The research and development (R&D) tax credit can effectively defray experimentation costs of cutting-edge companies. However, not all expenses involved in product innovation and design result in a credit.
In a new Tax Court case, Max, TC Memo 2021-37, 3/29/71, a clothing manufacturer could not claim the R&D tax credit for its process of designing garments.
Generally, the R&D credit is equal to 20 percent of the amount of qualified research expenses for the year above a base amount. The base amount is a percentage (not to exceed 16 percent) of average annual receipts for the prior four years. In no case, however, can the credit amount to less than 50 percent of the annual qualified research expenses.
Alternatively, a business may elect to use a “simplified credit” based on 14 percent of the amount by which qualified expenses exceed 50 percent of the average for the three previous tax years.
To qualify for the R&D credit, a business must meet the following four requirements:
1. The purpose of a project must be related to creating a new or improving an existing business component.
2. The work must be technological in nature and rely on principles of physical, biological or computer science or engineering.
3. When work begins, there must be uncertainty about the ability to create the product or improvement, the methodology that would be used or the product.
4. The project must involve a process that involves testing alternatives and resolving this uncertainty.
Facts of the new case: The taxpayer, who emigrated from the former Soviet Union, became a successful clothing designer in the Los Angeles area. His firm designed, developed, produced and sold clothing under numerous brands or clothing lines.
Each of these clothing lines was sold in retail stores catering to different customer tastes and profiles. These retail stores used customer profiles to identify the tastes, preferences and price points of their consumers. The firm designed each clothing line using these metrics:
For each clothing line, the firm produced a new collection every month. Retail stores occasionally dictated garment selections and designs of the monthly lines.
Stores would request a length or style of dress that had sold well in a previous year or request a specific design. The firm would then create garments to fit retailer criteria.
The firm followed a structured process for conceptualizing, designing and developing garments, including the following components:
- Broad conceptual planning
- Design concept and sketch
- The first pattern
- Pattern cutting
- The first sample
- Fitting
- Sale sample
- Production prototype
- Production approved sample
During the pre-production process, employees encountered problems and had to address a variety of issues with the designs and structures of garments.
Not a good fit: After a thorough analysis, the Tax Court determined that the firm did not pass the four tests to qualify for the R&D tax credit. Notably, the work was not technological in nature. These activities were more related to style and taste—not research. Accordingly, the credit was denied.
If you have clients in similar circumstances, document the expenses that would pass the four tests for the R&D credit. Be prepared for any IRS challenge.