
The dispute involved RTCs claimed by Leon Max, owner of Leon Max, Inc. (LMI) a pass-through entity, for the design and production of garments for tax years 2011 and 2012. 
 
In 2013, LMI claimed $426,255 of RTCs on an amended Form 1120S for tax year 2011 and $496,462 of RTCs on a timely filed Form 1120S for tax year 2012. Subsequently, Leon Max, a pass-through shareholder of LMI, claimed the RTCs on his amended 2011 tax return and on his timely filed 2012 tax return.  The IRS disallowed the entirety of the credits claimed.
 
LMI is a corporation that designs garments and tests fabrics. The petitioner argued that such designing and testing constitute qualified research under IRC Section 41. The IRS undertook a four-part analysis of petitioner’s activities, ruling that the taxpayer failed three of the four elements of the test. Additionally, the court held that LMI’s clothing design and development  did not qualify because it was “nontechnical, typical of the industry, and concerned more with style, taste, and seasonality,” the last concern being specifically excluded by IRC Section 41(d)(3)(B) as research undertaken for style, taste, cosmetic or seasonal design factors.
 

IRC Section 174 Test

The court found that the uncertainties claimed by the taxpayer did not constitute uncertainties under IRC Section 174. LMI claimed that it engaged in “materials engineering” by testing garments and fabrics and that, as a result, LMI had the requisite uncertainty regarding the design of one of its garments. The court rejected the argument, finding that LMI simply cut and draped fabric “to see how it worked.” According to the court, any uncertainty was addressed by “simply marking and aligning the fabric.”
 
Further, LMI’s “testing” of the fabrics involved applying steam, washing them, and testing durability by tugging. The Tax Court found that these steps were not a “systematic inquiry or [a] careful study.” Thus, the activities were not “investigative in nature.” LMI was, in the court’s words, simply applying “common solutions to common problems.” As a result, the court found LMI was undertaking standard activities that employees performed daily. Therefore, the necessary uncertainty needed for the activities to qualify for the RTC did not exist.
 

Technological in Nature

Although the Tax Court found that the activities failed to satisfy the IRC Section 174 test—which was fatal to the petitioner’s claims—the court continued its analysis of the claim, finding that LMI’s activities also failed to meet the “technological in nature” test.
 
Petitioner argued that LMI met this test because “fit” testing relies primarily on engineering principles, fabric draping and fabric print alignment rely primarily on material sciences and fabric shrinkage and colorfastness primarily rely on chemistry. The court found that such arguments “defy a common understanding of words and terms.” The court emphasized, however, that “[t]his is not to say that hard science is necessarily absent from the apparel and garment industries,” but in this case the court found that the taxpayer had failed to demonstrate that the activities rose to the level of meeting the technological in nature test.
 

Process of Experimentation

Lastly, the Tax Court held that substantially all of the activities did not constitute a process of experimentation. Per the court, “to be a true process of experimentation, the project must use the scientific method.” This means that “the project must involve a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.”
 
Additionally, the Tax Court found that regardless of how formalized and intricate LMI’s process was, it was not a “process of experimentation” because it was not rooted in the hard sciences. The court stated that the regulations provide that a process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering or computer science, and it had already found that the taxpayer’s activities did not fundamentally rely on science or engineering.
 

Quality-Control Exclusion

The court further found that the purpose of the testing was quality control, which is excluded by IRC Section 41(d)(3)(B). The Tax Court held that the tests LMI performed were not undertaken to resolve  uncertainty “but to ensure a high-quality product.”[1] Arguably, the court seems to imply that quality control-type of activities may qualify if they involve “combatting uncertainty,” such as design-validation testing for new or improved components.
 
  

 
[1] Taxpayers should note the distinction between quality-control testing and design-validation testing.  Quality-control testing is undertaken to determine if the taxpayer is producing the product that it has designed after all design uncertainty has been resolved; design-validation testing is undertaken to validate a new or improved design. Treas. Reg. §1.174-2(a)(7). Validation testing to ensure that a product design meets its intended objectives may qualify.