April 5, 2021
Tax Court holds clothing designer may not claim research credits for expenditures related to designing clothes
In Leon Max v. Commissioner, T.C. Memo. 2021-37 (March 29, 2021), the Tax Court held a clothing designer may not claim research credits under IRC Section 41 for amounts spent on turning an idea into a garment, finding that the fashion design process is not qualified research.
Leon Max is a clothing designer and S corporation owner (Leon Max, Inc. (LMI)) that specialized in apparel for women.
LMI's garment development process began with pre-production, which involved the design team creating a concept for each collection. The designers then chose the textiles for the collection and determined the design elements LMI would present to the stores. If the designers did not know how to incorporate certain design elements, they used trial and error to determine how the elements could be included.
Once the textiles and design elements were selected, the designers sketched the clothing and often chose the fabric for the designs. The patternmakers used the designers' sketches to make blueprints of the garments' components. After the components were developed, pattern cutters cut out the separate pieces.
A sample maker sewed the components together to make a sample and a fit model tried on the sample to illustrate how the garment would fit on a person. During the fitting, LMI's team would observe how the garment looked on the model, assess how the model felt in the clothing, and how the clothing moved with the model.
If the sample was approved after the fitting, the LMI team created a sale sample for the stores. Based on the sale sample, the stores decided whether to order the clothing for resale. On some occasions, the stores would provide feedback some of which LMI incorporated into the clothing.
Once a store ordered the clothing, LMI created a production prototype, which it sent to third-party manufacturers. The manufacturers created a production approval sample, which was sent to LMI for approval. If LMI approved the sample, the manufacturers produced the clothing.
Before shipping the garments to the stores, LMI performed various quality assurance tests to ensure the garments satisfied quality standards, such as color fastness, strength and safety.
LMI hired alliantgroup in 2013 to conduct a study on the research and development tax credit from 2009 to 2012. The study sampled 35 garments produced by LMI from 2009 to 2012 and determined that the development of 32 of the 35 garments qualified for the research credit.
Based on alliantgroup's study, LMI filed an amended 2011 income tax return, claiming approximately $426,000 of research credits. On its 2012 tax return, LMI claimed approximately $496,000 of research credits. Mr. Max also amended his 2011 personal income tax return to claim the passthrough of LMI's research credits and he filed a 2012 income tax return, claiming passthrough research credits on Form 3800, General Business Credit.
The IRS issued a notice of deficiency to Mr. Max in 2016, disallowing the research credits. Mr. Max filed suit in the Tax Court, arguing that LMI's "process of designing garments, fit testing, and fabric testing constituted research and experimentation under [IRC S]ection 41 and that the wages, supply expenses, and contract expenses were qualified research expenditures." The IRS asserted LMI's process did not qualify for the research credit because the process "was nontechnical, typical of the industry, and [was] concerned more with style, taste, and seasonality."
In determining that Mr. Max did not qualify for the research credit, the Tax Court applied the four-part test in IRC Section 41 — the IRC Section 174 test, the technological information test, the process of experimentation test, and the business component test — to the activities LMI included in its research credit claims to evaluate whether they were qualified research activities.
IRC Section 174 test
The IRC Section 174 test "requires research expenditures to be eligible for treatment as expenses under [IRC S]ection 174." IRC Section 174 research and experimental expenditures are expenditures incurred in the taxpayer's trade or business that represent research and development costs in the experimental or laboratory sense. Research and development costs in the experimental or laboratory sense are 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.
The Tax Court observed that uncertainty may not require experimentation and that the taxpayer must show that it has experimental expenditures because (1) it does not have information to address a capability or method for improving the product or design and (2) its activities were meant to eliminate uncertainties. The court found that LMI's issues, including how to drape fabric and the proper thread size to use, are not uncertainties under IRC Section 174. The court also found that LMI's activities, such as testing fabric shrinkage by washing it, were not investigative in nature. The activities were "common solutions to common problems."
The court also pointed out that LMI had the information required to resolve problems as they arose. The court found LMI previously encountered the uncertainties it faced in 2011 and 2012 and its employees "knew how to align prints, alter standard patterns for the plus-size line, fit garments, and cut fabrics along the proper grain," making these standard activities. The court noted that "LMI faced these issues so regularly that it required new employees to prove they could accomplish these tasks before being permanently hired."
Rejecting Mr. Max's argument that the quality assurance testing "falls into the category of 'testing to determine if the design of the product is appropriate' and is thus not quality control," the court determined that the goal of LMI's quality assurance testing was quality control and therefore specifically excepted from the definition of research or experimental expenditures.
Accordingly, the court held Mr. Max did not meet the IRC Section 174 test.
Technological information test
An activity is qualified research if it is undertaken for the purpose of discovering information that is technological in nature. In determining whether LMI's activities were qualified research, the court relied on Merriam-Webster for the definition of engineering, which is "'the application of science and mathematics by which the properties of matter and the sources of energy in nature are made useful to people' or 'the design and manufacture of complex products.'" Based on that definition, the court found that LMI's fit testing was not engineering and, therefore, LMI did not use principles of engineering.
The court also found that draping fabric does not use material science. Although there are draping coefficients, LMI did not use them.
In addition, the court observed that shrinking tests are not chemistry. The court noted that using chemistry "implies fundamentally changing the structure or composition of materials; washing fabric to determine whether it is prone to shrinkage is not that."
Thus, the court held Mr. Max did not satisfy the technological information test.
Process of experimentation test
Under the process of experimentation test, "substantially all of the research activities [must] constitute elements of a process of experimentation for a qualified purpose." The court stated that this test consists of three elements — (1) the "substantially all" element, (2) the "process of experimentation" element, and (3) the "qualified purpose" element — and addressed each element separately.
The court ruled that Mr. Max failed to meet the qualified purpose element of the process of experimentation test, finding a "purpose is not qualified if it relates to style, taste, cosmetic, or seasonal design factors."
In addition, the court found that LMI did not satisfy the process of experimentation element. A process of experimentation is a process designed to evaluate one or more alternatives to achieve a result when the taxpayer is uncertain at the beginning of its research activities of the capability or method of achieving the result or its appropriate design. The court stated that it "previously concluded that LMI did not face uncertainty under the [IRC S]ection 174 test. LMI, thus, did not face uncertainty for the purpose of the process of experimentation test." The court also observed that taxpayers should "use a formalized scientific method to address uncertainties," and that LMI's process was not akin to the scientific method, but rather a "thorough integration of a creative development process."
The court further determined that LMI did not prove that at least 80% of LMI's activities were part of a process of experimentation because "[m]any of LMI's activities were not for a qualified purpose because they related to style, taste, and seasonal design factors" and "[e]ven nondisqualified activities did not undergo a process of experimentation." LMI, therefore, failed the substantially all element of the process of experimentation test.
Business component test
After ruling the Mr. Max did not satisfy the other tests, the court found it did not need to address this test.
The IRC Section 41(d)(3)(B) exclusion of style, taste, cosmetic or seasonal design factors from the definition of "qualified purpose" is a high hurdle for taxpayers in the fashion industry, and these taxpayers should carefully consider the application of this exclusion to their design activities when evaluating whether to claim a research credit for such activities. Last year, the California Office of Tax Appeals issued a very similar decision in another alliantgroup case, In re Swat-Fame, Inc., 2020-0TA-046P (June 1, 2020). In Swat-Fame, the court denied a clothing designer's research credit for many of the same reasons set forth in Leon Max: the research was not for a qualified purpose because it relates to style, taste, cosmetic, or seasonal design factors; and the taxpayer did not demonstrate its design process involved a process of experimentation.
More problematic, and more widely applicable to all taxpayers, is the Tax Court's assertion that, "[t]o be a true process of experimentation, the project must use the scientific method" and that there is a distinction between "systematic trial and error" and "simple trial and error." These interpretations of the process of experimentation test have shown up in a few recent cases, including Swat-Fame, but reflect a standard that was specifically rejected in the preamble to T.D. 8930 (the 2001 Treasury Regulations) based on commentator input that commercial and industrial practice does not always conform precisely to the scientific method. A formulaic process of experimentation and reliance on the "scientific method" was also specifically rejected in T.D. 9140 (the final 2004 Treasury Regulations, currently applicable), which provide a more flexible definition of a process of experimentation and takes into account a taxpayer's facts and circumstances. The definition of a process of experimentation in T.D. 9140 sufficiently demonstrates that the use of the scientific method is not necessary for a taxpayer's activities to be considered a "true" process of experimentation. Taxpayers should be aware that the IRS is likely to raise similar issues when auditing research credit claims, and should be prepared to defend why their activities meet the definition of a process of experimentation as provided in the current Treasury Regulations.
See Tax Court case attached below.
Leon Max v Commissioner