Featured Snippet: Cleveland v. Commissioner (1961) laid foundational precedents for determining qualified research expenditures under Section 174, emphasizing that actual legal relationships—like joint ventures—matter more than mere financial backing. Modern R&D tax credit claims must also navigate Section 41’s Four-Part Test, substantiating technical uncertainty, process of experimentation, technological nature, and permitted purpose with robust evidence such as labor allocations and risk-bearing contracts.
The U.S. research and development (R&D) tax credit requires separate analysis of research eligibility, qualifying costs, contractual funding, and substantiation. Cleveland v. Commissioner addressed historical research deductions, while later Section 41 decisions examine the additional requirements for a credit. This study considers those distinctions, relevant court decisions, and the domestic research expensing rules enacted in 2025.
The Jurisprudential Foundations of Section 174 and the Cleveland Precedent
Historically, Section 41 linked qualified research to the research and experimental expenditure rules of Section 174. For amounts paid or incurred in taxable years beginning after December 31, 2024, Section 41(d)(1)(A) instead refers to expenditures treated as domestic research or experimental expenditures under Section 174A. Cleveland v. Commissioner, 297 F.2d 169 (4th Cir. 1961), concerned deductions under the earlier Section 174, not the subsequently enacted research credit.
The Factual Context of Cleveland v. Commissioner
Richard F. Cleveland, an attorney, financed Hans Kerla’s development of an inorganic binder called Kerloid and supplied business assistance and laboratory premises. The dispute concerned whether his advances were loans or expenditures connected with a joint business venture.
The Fourth Circuit upheld disallowance for advances before April 20, 1956. It held that the written agreement executed that day created a joint venture and allowed qualifying experimental expenditures thereafter. Although the agreement was dated retroactively to December 31, 1954, the court did not treat that date as the start of the qualifying relationship. The judgment was affirmed in part, reversed in part, and remanded.
Impact on the Scope of Research and Development
Cleveland illustrates the importance of the parties’ actual legal relationship; providing financial support alone did not establish deductible research expenditures. Snow v. Commissioner, 416 U.S. 500 (1974), subsequently held that the absence of current sales did not prevent a research partnership from qualifying under the historical Section 174. Snow explains the broader reach of that provision compared with Section 162’s requirement of carrying on a business. Neither decision dispenses with the separate eligibility, expense, and trade-or-business requirements of Section 41.
| Feature of Cleveland Case | Legal Determination | Long-term Implication for R&D |
|---|---|---|
| Relationship Status | Joint venture arose under the agreement executed April 20, 1956. | Earlier advances remained loans. |
| Role of Taxpayer | Provided funding and business assistance. | Research participation need not be exclusively technical. |
| Nature of Invention | Inorganic binder (Kerloid). | The case concerned historical research deductions. |
| Statutory Standard | Connection with a trade or business. | The actual venture relationship mattered. |
The Modern Regulatory Environment and the Four-Part Test
While Cleveland and its progeny defined the entry points for Section 174, modern taxpayers must navigate the more restrictive “Four-Part Test” established under Section 41(d) to claim the research credit. This test requires that the research activity be undertaken for a qualified purpose, be technological in nature, involve the elimination of uncertainty, and fundamentally consist of a process of experimentation.
The Research Expenditure and Uncertainty Test
For the older claim years discussed in these cases, the research expenditure requirement referred to Section 174. Current Section 41 refers to domestic research or experimental expenditures under Section 174A. Technical uncertainty concerns whether the taxpayer’s available information establishes the capability or method for development or improvement, or the appropriate design. A research deduction alone does not establish entitlement to a research credit.
In Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, the Tax Court found that none of the three trial projects involved qualified research and upheld accuracy-related penalties under the parties’ stipulations. Design changes and engineering complexity did not, on that record, establish the required uncertainty and experimentation. This was a fact-specific determination, not a categorical exclusion of engineering services.
The Technological in Nature Requirement
The technological-in-nature requirement asks whether the experimental process fundamentally relies on physical or biological science, engineering, or computer science. It does not require a discovery beyond the knowledge of skilled professionals. Established engineering principles can satisfy this requirement, although the activities must separately satisfy uncertainty and experimentation requirements. Phoenix Design Group should not be read as imposing an industry-wide novelty test.
The Business Component Test
The information sought must be intended for use in developing a new or improved business component: a product, process, computer software, technique, formula, or invention sold, leased, licensed, or used in the taxpayer’s business. The qualified purpose must concern function, performance, reliability, or quality. The tests apply first to the business component; the shrinking-back rule applies when that component fails, rather than permitting arbitrary selection of a favorable subset.
The Process of Experimentation and the 80% Threshold
The process-of-experimentation test requires that at least 80% of the relevant research activities constitute elements of experimentation for a qualified purpose. The regulation permits cost or another consistently applied reasonable basis. The evaluation must address alternatives for an uncertain capability, method, or design; product novelty by itself is insufficient.
Analyzing Little Sandy Coal, Inc. v. Commissioner
In Little Sandy Coal Co. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), the Seventh Circuit affirmed denial of shipbuilding research credits because the taxpayer failed to substantiate the substantially-all requirement. It nevertheless disagreed with parts of the Tax Court’s reasoning, including its categorical treatment of direct support and supervision in the experimentation analysis.
The decision explained the existing regulatory fraction rather than creating a new statutory test:
Numerator: Research activities that constitute elements of experimentation for a qualified purpose, including qualifying direct support or supervision where the applicable facts establish that connection.
Denominator: The relevant research activities meeting the research-expenditure requirement, excluding activities barred by Section 41(d)(4), assessed on the same measurement basis. The opinion applied historical Section 174; current claims must account for the statutory change to Section 174A.
Developing a pilot model does not automatically make all associated work experimentation. Taxpayers must establish the nature of the activities and their relationship to the experimental process.
The Shrinking-Back Rule
If a business component fails the qualified-research tests, Treasury Regulation Section 1.41-4(b)(2) requires testing the most significant subset of its elements and continuing to smaller subsets until a qualifying subset is reached or the most basic element fails. Evidence must support the activities and allocations for the subset claimed. A lack of separately coded time does not itself prohibit shrinking back, but an unsupported allocation cannot establish qualification.
| Case Comparison | Business Component | Key POE Failure | Legal Outcome |
|---|---|---|---|
| Little Sandy Coal | Tanker and dry-dock shipbuilding projects. | Insufficient proof of the substantially-all requirement. | Denial affirmed; some lower-court reasoning rejected. |
| Phoenix Design Group | MEPF engineering systems. | Qualified uncertainty and experimentation not established for the trial projects. | Three trial projects failed; stipulated penalties upheld. |
| Moore v. Commissioner | Electronics and scoring displays. | Primarily a wage-substantiation issue, not a project-wide POE ruling. | Claimed COO wages disallowed; affirmed in 2024. |
| Betz v. Commissioner (Catalytic Products International) | Industrial air-pollution-control equipment. | Insufficient evidence of qualifying research and expenses. | Research credit disallowed, T.C. Memo. 2023-84. |
Substantiating Executive Compensation: Moore v. Commissioner
Section 41(b)(2)(B) permits wages for qualified services in three categories:
Engaged in the actual conduct of qualified research.
Engaged in the direct supervision of qualified research.
Engaged in the direct support of qualified research.
The “One-Up” Rule for Supervision
In Moore v. Commissioner, T.C. Memo. 2023-20, affirmed by the Seventh Circuit in 2024, the taxpayers did not substantiate a qualifying portion of the Nevco president and COO’s compensation. Direct supervision means immediate supervision of qualified research, not supervision of managers who supervise researchers. An executive’s title alone neither qualifies nor disqualifies the executive’s wages.
The appellate court emphasized that the evidence did not establish how much time the executive spent on qualified research rather than broader product development. The decision supports careful activity allocations, but it does not impose a universal requirement for a particular time-tracking system or make all estimates inadmissible.
The 80% Wage Rule for Individuals
Treasury Regulation Section 1.41-2(d)(2) permits all of an employee’s wages to qualify when at least 80% of the employee’s services satisfy the qualified-services requirement. Below that threshold, only the supported qualified portion is included. This employee wage rule is distinct from the business-component experimentation threshold. Reliable records and a reasonable allocation basis are necessary; unsupported retrospective percentages are vulnerable.
Funded Research and the Allocation of Intellectual Property Rights
Section 41(d)(4)(H) excludes research to the extent funded by another person. For a research provider, contractual payment risk and retained rights must be evaluated separately. Research performed for a customer is not automatically excluded, and funding may be partial.
The Economic Risk and Substantial Rights Tests
The determination of whether research is funded hinges on two criteria:
Economic Risk: Payments contingent on successful research are not treated as funding under the applicable regulation. Payments due irrespective of success generally constitute funding to their extent. Contract labels such as fixed-price or time-and-materials are not conclusive; the actual payment obligations control.
Substantial Rights: The provider must retain meaningful rights to use the research results. General experience is only an incidental benefit. If the provider retains no substantial rights, the research is fully funded for its credit purposes; where substantial rights exist, expenses exceeding noncontingent funding may remain eligible under the allocation rules.
In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, a January 2025 order denied the IRS’s motion for partial summary judgment on funded research. The court considered Indiana law in assessing payment contingency. The order does not establish a general rule that warranties or potential refund remedies make every service contract eligible.
The Role of Architectural and Engineering Contracts
The AS+GG litigation is Smith v. Commissioner. Its later merits decision, T.C. Memo. 2026-50, found that payments under six contracts were not contingent on research success. AS+GG retained substantial rights under four contracts, allowing potential credits to the extent research expenses exceeded payments. Milestone approval therefore does not automatically establish success-contingent payment. Copyright and license provisions must be assessed for the rights they actually preserve.
Legislative and Administrative Shifts: Sections 174 and 174A
The landscape of innovation incentives was radically altered by the Tax Cuts and Jobs Act (TCJA) of 2017. Effective for tax years beginning after December 31, 2021, Section 174 was modified to require the capitalization and amortization of research and experimental expenditures.
The 2022–2024 Capitalization Period
For taxable years beginning in 2022 through 2024, the TCJA generally required five-year amortization for domestic research and fifteen-year amortization for foreign research, beginning at the midpoint of the year. The 2025 legislation changed domestic treatment. Research expenditure deductions and the Section 41 credit remain separate computations; only eligible expense categories associated with qualified research enter the credit.
Enacted Domestic Expensing Relief: Section 174A
Public Law 119-21, enacted July 4, 2025, added Section 174A. It generally permits immediate deduction of domestic research expenditures for taxable years beginning after December 31, 2024, with an election to capitalize eligible costs and amortize them over at least 60 months. Foreign research remains subject to fifteen-year amortization under Section 174. Transition elections permit recovery of remaining 2022–2024 domestic balances over one or two years beginning with the first taxable year after 2024. Eligible small businesses also received a time-limited retroactive election. Revenue Procedure 2025-28 provides implementation procedures, including statements in lieu of Form 3115 in specified cases; Form 3115 is not universally mandatory.
| Statutory Provision | Pre-2022 Treatment | Post-2021 Treatment | Proposed Future (H.R. 1) |
|---|---|---|---|
| Domestic R&D Costs | Immediate deduction generally available under former Section 174. | 2022–2024: five-year amortization, subject to enacted transition relief. | Enacted July 4, 2025: Section 174A generally allows expensing for tax years beginning after 2024. |
| Foreign R&D Costs | Immediate deduction generally available under former Section 174. | Fifteen-year amortization for tax years beginning after 2021. | Enacted law retains fifteen-year amortization. |
| Section 41 Credit | Regular credit generally 20% of QREs above the base; alternative simplified credit available. | Credit remains separately computed from research amortization. | Enacted law changes the research-expenditure reference to Section 174A; Section 280C coordination applies. |
| Method Changes | Applicable elections and accounting-method rules. | Transition procedures may permit statements instead of Form 3115. | Enacted transition and method-change procedures appear in Revenue Procedure 2025-28. |
The IRS Refund-Claim Information Requirements
The IRS announced five information items for research-credit refund claims in 2021. For claims postmarked after June 18, 2024, it waived two items at filing, leaving three required categories. The waived information may still be requested during examination.
The Requirements for a Valid Refund Claim
Business Component Identification: The taxpayer must list all business components that form the basis for the credit.
Activity Description: For each business component, a description of the research activities performed is required.
Personnel Listing: Naming the individuals who performed each research activity is no longer a required filing item for claims postmarked after June 18, 2024, although the IRS may request this information later.
Information Sought: Identifying the information each individual sought to discover is likewise waived at filing for claims postmarked after June 18, 2024, but may be requested during examination.
Cost Detail: The total qualified employee wage, supply, and contract expenses related to the activities.
The IRS has extended the transition period through January 10, 2027. During that period, taxpayers notified of a deficient research-credit refund claim generally have 45 days to supply missing information before the IRS’s final determination. The submission must describe the taxpayer’s actual activities; repeating statutory language alone does not provide the required factual detail.
Linking Activities to Claimed Expenses
The practical lesson from these cases and filing requirements is to connect claimed costs to the work that qualifies. General-ledger totals and broad percentages are not substitutes for evidence of research activities. Project records, credible testimony, technical materials, and supported allocations should collectively explain eligibility and expense amounts. These decisions apply existing proof requirements rather than creating a separate statutory audit model.
State-Level Implications: The Ohio R&D Investment Tax Credit
Ohio’s Research and Development Investment Tax Credit is a nonrefundable credit against Commercial Activity Tax (CAT) liability. Eligibility is not limited to corporations.
Mechanics of the Ohio Credit
Ohio Revised Code Section 5751.51 generally allows 7% of current-calendar-year Ohio qualified research expenses above the average for the preceding three calendar years. Key features include:
Applicability: The credit is used to offset Commercial Activity Tax (CAT) liability.
Nexus: Only qualified research expenses incurred in Ohio enter the state calculation; having research elsewhere does not automatically disqualify the Ohio expenses.
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states here at swanson read the biggest problem we see as specialized r d tax advisors is self-censorship companies believing they are not eligible for the r d tax credit when in reality the irs has a very broad definition of what it considers r d does your company design engineer or manufacture its own products do you look to improve the functionality performance or reliability of these products do you create new or improved processes in order to make things better faster or cheaper do you develop prototypes or computer generated models or do you develop software technology or other intellectual property if you answered yes to any of the previous questions your company may qualify for the r d tax credit congress has created a four-part test to help you identify activities that would be considered qualified research your work must satisfy these four main requirements it must be technological in nature a process of experimentation there must be technical uncertainty and a permitted purpose let’s go through these one by one one technological in nature this means the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences engineering or computer science two process of experimentation this is defined as a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result or the design of that result is uncertain the beginning of the research three technical uncertainty as a taxpayer you must intend to discover information that would eliminate uncertainty concerning the development or improvement of the business component and four permitted purpose it is a qualified purpose if research relates to a new or improved function increased performance enhanced reliability or enhanced quality it is not a qualified purpose if research relates to aesthetics meaning style taste cosmetics or seasonal design companies that are 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