The Statutory Architecture of the Section 41 Credit

Section 41 requires satisfaction of four related conditions. Under the law applicable to the research years in Phoenix Design Group, expenditures had to satisfy the Section 174 research-and-experimental standard. The research must seek technological information, relying fundamentally on physical or biological science, engineering, or computer science; its application must be intended to develop or improve a business component; and substantially all research activities must constitute elements of a process of experimentation for a permitted purpose. Permitted purposes concern function, performance, reliability, or quality. For tax years beginning after 2024, the amended statute refers to Section 174A. The remaining credit requirements and statutory exclusions must also be satisfied.

The substantially-all threshold is 80% or more of the taxpayer’s research activities for a business component, measured by cost or another consistently applied reasonable basis, such as hours. When the requirements are not met for the whole component, the shrinking-back rule applies them to the most significant subset of its elements, continuing to smaller subsets as necessary. Phoenix Design Group demonstrates the need for evidence that supports analysis at the relevant level; the rule does not prescribe one mandatory recordkeeping system.

Quantification of Disputed Research Expenditures

The research years were 2013 through 2016, while the examined credit-use years were 2015 through 2019. The opinion separately lists credits generated, credits used, and deficiencies and penalties determined in the notice of deficiency. These amounts are not interchangeable. The table preserves the original headings and corrects the credit-use amounts to match the opinion.

The notice of deficiency separately determined tax deficiencies of $55,504, $47,811, $219,177, $68,147, and $71,102 for 2015 through 2019. The penalties shown are the notice amounts, not estimates or 20% of the credit-use column. Under the parties’ stipulation, the absence of qualified research in all three trial projects resulted in penalty liability for credit years with a deficiency ultimately determined by the court or agreed by the parties.

Factual Underpinnings of the Phoenix Design Group Litigation

Phoenix Design Group (PDG) is an engineering consulting firm designing mechanical, electrical, plumbing, and fire protection systems, including systems for hospitals and laboratories. A consultant reviewed documentation for projects undertaken between 2012 and 2016 and identified 419 possible projects, subsequently reducing that group to 238 after removing known nonqualifying and de minimis projects. The claimed credits related to research years 2013 through 2016. The parties tried three projects as an expressly nonbinding sample and limited the trial to research qualification rather than the amount of qualified research expenses.

PDG relied on the complexity and iterative nature of its engineering design work. The court distinguished technically demanding professional services from qualified research under Section 41. PDG had time sheets and design records, but the evidence did not adequately connect the activities in the trial projects to objective uncertainty and qualifying experimentation. The problem was the sufficiency and consistency of the proof, not the complete absence of contemporaneous records.

Detailed Analysis of Sampled Projects

The trial projects were Gerald Champion Military Psychiatric Unit (No. 13008.00), Baptist Memorial Health North Mississippi Oxford (No. 13003.00), and Vanderbilt University Engineering and Science Building, or VU ESB (No. 12010.01). VU ESB involved laboratory and building systems, including HVAC and steam piping. The record included iterative pipe-stress modeling, but the court found the proof insufficient at the business-component and shrinking-back levels. Some activities related to separately numbered projects beyond the trial’s scope. It would therefore be misleading to characterize every activity as routine without acknowledging the modeling evidence and the scope and allocation problems.

At BHNM Oxford, PDG designed systems for a hospital with differing temperature, ventilation, electrical, and equipment requirements. The court found insufficient proof of technical uncertainty and qualifying experimentation, including at smaller component levels. Time sheets did distinguish many mechanical, electrical, and plumbing hours, but did not identify the precise relevant activities well enough to establish qualification. Unexplained drawings, equipment selections, and changes did not establish the required experimental process.

Deconstructing the Section 174 Test and the Nature of Uncertainty

For the historical research years, the Section 174 test asked whether activities were intended to eliminate uncertainty about the capability, method, or appropriate design of a product or improvement. The applicable regulation focuses on information available to the taxpayer. It does not require research to advance knowledge throughout the industry.

The relevant uncertainty must exist when the research activities begin. Commercial concerns, such as profitability or customer preferences, do not by themselves establish technical uncertainty. Conversely, uncertainty about appropriate design can qualify even where basic engineering principles are established. In Phoenix Design Group, the court examined whether the information already available established the design and whether subsequent activities actually evaluated alternatives.

An unfinished design does not by itself prove Section 174 uncertainty, and routine calculations or code compliance do not by themselves establish a process of experimentation. However, the ruling does not categorically exclude engineering work that uses standard principles. Qualification depends on the actual uncertainty, activities, and supporting evidence.

The Role of Investigative Activities

Investigative work should be tied to an identified technical uncertainty. Emails, meeting records, calculations, and design revisions may help establish the information available and the steps taken to resolve uncertainty. They are evidence, not automatically qualifying activities. In PDG’s trial projects, the court found the technical knowledge gaps and evaluative work insufficiently established.

The Process of Experimentation and the Scientific Method

A process of experimentation evaluates one or more alternatives to achieve a result whose capability, method, or appropriate design is uncertain at the outset. Modeling, simulation, and systematic trial and error can satisfy this requirement when the facts meet the regulation. Phoenix Design Group applied existing statutory and regulatory standards; it should not be described as creating a new formal laboratory protocol for all claimants.

PDG argued that its six-stage design process, including schematic design, design development, and construction documentation, demonstrated experimentation. The court rejected reliance on those general stages because the evidence did not show the required evaluation of alternatives and some time-sheet descriptions conflicted with the stated stages. The court used scientific-method reasoning, but the legal test does not mandate a separately labeled hypothesis document for every project.

Failure of Narrative Descriptions

Generic descriptions of design work were insufficient to establish experimentation. A notation that an engineer revised an HVAC layout does not explain the uncertainty, alternatives considered, or evaluative steps. Contemporaneous records can be persuasive, but their existence alone is not enough: the records and testimony must substantiate the actual qualifying activities.

Comparative Analysis: Little Sandy Coal and the 80% Threshold

Little Sandy Coal Co., Inc. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), affirmed the denial of research credits involving a shipbuilder’s claim for eleven first-in-class vessels, with two vessels selected for trial. The taxpayer did not substantiate the 80% experimentation threshold. The decision informs the activity-focused analysis discussed in Phoenix Design Group.

The Quantitative Reality of “Substantially All”

The numerator of the substantially-all fraction measures research activities constituting elements of a process of experimentation; the denominator measures all research activities for the business component on the same basis. Little Sandy Coal rejected the inference that a new vessel’s physical novelty establishes the required proportion of experimental activities. A prototype label does not make every construction activity experimental.

The Seventh Circuit disagreed with categorically excluding direct support and direct supervision from the experimentation fraction. Those activities can enter both numerator and denominator where properly connected to qualifying experimentation. The taxpayer still needed a principled, evidentiary basis for allocation. This clarification does not make all production or supervisory time qualifying.

Mathematical Formulation of the Section 41 Credit

The regular credit’s principal QRE component is 20% of qualified research expenses exceeding the base amount, subject to the statutory base rules, including the minimum base amount. The alternative simplified credit generally uses 14% of current-year QREs above 50% of the average QREs for the preceding three years; a special 6% rule applies when there were no QREs in any one of those years. Section 280C coordination, other statutory components, and credit-use limitations must also be considered. The 80% experimentation test is an eligibility test, not the credit rate.

The 80% test can be expressed as:

Qualification ratio = hours constituting elements of a process of experimentation ÷ total research hours for the business component ≥ 0.80, when hours are the consistently applied reasonable measurement basis.

Meeting the 80% threshold does not automatically turn all project costs into QREs. The remaining research activities must satisfy the applicable conditions, and individual costs remain subject to Section 41(b), the exclusions, and substantiation requirements. Where the component fails, the shrinking-back rule may permit qualification at a smaller level. The court applied that analysis in PDG but found the evidence insufficient for the three trial projects.

Documentation Standards and Contemporaneous Evidence

Phoenix Design Group, Little Sandy Coal, and Betz v. Commissioner illustrate the weakness of unsupported allocations and general accounts of technical work. Treasury Regulation Section 1.41-4(d) requires records sufficiently usable and detailed to substantiate eligibility and expenses. Contemporaneous technical and financial records are useful evidence, but there is no universal requirement for a particular software system or minute-by-minute timekeeping.

Limits of Unsupported Estimates

In Betz v. Commissioner, T.C. Memo. 2023-84, the taxpayers did not establish the necessary foundation for claimed employee research services and estimates. PDG likewise failed to substantiate qualifying activities despite having time and design records. These decisions do not abolish retrospective studies or all reasonable estimates. A later study must be supported by reliable evidence of actual qualified research and a defensible expense allocation.

To support a defensible claim, taxpayers should consider retaining:

• Real-time tracking systems that categorize time by research phase.
• Technical design records, including modeling logs and testing protocols.
• Email correspondence and meeting minutes specifically detailing the resolution of technical hurdles.
• Employee activity logs that capture the iterative nature of the work.

Funded Research and the Mitigation of Financial Risk

Section 41(d)(4)(H) excludes research to the extent funded by another person. Under Treasury Regulation Section 1.41-4A(d), payment contingency and substantial rights are central considerations. Where payments are contingent on successful research, the performer may bear the relevant risk. Where payments are not contingent, funded amounts generally reduce otherwise eligible expenses if substantial rights are retained. Failure to retain substantial rights can exclude the research altogether. Contract labels alone do not determine the result.

The Procedural and Substantive Lessons of Smith and System Technologies

The early procedural rulings discussed in January 2025 commentary denied IRS summary-judgment motions; they were not blanket awards of research credits. In Smith, the court initially found unresolved issues concerning contracts, payment, rights, and governing law. Subsequently, Smith v. Commissioner, T.C. Memo. 2026-50, issued June 16, 2026, largely denied the architectural partnership’s claimed credits under the funded-research rules while allowing limited treatment for projects with retained substantial rights. Milestone billing therefore should not be presented as conclusively establishing unfunded research.

In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, the Tax Court denied the IRS’s motion for partial summary judgment on funded research. The court considered Indiana remedies for total breach and concluded that the warranty provisions did not eliminate the possibility of repayment for failure. That analysis concerns the specific contracts and governing law; it does not establish a universal exception for fixed-price work or resolve every other credit requirement.

Administrative Evolution: Updates to Form 6765

The IRS’s December 2025 Form 6765 instructions make Section G optional for tax years beginning before 2026 and generally required for years beginning after 2025, subject to exceptions. Separate [{“@context”:”https://schema.org”,”@type”:”VideoObject”,”name”:”What is the R&D Tax Credit?”,”description”:”The research and experimentation tax credit, most frequently known as the R&D tax credit, is a dollar-for-dollar reduction of your tax liability.”,”thumbnailUrl”:[“https://i.ytimg.com/vi/mzGRiA_MUl4/sddefault.jpg”,”https://www.dropbox.com/s/n1iyfxaeo6rm5tg/Fed%20-%20US%20Flag.jpg?raw=1″],”uploadDate”:”2019-10-14T00:00:00+00:00″,”duration”:”PT3M54S”,”contentUrl”:”https://www.youtube.com/watch?v=mzGRiA_MUl4″,”embedUrl”:”https://www.youtube.com/embed/mzGRiA_MUl4″,”publisher”:{“@type”:”Organization”,”name”:”Swanson Reed”,”url”:”https://swansonreed.com”,”logo”:{“@type”:”ImageObject”,”url”:”https://swansonreed.com/logo.png”}},”transcript”:”the research and experimentation tax credit most frequently known as the r d tax credit is a dollar for dollar reduction of your tax liability it was established in 1981 as an incentive for companies to invent create and innovate within the united 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 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