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In Intermountain Electronics, Inc. v. Commissioner, Docket No. 11019-19, the Tax Court denied the IRS’s motion for partial summary judgment, finding genuine issues of material fact remain as to whether the taxpayer’s activities were a process of experimentation.

The IRS requested that the Tax Court rule that Intermountain Electronics, Inc. (Intermountain), a company that designs and manufactures electrical distribution and control equipment, is not eligible for the IRC Section 41 research credit because (1) Intermountain’s pilot models failed to satisfy the process-of-experimentation test or, alternatively, (2) Intermountain inappropriately treated production expenses as IRC Section 174 expenditures. A motion for summary judgment may only be granted if there is no genuine dispute as to any material fact and judgment may be granted as a matter of law. See U.S. Tax Court Rule 121(a)(2).

The process-of-experimentation test under IRC Section 41(d)(1)(C) and related Treasury regulations requires a taxpayer to show that substantially all (at least 80%) of the research activities conducted in developing or improving a business component are an evaluative process to resolve uncertainty.

The Tax Court rejected the IRS’s argument that Intermountain did not satisfy the process-of-experimentation test because it included ineligible production costs in the numerator of the equation in determining that it met the substantially all requirement. “Because the proportion of non-production costs to all other research costs would not exceed 80% of all expenses paid, the Commissioner argues that Intermountain’s activities would not be qualified research…The Commissioner contends production expenses are categorically excluded from the numerator of the equation. If this were the case, then it would be mathematically impossible for Intermountain to exceed the 80% threshold.”

The Tax Court noted that the IRS relied on a 2021 Tax Court decision, Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15, for its position that production expenses are categorically excluded from the numerator for purposes of the substantially all requirement under IRC Section 174 (see Tax Alert 2021-0424). The Tax Court, however, disagreed with the IRS’s interpretation of the Little Sandy Coal Co. decision, stating that the case “does not foreclose production expenses from being included in the numerator of the substantially all equation.” The Tax Court pointed to several instances in the Little Sandy Coal Co. opinion that proved its opinion (in Little Sandy Coal Co.) was not based on a legal conclusion that production costs are excludable from the numerator, but that they were not includable in the numerator for Little Sandy Coal Co. based on that taxpayer’s facts.

The Tax Court noted that “Intermountain contends that the production processes were part of an evaluative process to address uncertainty relating to the development of custom electrical equipment.” The Tax Court then explained that “[b]ecause the production costs are not categorically excluded from the numerator… [g]enuine disputes of material fact remain as to whether Intermountain’s production activities constituted a process of experimentation.” Therefore, the Tax Court denied the IRS’s motion for partial summary judgment.

EY observation:

The Tax Court’s description of Intermountain’s claim implies that Intermountain is treating some or all of its business components as “pilot models” under IRC Section 174. Treas. Reg. Section 1.174-2(a)(4) defines a pilot model as “any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term includes a fully functional representation or model of the product…” In Little Sandy Coal Co., the Tax Court concluded that the numerator of the 80% substantially all fraction could not include the wages paid to the taxpayer’s employees to produce a pilot model (a marine vessel) because the taxpayer did not demonstrate that there was a nexus between constructing the vessel and testing the vessel. At best, the Tax Court found the construction of the taxpayer’s vessel could be an activity that directly supported the research; without nexus to the testing of the vessel, however, the wages paid for constructing the vessel could not be considered qualified research. In the Tax Court’s view, the numerator of the 80% substantially all equation could only include direct research activities, and not activities that were direct support or direct supervision of research, although all those categories are activities that could generate qualified research expenses under IRC Section 41(b).

In the taxpayer’s appeal of the Tax Court decision in Little Sandy Coal Co., the Seventh Circuit rejected the Tax Court's position that pilot model production activities should be excluded from the numerator of the 80% substantially all equation because they were direct support activities. Little Sandy Coal Co. v. Commissioner, 62 F.4th 287 (7th Cir. 2023). Because pilot models (meeting the definition under IRC Section 174) are produced to resolve uncertainty around the product during its development or improvement, the Seventh Circuit found that labor costs incurred for pilot model production activities can potentially be included in both the numerator and denominator of the substantially all equation. The Seventh Circuit described the 80% substantially all equation as research activities (whether direct research, direct supervision of research or direct support of research) that constitute elements of a process of experimentation over research activities not excluded under IRC Section 41(d)(4) and whose expenses are deductible under IRC Section 174. See Tax Alert 2023-0708 (April 13, 2023) for details regarding the Seventh Circuit decision in Little Sandy Coal Co. v. Commissioner.

The Tax Court’s order in Intermountain Electronics does not refer to the Seventh Circuit’s decision in Little Sandy Coal Co. Based on the Tax Court’s reflection on its decision in Little Sandy Coal Co. (“Nothing in that statement forecloses a finding that a production worker is directly engaged in qualified research;” emphasis added), the Tax Court may try to adhere to its position that the numerator of the 80% substantially all equation only includes direct research activities when it evaluates the merits of the Intermountain Electronics case.

Although the Tax Court’s denial of the Commissioner’s motion for partial summary judgment was favorable for Intermountain, it will be interesting to see how the Tax Court applies the 80% substantially all requirement when evaluating whether Intermountain has met the process-of-experimentation test under IRC Section 41(d)(1)(C).