Does Work to Validate Prior Research Qualify for the R&D Tax Credit?

For the research tax credit, does work to validate prior research count as a qualified research expense?  The court recently addressed this in United States v. Davenport, No. 3:09-cv-02455-L (N.D. Tex. 2012).

Facts & Procedural History

Morris and David Davenport (collectively, “Davenports”) were fifty percent owners of Burly Corporation (“Burly”).  Burly manufactures residential metal roofing and stand-alone metal buildings.

The Davenports filed amended returns for tax year 2002 and 2003 to claim research tax credits for expenses incurred to develop software to manage, automate, and integrate all aspects of their subsidiary’s business, including automation and integration of manufacturing, design, sales, accounting, and shipping.

The software was created using the J.D. Edwards OneWorld software application, which is commercially available and used for enterprise resource planning.

The research tax credits only included wage expenses or QREs for employees and contract expenses or QREs for four consultants.

The IRS issued refund checks to the Davenports for tax year 2003 without conducting an audit.   The IRS then audited the refund claim for the 2002 tax year and disallowed the claim.

The Davenports brought suit against the U.S. government for the research tax credit refunds that were disallowed by the government for tax year 2002.  The government brought suit to recover the refunds issued to the Davenports for tax year 2003.  The court consolidated the two cases.

The Research Tax Credit

The research tax credit is one of the largest tax benefits available to businesses.  It rewards taxpayers for technical design-related work performed in the U.S.  The Code sets out a four-part test for determining whether work can qualify.  The four-part test allows quite a few different design-activities to qualify.  For example, when these rules are applied, software development is one type of activity that typically qualifies.

Validating Previous Research

The government argued that the research did not satisfy the Section 174 test or the process of experimentation test.

The court concluded that the research was not performed to test and refine a hypothesis to determine the strengths and weaknesses of the alternative tested or to determine whether other alternatives might be better suited for achieving the goal. The court cited the Union Carbide court case in support of this rule.

In applying this rule and evaluating the facts, the court concluded that the evidence showed that the research was done after third parties had finished developing or customizing the base software. The work at this phase–which was the basis for the research tax credits–was to validate the previous work performed by the contractors. The court concluded that this was a “simple trial and error [process] to validate a process or product change meets the taxpayer’s needs” and was not sufficient. Thus, the Davenports’ refund claims were not allowed.