Featured Answer: The United States v. Davenport case highlights the strict requirement for claiming R&D tax credits on enterprise software development: taxpayers must demonstrably prove a process of experimentation. The court ruled for the government because the taxpayers’ activities were limited to validation and configuration testing of a completed system against known requirements, failing to establish that they systematically evaluated alternatives to resolve technical uncertainty.
The United States federal income tax system encourages innovation through the Credit for Increasing Research Activities under Section 41 of the Internal Revenue Code. Introduced in 1981, the research and development (R&D) tax credit reduces the after-tax cost of qualifying research. Its application has generated substantial litigation over the distinction between eligible experimentation and other technically demanding business activities. United States v. Davenport, 897 F. Supp. 2d 496 (N.D. Tex. 2012), illustrates the importance of proving a process of experimentation when claiming credits for enterprise software development and customization. The decision concerns the evidence supporting the activities claimed; it does not establish that only transformative innovations qualify.
The Statutory Architecture and the Four-Part Test
Under the regular credit method, Section 41(a)(1) generally provides a credit equal to 20 percent of qualified research expenses (QREs) exceeding a statutory base amount, subject to the applicable limitations. That is not the only calculation method: the alternative simplified credit generally equals 14 percent of current-year QREs exceeding 50 percent of average QREs for the preceding three tax years, with a special rule where a preceding year has no QREs. Section 41 also provides separate credit components for certain basic research payments and energy research payments.
The four-part test requires qualifying research expenditures, technological information, a qualifying business component and purpose, and a process of experimentation. For the years considered in Davenport, the expenditure requirement referred to Section 174. For tax years beginning after 2024, Section 41(d)(1)(A) refers to domestic research expenditures eligible for treatment under Section 174A. Eligibility for a research deduction alone does not establish eligibility for the credit.
The expenditure test addresses research and development in the experimental or laboratory sense, including uncertainty concerning capability, development method, or appropriate design. The technological requirement looks to physical or biological sciences, engineering, or computer science. The intended application must concern a new or improved product, process, software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s business. The qualified purpose must concern function, performance, reliability, or quality. Under Treasury Regulation Section 1.41-4(a), at least 80 percent of the relevant research activities must constitute elements of a process of experimentation, measured on a cost or other consistently applied reasonable basis.
| Test Component | Statutory Reference | Core Requirement | Judicial Focus |
|---|---|---|---|
| Section 174 Test; Section 174A for tax years beginning after 2024 | I.R.C. § 41(d)(1)(A) | Eligible research expenditures addressing technical uncertainty | Capability, method, or appropriate design |
| Technological Nature | I.R.C. § 41(d)(1)(B)(i) | Reliance on physical or biological sciences, engineering, or computer science | Technological basis of the research |
| Business Component | I.R.C. § 41(d)(1)(B)(ii), (d)(2), and (d)(3) | New or improved business component and qualifying functional purpose | Product, process, software, technique, formula, or invention |
| Process of Experimentation | I.R.C. § 41(d)(1)(C) | Substantially all relevant research activities constitute elements of experimentation | Identification of uncertainty and evaluation of alternatives |
Section 280C(c) coordinates the credit with research deductions and capitalization. Under the rules applicable to tax years beginning after 2024, domestic research expenditures otherwise deducted or capitalized are generally reduced by the credit allowed under Section 41(a), unless the taxpayer elects a reduced credit under Section 280C(c)(2). With the current 21 percent maximum corporate tax rate, that election generally produces a credit equal to 79 percent of the otherwise determined amount. The subsection numbering and operation of Section 280C have changed over time; historical claims require the law applicable to their particular tax years.
Case Analysis: United States v. Davenport
Morris and David Davenport each owned 50 percent of Burly Corporation, which operated through Mueller Supply Incorporated. Mueller manufactured metal roofing and standalone metal buildings and implemented an enterprise resource planning system to integrate its operations.
The OneWorld Project and Technical Context
Mueller used J.D. Edwards OneWorld software and IBM’s ERP Bridge in a project involving manufacturing, distribution, accounting, and related business functions. The disputed credits for 2002 and 2003 arose from claimed employee wages and contractor expenses associated with the OneWorld project.
The IRS issued the disputed 2003 refunds in 2007 and 2008 without first auditing those claims. The government sued to recover $292,095 in refunds, while the taxpayers sought recovery of credits disallowed for 2002. The consolidated dispute was resolved on summary judgment, rather than through a trial on the merits.
Analysis of the Court’s Findings
The Northern District of Texas granted summary judgment for the government because the record failed to establish a qualifying process of experimentation. The evidence showed configuration and validation testing intended to confirm that the completed system met previously identified requirements. The taxpayers did not produce sufficient contrary evidence or a supported allocation to a qualifying smaller component. The court expressly declined to decide the remaining eligibility arguments.
The distinction is between validation and a demonstrated evaluation of alternatives directed at uncertainty. Systematic trial and error can qualify under Treasury Regulation Section 1.41-4(a)(5); trial and error is not categorically excluded. Davenport’s discussion of Union Carbide Corp. v. Commissioner, T.C. Memo. 2009-50, emphasizes the purpose and structure of the evaluative work. A description of debugging or integration must explain the uncertainty, alternatives, and testing actually involved.
The government also raised the adaptation exclusion under Section 41(d)(4)(B), which excludes research adapting an existing business component to a particular customer’s requirements. However, this was not a separate holding in Davenport. Purchasing commercial software does not by itself resolve whether every subsequent development activity is excluded. The analysis must address the particular activities and applicable exclusions.
The Internal Use Software Threshold
The government raised the internal-use-software exclusion, but Davenport did not decide the parties’ dispute about the applicable internal-use-software standards. The following table distinguishes that procedural outcome from the modern high-threshold test. The current regulations generally address software developed primarily for general and administrative functions and include exceptions and rules for third-party and dual-function software. They should not be treated as findings made in the 2012 decision.
| IUS Requirement | Description | Davenport Findings |
|---|---|---|
| Innovative | Anticipated cost reduction, speed improvement, or other measurable improvement that is substantial and economically significant | No separate determination; the court resolved the case on experimentation grounds |
| Economic Risk | Substantial resources committed with substantial technical uncertainty about recovery within a reasonable period | No separate determination under the high-threshold test |
| Commercial Availability | Software cannot be purchased, leased, or licensed and used for the intended purpose without modifications satisfying the innovation and economic-risk requirements | The existence of a commercial base suite was not a separate ruling on this requirement |
Software customization therefore requires an activity-specific assessment. It need not advance the general state of computer science: the regulations do not require discovery beyond the existing knowledge of skilled professionals. Where the internal-use-software high threshold applies, it adds requirements to the ordinary research-credit tests rather than replacing them.
Comparative Jurisprudence and the Evolution of POE
Davenport can be compared with decisions involving telephone systems, shipbuilding, executive wages, and custom industrial equipment. These cases illustrate different evidentiary records and legal issues; they do not establish an inevitable trend toward either approval or denial.
Contrast with Suder v. Commissioner (2014)
In Suder v. Commissioner, T.C. Memo. 2014-201, Eric Suder’s company, ESI, developed telephone systems combining hardware and software. The Tax Court found that 11 of the 12 projects examined satisfied the qualified-research requirements. The record included extensive documentary evidence and testimony about technical uncertainties and the development process.
Suder shows that the use of established engineering principles and existing components does not automatically disqualify development. Integration can involve qualifying uncertainty, but it does not necessarily do so. The taxpayer must establish what was uncertain and how alternatives were evaluated. The decision also addressed reasonable compensation and wage allocations, so it should not be described as an unrestricted allowance of all claimed costs.
Substantiation in Little Sandy Coal and Scott Moore
In Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15, affirmed at 62 F.4th 287 (7th Cir. 2023), the taxpayer failed to substantiate the experimentation percentage for the shipbuilding projects at issue. Calling a vessel a prototype does not establish that substantially all relevant activities were experimental. The Seventh Circuit nevertheless rejected the Tax Court’s categorical exclusion of certain direct-support activities from the experimentation numerator: pilot-model production can be part of experimentation when the evidence establishes that role.
In Moore v. Commissioner, T.C. Memo. 2023-20, affirmed by the Seventh Circuit in 2024, the disputed claim included 65 percent of the compensation of Nevco’s president and chief operating officer, Gary Robert. The evidence did not establish a reliable allocation of his time to qualified research. The appellate court emphasized that the problem extended beyond missing written records: the evidence did not establish how much of his work involved qualifying experimentation. This was a failure of proof, not a universal prohibition on testimony or estimates.
The Adaptation Exclusion in Betz v. Commissioner (2023)
Betz v. Commissioner, T.C. Memo. 2023-84, involved custom air-pollution-control systems. The court examined the taxpayer’s established design methods and available technical information when assessing uncertainty and adaptation. The decision also addressed experimentation, substantiation, and funded research. It illustrates that custom manufacture and project difficulty alone do not prove qualified research. Whether existing knowledge resolves the relevant design uncertainty is a factual question; the existence of preliminary specifications is not a universal rule excluding all later development.
Administrative and Legislative Shifts
Form 6765 changes and amendments to the research-expenditure provisions affect compliance alongside the case law. These developments should be distinguished from the holdings of individual cases rather than presented as legislative or administrative codification of Davenport.
Revisions to Form 6765
The IRS proposed substantial Form 6765 changes beginning in 2023 and subsequently revised both the form and its instructions. Under the IRS’s announced implementation schedule, Section G is optional for tax year 2025 and generally mandatory for tax year 2026 and later, subject to exceptions. Those exceptions include qualifying small businesses electing the payroll tax credit and certain original-return filers with no more than $1.5 million in QREs and no more than $50 million in gross receipts, applying the specified aggregation rules.
Where Section G is required, the instructions generally call for:
- Identification and classification of business components, generally covering at least 80 percent of total QREs but no more than 50 components, with remaining components aggregated.
- Component-level wage allocations for direct research, direct supervision, and direct support.
- Applicable supply, computer-use, and contract-research expense amounts.
- Activity descriptions where required, including the amended-return requirements identified in the instructions.
Form 6765 requirements should be distinguished from separate refund-claim requirements. For research-credit refund claims postmarked after June 18, 2024, the IRS waived the initial submission requirements to name each individual and describe the information each individual sought to discover. Identification of business components, research activities, and the required expense totals remains necessary. The IRS may request further substantiation during examination.
Component-level records also support the shrinking-back rule. If the identified business component does not satisfy the research tests, the rule permits testing its most significant subset of elements, continuing to smaller subsets as necessary. It does not waive other eligibility requirements or supply missing evidence. Taxpayers should maintain records that support both the qualifying subset’s activities and the related expenses.
Section 174 Capitalization and Section 174A Domestic Expensing
The Tax Cuts and Jobs Act required research expenditures incurred in tax years beginning after 2021 to be capitalized and amortized over five years for domestic research and fifteen years for foreign research. However, describing five-year domestic amortization as the continuing general rule is outdated. Public Law 119-21 added Section 174A, which generally allows immediate deductions for domestic research expenditures in tax years beginning after 2024, with an alternative capitalization election.
Foreign research expenditures remain subject to fifteen-year amortization under Section 174. The 2025 legislation also provided transition options for previously capitalized domestic costs and limited retroactive relief for eligible small businesses, subject to applicable elections and deadlines. Revenue Procedure 2025-28 addresses implementation. Domestic deduction eligibility and Section 41 credit eligibility remain separate analyses: software-development costs may receive research-expenditure treatment without all activities or costs qualifying for the credit.
Implications for Future R&D Tax Credit Applications
The practical lesson of Davenport, Little Sandy Coal, and Moore is to connect the technical work to the legal requirements and the expenses claimed. Advisors and executives should evaluate the actual evidence, the applicable tax year, and the specific issue involved instead of relying on broad descriptions of innovation or litigation trends.
The Limits of Retrospective Interviews
After-the-fact interviews are not categorically invalid. They can explain technical records and help reconstruct activities when the testimony is credible and sufficiently specific. Unsupported percentages and general recollections are vulnerable, however. Businesses should preserve design revisions, test results, meeting notes, task records, and reasonable time allocations as work proceeds. Daily time sheets are one possible method, not a universal statutory prerequisite. The applicable recordkeeping standard requires records sufficient to substantiate entitlement and the claimed amounts.
The Rigor of the Internal Use Software (IUS) High Threshold
Companies should first determine whether the software falls within the internal-use rules and whether an exception applies. For software subject to the high threshold, the evidence should address the anticipated measurable improvement, the substantial resources and technical risk, and the availability of a commercially obtainable solution for the intended purpose. Contemporary benchmarks and development assessments can support those issues. Being new to the company, or expensive to implement, does not alone establish eligibility.
Contractual Structure and Funded Research
Contract disputes, including Smith v. Commissioner and Meyer, Borgman & Johnson, illustrate why providers must examine payment rights, performance obligations, and rights to research results. Under Treasury Regulation Section 1.41-4A(d), amounts contingent on successful research are treated differently from payments owed regardless of success. Substantial rights in the results are a separate requirement. The entire contractual arrangement and applicable law matter; there is no universal requirement that every contract use specified research milestones.
| Funding Issue | Definition | Impact on Credit |
|---|---|---|
| Contingency | Payment depends on successful research rather than being owed regardless of outcome | Can support treatment as unfunded research for the researcher; all other requirements must also be met |
| Substantial Rights | The researcher retains substantial rights to use the research results | A separate requirement; retaining rights alone does not establish credit eligibility |
| Fixed Price | A specified contract price rather than reimbursement of actual costs | Not automatically funded or unfunded; payment conditions, risk allocation, and retained rights must be evaluated |
