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In Siemer Milling Co. v. Commissioner, T.C. Memo 2019-37, the Tax Court has held that a company in the business of milling and selling wheat flour could not claim a research credit for the tax years at issue because it failed to prove that its activities constituted qualified research under IRC Section 41.

Facts

In the wheat milling business since the 1950s, Siemer Milling Company (Siemer) owned and operated two mills during the years at issue. Siemer hired an accounting firm to prepare its research credit studies beginning in 2004; the studies were based on interviews with Siemer employees and documents Siemer provided. Siemer claimed IRC Section 41 credits on its returns for several years beginning in the early 2000s through the years at issue (2011 and 2012).

Siemer identified four research projects for its tax year ending May 31, 2011:

1. Flour Heat-Treatment Project: developing processes to produce (a) cake flour without using chlorine, (b) low-microorganism, low-bacteria flour without using chemicals, and (c) all-natural replacements for modified starches; included heating flour for differing lengths of time and with various methods and testing the flour to measure its composition, functional characteristics, and level of bacteria
2. Pulsewave Project: determining whether it could increase the speed at which the Pulsewave machine operated and the effect of processing different materials within the Pulsewave
3. Wheat Hybrids Project: testing new varieties of wheat to determine whether they could be used in current or new products
4. Ozone Project: introducing ozone into various stages of the milling process to produce a low-microorganism flour; samples of wheat at each stage of the process were tested and compared with untreated grain

Five projects were identified for the tax year ending May 31, 2012:

1. Flour Heat-Treatment Project: continuing the project from 2011
2. Pulsewave Project: determining whether the Pulsewave machine could (i) adjust the moisture level in finished flour, (ii) keep the oil packet in the wheat kernel intact during milling, and (iii) produce ultrafine flour
3. Littleford Day Project: working on a system to incorporate into Siemer's existing milling facilities to toast wheat and bran to produce toasted products; included heat treating samples using varying times and temperatures and conducting compositional analyses of the results
4. Whole Wheat Flour Project: attempting to produce an ultrafine whole wheat flour by using pearling machines (which had been used to process other types of grain but not wheat) to strip the bran layer from the flour
5. Hydration Project: finding a method to maintain a consistent level of moisture in flour; experiments involved reintroduction of moisture to finished flour and introduction of ozone

On its 2011 and 2012 tax returns, Siemer claimed research credits of $122,424 and $116,246, respectively. The IRS disallowed the credits in their entirety on the grounds that Siemer had not proven its expenses qualify for the research credit.

Tax Court's opinion

The Court addressed two questions: (1) whether Siemer had proven that it qualified for IRC Section 41 credits for its 2011 and 2012 tax years; and (2) whether Siemer was liable for IRC Section 6662 accuracy-related penalties.

The credit available under IRC Section 41 is determined based on expenses for qualified research. To constitute qualified research, an activity or project must meet a four-part test:

1. IRC Section 174 test
2. Technological information test
3. Business component test
4. Process of experimentation test

The court concluded that Siemer failed to establish that any of its projects met all four parts of the four-part test. Reasons provided by the court as to why the projects failed are outlined below.

Flour Heat-Treatment Project: Siemer did not prove that the activities satisfied the process of experimentation test because, although Siemer showed it "set out to develop three new products with the use of its flour heat treatment facility, it is not clear how it set out to do that and whether that process was a true process of experimentation."

Pulsewave Project: Siemer did not prove that the activities satisfied the IRC Section 174 test because Siemer failed to show it faced uncertainty about the speed at which the Pulsewave machine could run. The company wanted to run the machine at 5,000 RPM but it experienced mechanical problems if it ran faster than 3,600 RPM — Siemer's activities to address this issue were "more akin to mechanical maintenance," the Court said. Further, the Court stated that Siemer did not establish that it met the technological information test because the record did not demonstrate that the project had relied on principles of engineering and the physical and biological sciences. Finally, Siemer failed to show that it engaged in a process of experimentation in this project.

Wheat Hybrids Project. Siemer did not prove that the activities satisfied the business component test because the company "did not establish what business component it sought to develop" and the evidence showed that Siemer "was simply determining what was available from wheat breeders and growers," rather than developing a new product or process. Further, Siemer failed to show that it engaged in a process of experimentation in this project.

Ozone Project. Siemer did not prove that the activities satisfied the process of experimentation test. Although Siemer explained the steps in its process were "designed to evaluate alternatives with respect to inserting ozone into the milling process," it did "not expand on what theory that it may have been testing or how it refined its process based on data collected."

Littleford Day Project. Siemer did not prove that the activities satisfied the technological information test because the record did not demonstrate that the project had relied on principles of engineering and the physical and biological sciences. Further, Siemer failed to show that it engaged in a process of experimentation. The Court stated that "narrating the steps of its process does not establish that it engaged in testing of a hypothesis so that it constitutes experimentation in the scientific sense."

Whole Wheat Flour Project. Siemer did not prove that the activities satisfied the technological information test because the company failed to explain what principles its testing relied on or how the principles were incorporated into research. Further, Siemer failed to show that it engaged in a process of experimentation in this project.

Hydration Project. Siemer did not prove that the activities satisfied the process of experimentation test because "all it did was recite the steps in its process. It does not explain how its process is scientific," the Court stated.

In most instances, the Court cited language from Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo 2009-50, that a 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" to support its findings that a process of experimentation was not demonstrated.

Although it fully denied the research credits claimed, the Court held that Siemer was not liable for IRC Section 6662 accuracy-related penalties because the company had reasonably relied in good faith on the advice of its accounting firm. The Court found that (1) the accounting firm was "a competent adviser"; (2) Siemer provided the firm with necessary and accurate information; and (3) Siemer actually relied in good faith on the firm.

Implications

This case provides insight into the level of detail both the IRS and courts are expecting in a taxpayer's substantiation for its research credit. All four parts of the four-part test were at issue in this case, which is unusual and suggests that the documentation and testimony provided did not enable the IRS or the court to fully understand either the business component being improved, the uncertainties the taxpayer faced, the process of experimentation undertaken to resolve those uncertainties, and/or the technological nature of the research. As the case does not reveal the exact nature of the taxpayer's explanations in support of its qualification of the activities in its projects, it is impossible to tell by what magnitude they fell short. It is clear that simply stating that testing took place is inadequate, but the court found in certain projects that even describing the exact steps in the testing process in detail may be insufficient if it is not made clear that the steps constituted a process of experimentation. Because the projects described in this case appear to have possibly involved qualified research, the main takeaway is that taxpayers should be wary of including minimalistic descriptions of their research activities to support the qualifying nature of the activities.

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