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Max v. Commissioner (T.C. Memo. 2021-37)

On March 29, 2021, the Tax Court issued a Memorandum Opinion in the case of Max v. Commissioner (T.C. Memo. 2021-37). The primary issue presented in Max was whether drawing fashion sketches qualify as “qualified research” under IRC § 41.

General Observations

Who knew Judge Buch was such a fashionista?

If you don’t believe me, read the first 21 pages of the opinion.  The editor of Teen Vogue better watch out.  Judge Buch knows his stuff about garmentry and tax, in (seemingly) equal measure.

His praise of the petitioner’s clothing is effusive.  His praise of his tax strategies, not so much.

The Whole Nine Yards – Product Development

First comes the concept.  Then comes the “mood board.” Then comes the design concept and sketch. Then comes the patternmakers and a “blueprint” of the garment’s components.  Then comes the pattern cutting. Then comes the first sample. Then comes the fitting.  I include the following, only because the details made me chuckle.

At the fitting stage, the petitioner used a “fit model,” which was likely as much about the fitting stage as it was about her size zero waist.  According to Judge Buch, the petitioner asked the model to position her arms to mimic driving a car, holding a baby, or reaching for an item on a high shelf. The fit model could be asked to walk on a flat surface, walk up stairs, or sit down to determine her range of motion while wearing the garment. The team may have also asked her to stand in the sunlight to ensure the garment was not too transparent.

For whatever reason, Judge Buch felt that the following was important enough to include:

if the model could not sit in a pair of pants, the patternmakers would change the shape of the crotch and adjust the fit to the extent the fabric allowed.

There is certainly something to be said for practicality, I suppose.

After fitting, a sales sample was created, and then a production prototype, and then marketing and grading were performed, and then the production approval sample was produced.

The opinion spends an inordinate amount of time talking about patterns, trims, linings, and thread.  If you are curious, I urge you to read the opinion, because you won’t get that nonsense in this summary.

The Actual Tax Issues…

Twenty-one pages of fashion turbonerdery later, we arrive at the actual meat of the opinion. (This is not to say that Judge Buch has run out of steam talking about sartorial matters.  There are 27 pages left in the opinion, and each one is fashionable.

IRC § 41 Credits for Research and Development Overview

IRC § 41 allows taxpayers to take a credit for increasing research activities. As is potentially relevant here, the credit is 20% of the excess of a taxpayer’s qualified research expenses for the taxable year over the base amount. IRC § 41(a)(1). Qualified research expenses are (i) in-house research expenses, including wages for employees working on qualified research and costs paid or incurred for supplies for qualified research, and (ii) contract research expenses. IRC § 41(b)(1), (2)(A).

To be qualified research, the research must relate to a new or improved function, performance, reliability, or quality of the product or process. IRC § 41(d)(3)(A). Certain activities cannot be qualified research. Qualified research does not include research after commercial production; adaptation or duplication of an existing business component; market research, testing, or development; or routine or ordinary testing or inspection for quality control. IRC § 41(d)(4). To be qualified research under IRC § 41, activities or projects must satisfy four tests. These four tests are (i) the IRC § 174 test; (ii) the technological information test, (iii) the business component test, and (iv) the process of experimentation test. IRC § 41(d); Siemer Milling Co. v. Commissioner, T.C. Memo. 2019-37, *19.

The IRC § 174 Test

The IRC § 174 test requires research expenditures to be eligible for treatment as expenses under IRC § 174. IRC § 41(d)(1)(A). IRC § 174 generally allows taxpayers to deduct research and experimental expenditures during the taxable year in which they are paid or incurred. IRC § 174(a)(1). The regulations define research and experimental expenditures as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” Treas. Reg. § 1.174-2(a)(1).

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.” Treas. Reg. § 1.174-2(a)(1). But resolution of uncertainty does not necessarily require experimentation. Little Sandy Coal Co. v. Commissioner, T.C. Memo 2021-15, at *36.

Essentially, for there to be experimental expenditures, the taxpayer must show (1) that it does not already have information that can address a capability or method for improving the product or design of the product (uncertainty exists) and (2) its activities were meant to eliminate those uncertainties. Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo. 2009-50, aff’d, 697 F.3d 104 (2d Cir. 2012).

The petitioner argued that he faced many uncertainties throughout the development process. These claimed uncertainties include:

  1. how to cut and drape printed fabrics;
  2. fabric choices;
  3. thread sizes;
  4. details such as twists, pintucks, and pleating in the fabric;
  5. modifying patterns for plus-size garments;
  6. fabric shrinkage;
  7. and the final fit of the garment.

As much of a fan Judge Buch may be of the designing world, these are not “uncertainties as contemplated by IRC § 174.”[1]

Beyond not being “uncertain,” expenditures under IRC § 174 must be used for an investigative purpose. Indeed, IRC § 174 is intended to limit deductions to those expenditures of an investigative nature used to develop the concept of a model or product. Mayrath v. Commissioner, 41 T.C. 582, 590 (1964), aff’d, 357 F.2d 209 (5th Cir. 1966). Expenses for the “actual construction” of the product are not of an investigative nature. Id.

To be covered under IRC § 174, the activities must have been investigative in nature.  Through a laundry list (couldn’t help it) of examples, Judge Buch dispels the investigatory nature of the activities—my personal favorite being “Testing a fabric’s durability [merely] involved tugging at it.”  Tugging, it turns out, is not an IRC § 174 activity.  Now you know. For an uncertainty to exist under IRC § 174, a taxpayer must be uncertain about whether it can achieve its objective through research.  The petitioner was certainly a good designer, and he lacked the requisite uncertainty to meet the IRC § 174 test.

Quality Control ≠ Research and Experimentation under IRC § 174

Certain activities cannot qualify as research or experimental expenditures at all. Treas. Reg. §  1.174-2(a)(3) states that the term “research or experimental expenditures” does not include expenditures for the ordinary testing or inspection of materials or products for quality control, a/k/a “quality control testing.” The regulations define “quality control testing” as “testing or inspection to determine whether particular units of materials or products conform to specified parameters.” Treas. Reg. §  1.174-2(a)(4).

Quality control is not, however, “testing to determine if the design of the product is appropriate.”  This is what the petitioner argued, but Judge Buch was not convinced…at least not as convinced as using a half-loop stich on China silk will make it pucker.

The Technological Information Test

To be “qualified research” an activity must be undertaken for the purpose of discovering information that is “technological in nature.” IRC § 41(d)(1)(B)(i). Information is technological in nature if “the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.” Treas. Reg. § 1.41-4(a)(4). A taxpayer may rely on existing principles of science and engineering to satisfy this requirement. Id.

In the best line of the opinion, Judge Buch observes that “enlarging too-tight armholes or creating more room in a pant leg is not applying ‘the properties of matter and the sources of energy in nature.’”  Too true, too true.

The Centerfielder Argument.  Brilliant.

Judge Buch quotes himself.  Normally, this would be grounds for scathing mockery, but his analogy is just so spot on that I will quote it for you now.

I am confident that there is a formula out there that can be used to calculate the place point of impact, if you launch a spherical projectile at a particular rate and speed and angle, and where it will land. I’m sure there are devices that our military uses to figure out exactly where such a thing would land. I don’t think that makes a centerfielder a mathematician.

Bravo, sir. I tip my tattered old Red Sox cap to you.

Process of Experimentation Test

The process of experimentation test requires that substantially all of the research activities constitute elements of a process of experimentation for a qualified purpose. IRC § 41(d)(1)(C); Union Carbide Corp., T.C. Memo. 2009-50. The Tax Court has previously described this test as consisting of three elements: (1) the “substantially all” element, (2) the “process of experimentation” element, and (3) the “qualified purpose” element. Id. These elements are applied to each of the taxpayer’s business components. IRC § 41(d)(2)(A); Treas. Reg. § 1.41-4(a)(6).

To potentially qualify for the research credit, research must be for a qualified purpose. A purpose is not qualified if it relates to style, taste, cosmetic, or seasonal design factors. IRC § 41(d)(3)(B).  Being that this is entirely what petitioner’s “research” concerned, your faithful editors don’t see much point into going any further down this rabbit hole.

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. Treas. Reg. § 1.41-4(a)(5)(i). Uncertainty in the process of experimentation is essentially the same uncertainty as is required by the IRC § 174 test. Union Carbide Corp., T.C. Memo. 2009-50. Because the petitioner did not face uncertainty under the IRC § 174 test, he likewise did not face uncertainty for the purpose of the process of experimentation test.

To conduct a process of experimentation, a taxpayer must also use hard sciences to achieve a business’ goal. The regulations state that the process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science. Treas. Reg. § 1.41-4(a)(5)(i). So, again, failure.

Finally, to be a true process of experimentation, the project must use the scientific method. Union Carbide Corp., T.C. Memo. 2009-50. 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. Id. Although the trial and error method is valid for experimentation purposes, the Tax Court has held that it is not sufficient that the taxpayer use a method of simple trial and error to validate that a process or product change meets the taxpayer’s needs. Id.

Finally, the petitioner did not satisfy the first element of the process of experimentation test because it did not prove that substantially all the garments underwent a process of experimentation. To meet the “substantially all” requirement, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose. Treas. Reg. § 1.41-4(a)(6).

The Business Component Test

The business component test requires that research undertaken to discover information must be intended to be used to develop “a new or improved business component of the taxpayer.” IRC § 41(d)(1)(B)(ii). A business component is any product, process, computer software, technique, formula, or invention which is held for sale, lease, or license, or used by the taxpayer in its trade or business. IRC § 41(d)(2)(B). Because the petitioner utterly, fully, and unequivocally failed all of the previous tests, the Tax Court did not deign to address this final test.

Footnote about Thread and Draping:

[1] Not to surrender his fashionista card, Judge Buch observes: “The proper thread size to use with a particular fabric and the proportions of a garment are well known and understood by the designers and patternmakers. How to drape a particular fabric to achieve the desired aesthetic may be unknown, but the petitioner’s garment makers already have the information necessary to address that unknown.”  Like, duh.

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