The federal Credit for Increasing Research Activities under Internal Revenue Code (IRC) Section 41 encourages qualifying research undertaken in a taxpayer’s trade or business. First enacted in 1981, it generally operates as a nonrefundable general business credit, subject to applicable limitations and carryover rules. Eligible small businesses may elect to apply a portion against specified payroll taxes. Architecture and engineering firms can qualify, but technical complexity and professional design work alone do not establish eligibility.
Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, issued December 23, 2024, illustrates the distinction. The Tax Court found no qualified research in three trial projects involving mechanical, electrical, plumbing, and fire protection (MEPF) systems and applied the parties’ stipulation concerning accuracy-related penalties. The opinion expressly did not determine the amounts of the tax deficiencies. It should not be identified as Kandarian v. Commissioner or described as a final determination disallowing every project in the broader claim.
The Statutory Framework of IRC Section 41 and Research Expenditures
Section 41(d)(1) imposes four requirements: qualifying research expenditures, technological information, an intended new or improved business component, and a process of experimentation for a permitted purpose. The tests apply separately to each business component. A business component can be a product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s trade or business. The permitted purposes concern function, performance, reliability, or quality; purely aesthetic changes do not qualify.
The Technical Foundation: The Research-Expenditure and Uncertainty Test
For the historical years considered in Phoenix Design Group, the first requirement referred to expenditures eligible for treatment under Section 174. Uncertainty exists when the information available to the taxpayer does not establish its capability or method for developing or improving the component, or the appropriate design. Current Section 41(d)(1)(A) refers to Section 174A following the 2025 legislation. The applicable statutory version therefore matters when examining a particular tax year.
Design uncertainty can qualify even when capability and method are known. However, an unfinished design does not by itself establish uncertainty of the required kind. The analysis should identify what was unknown, what information was already available, and what investigative activity addressed the uncertainty. Treasury Regulation Section 1.41-4 expressly rejects a requirement that the information sought exceed the common knowledge of skilled professionals. Using existing scientific principles does not itself defeat a claim.
The Methodology Requirement: Process of Experimentation
Section 41(d)(1)(C) requires substantially all of the relevant research activities to constitute elements of a process of experimentation for a permitted purpose. Treasury Regulation Section 1.41-4 defines substantially all as 80% or more, measured on a consistent reasonable basis, such as time or cost. The process must identify uncertainty, identify one or more alternatives intended to resolve it, and evaluate those alternatives through methods such as modeling, simulation, or systematic trial and error. Successful resolution is not required; unsuccessful research can qualify. A project label or a series of revisions does not establish that this process occurred.
| Component of the Four-Part Test | Statutory/Regulatory Basis | Critical Failure Point in Phoenix Design Group |
|---|---|---|
| Research-expenditure and uncertainty test | IRC Section 41(d)(1)(A); historical Section 174; current Section 174A | The evidence did not establish qualifying uncertainty and investigative work for the claimed components. |
| Technological in nature | IRC Section 41(d)(1)(B)(i) | Engineering subject matter did not cure the failures to establish the other requirements. |
| New or improved business component and permitted purpose | IRC Sections 41(d)(1)(B)(ii), 41(d)(2), and 41(d)(3) | The tests had to be applied to identified components; shrinking back did not establish qualifying research on the evidence presented. |
| Process of experimentation | IRC Section 41(d)(1)(C); Treasury Regulation Section 1.41-4(a)(5) and (6) | General design phases and unexplained engineering records did not demonstrate the required evaluation of alternatives. |
Case Analysis: Phoenix Design Group, Inc. v. Commissioner
Phoenix Design Group (PDG) was a multidisciplinary engineering consulting firm specializing in building systems. It was treated as a C corporation during the credit years addressed by the court. Its disputed research concerned work performed during 2013 through 2016, with credits affecting later years through carryovers. The proceeding concerned the corporation’s credits; it was not an individual shareholder case involving flow-through credits.
Methodology and Sampling in the Trial
PDG engaged a tax consultant to prepare an R&D study. The opinion describes an initial group of 419 possible projects that was narrowed to 238 before sampling. For trial, the parties agreed to a nonbinding sample of three projects and limited the immediate inquiry to whether qualified research occurred, rather than the amount of qualified research expenses. The projects concerned a military psychiatric unit, a hospital, and a university engineering and science building.
The court found that none of those projects qualified, including at the shrinking-back level. Penalties followed the parties’ stipulation for credit years with deficiencies ultimately determined by the court or agreed by the parties. The nonbinding trial sample did not automatically establish the credit outcome for all 238 projects. The opinion expressly reserved the amounts of the deficiencies.
The Rejection of AIA Design Phases as Proof of Experimentation
PDG relied on its structured design workflow, including schematic design, design development, and construction documents, to explain its activities. Such phases organize the delivery of architectural and engineering services and can contain qualifying work. They do not demonstrate that substantially all relevant activities constituted experimentation.
The evidentiary question is what employees actually did within those phases. A taxpayer should connect a technical problem to alternative solutions and explain how calculations, models, simulations, or tests evaluated those alternatives. Describing a project as iterative, or associating work with a broad design framework, leaves that connection unproven.
Routine Engineering and Investigatory Activity
PDG’s work included calculations, revisions, equipment selection, and coordination to satisfy project requirements. The court distinguished investigative work from straightforward calculations using information already available. That distinction concerns the purpose and substance of the activity, rather than whether an engineer performed it.
Established formulas and software can also be used within qualifying experimentation. The taxpayer must explain how their use addressed technical uncertainty and evaluated alternatives. Emails, meeting records, and calculations may help establish that explanation, but collecting requirements, communicating decisions, or selecting known equipment does not automatically constitute research.
Documentation and the Substantially All Requirement
The Phoenix Design Group opinion demonstrates the importance of explaining technical records. Drawings, calculations, and project time records may be extensive without showing why an activity constitutes qualified research. A useful R&D study connects the evidence to the statutory requirements and explains how the claimed expenses relate to qualifying work. The case involved failures to establish the underlying research requirements, not merely the absence of a preferred documentation format.
The 80% Threshold and the Little Sandy Coal Decision
In Little Sandy Coal Co., Inc. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), the Seventh Circuit affirmed the denial of research credits because the taxpayer had not established a principled allocation of activities to experimentation. Newness of the vessels and arbitrary estimates did not establish the substantially all test. The percentage concerns activities, rather than the percentage of a product’s physical features that are new.
The appellate court also rejected a categorical exclusion of certain pilot-model production activities from the experimentation calculation. Such activities can count when they satisfy the relevant research and experimentation requirements. Direct support or supervision is not automatically included merely because its wages might qualify under Section 41(b). Its treatment in the activity ratio requires its own analysis. The business-component experimentation test should also be distinguished from the separate 80% qualified-services rule for an individual employee’s wages.
| Case Name | Court/Year | Key Outcome regarding POE and Documentation |
|---|---|---|
| Phoenix Design Group, Inc. v. Commissioner | Tax Court, 2024 | The three trial projects failed to establish qualified research; design phases did not substitute for evidence of experimentation. |
| Little Sandy Coal Co., Inc. v. Commissioner | Seventh Circuit, 2023 | Denial affirmed for failure of proof; qualifying pilot-model production activities were not categorically excluded from the experimentation ratio. |
| Betz v. Commissioner | Tax Court, 2023 | Illustrates the need to establish objective uncertainty at the claimed product or subcomponent level, rather than relying on customization alone. |
| Phoenix Design Group: sampling and penalties | Tax Court, 2024 | The sample was nonbinding. Penalties followed the parties’ stipulation, and the opinion did not determine deficiency amounts. |
The Shrinking-Back Rule in Practice
Treasury Regulation Section 1.41-4(b)(2) directs taxpayers to apply the requirements first to the business component as a whole. If the requirements are not met, the inquiry proceeds to the most significant subset of elements, continuing until a qualifying subset is identified or the most basic element is reached. It is not enough to identify an interesting design feature after the fact: the evidence must establish the requirements for that subset. The rule does not itself override statutory exclusions.
Funded Research and Contractual Risk
Section 41(d)(4)(H) excludes research to the extent funded by another person. Treasury Regulation Section 1.41-4A(d) addresses both the taxpayer’s substantial rights in the research and whether payment is contingent on successful research. Retaining no substantial rights generally makes the research fully funded. Where substantial rights remain but payments are not contingent on success, research expenses exceeding the applicable funding may remain potentially eligible, subject to the regulations and the other credit requirements.
Smith: From Summary Judgment to the Later Trial Opinion
In its December 18, 2024 order in Smith v. Commissioner, the Tax Court denied the IRS’s summary judgment motion. Disputes concerning contractual rights and governing foreign law prevented a ruling for the IRS on that record. This was an interlocutory ruling, not a blanket determination that the architectural firm’s research qualified or that silence about intellectual property always preserved substantial rights.
The subsequent opinion, Smith v. Commissioner, T.C. Memo. 2026-50, issued June 16, 2026, found that two sample projects lacked retained substantial rights. Four others retained sufficient rights but involved payments not contingent on research success. For those four, any credit depended on research expenses exceeding funding, with amounts left for further computation. The later decision therefore prevents treating the 2024 order as an unqualified taxpayer victory. Contract language, actual rights, and payment obligations must be evaluated project by project.
Financial Risk and Milestone Payments
System Technologies, Inc. v. Commissioner, Docket No. 12211-21, concerned industrial finishing systems. In its January 3, 2025 order denying the IRS’s motion for partial summary judgment, the court examined Indiana law and the customer’s remedies if the company failed to deliver. The contractual warranties did not eliminate a refund remedy for total failure, supporting the conclusion that ultimate payment was contingent on success in those circumstances.
Neither that order nor the earlier Smith order creates a general safe harbor for milestone payments or warranties. The later Smith opinion demonstrates that progress payments and completion of service phases can remain noncontingent. The relevant issue is the enforceable allocation of research risk under the full agreement and governing law. A favorable determination on funding also does not establish that the underlying activities satisfy the four-part test.
| Funded Research Indicator | IRS Position (Recent Litigation) | Tax Court Clarification (Smith/System Tech) |
|---|---|---|
| Contract silence on intellectual property | The IRS challenged whether the taxpayer retained substantial rights under the actual agreements. | Silence alone is not a universal rule. Analyze the complete contract and governing law; Smith’s 2024 order did not conclusively resolve all rights. |
| Milestone payments | Payments for progress or service phases may be due regardless of research success. | Smith’s 2026 opinion confirms that milestone terminology alone does not establish contingent payment. |
| Warranty provisions | A warranty may be insufficient to demonstrate research risk. | System Technologies considered Indiana-law refund remedies for failure to deliver; its reasoning depends on those contractual and legal circumstances. |
| Retention of rights | Incidental knowledge or restricted publicity rights may not constitute substantial rights. | Exclusive ownership is not universally required, but meaningful retained rights must be established. Smith reached different results for different contracts. |
Implications for Future R&D Tax Credit Claims
These decisions reinforce the need to connect technical work, expenses, and contractual obligations to existing legal requirements. They do not establish an industry-wide ban on architecture or engineering credits, a mandatory software system, or a categorical prohibition on interviews and retrospective analysis. Evidence must be sufficiently reliable and specific to support the claim.
The Preparation of R&D Studies
Contemporaneous records are usually more persuasive than unsupported recollections. Firms should retain normal business records that explain uncertainties, alternatives, evaluations, and employee involvement. An R&D study can organize and interpret those records, but cannot turn routine activities into experimentation simply by applying research terminology.
Project-level documentation: Explain the technical objective, the information unavailable at the outset, the alternatives considered, and how each was evaluated. Preserve meaningful design changes and the reasons for accepting or rejecting alternatives.
Time and cost allocation: Use a consistent reasonable method linked to underlying records. Detailed time entries can help, but the legal test does not universally prescribe minute-by-minute logs. Distinguish direct research, support, supervision, and unrelated work, and explain the basis of any estimates.
Subcomponent evaluation: Identify the business component and consider progressively smaller subsets where appropriate. Preserve the same technical and expense evidence for any subset relied upon.
Contractual review: Examine executed contracts, purchase orders, amendments, intellectual-property provisions, termination rights, acceptance criteria, payment terms, and governing law. Descriptive labels alone do not establish retained rights or financial risk.
The Adaptation Exclusion and the Betz Warning
Section 41(d)(4)(B) excludes adaptation of an existing business component to a particular customer’s requirements. Treasury Regulation Section 1.41-4(c)(3) also explains that work is not disqualified merely because a component is intended for a specific customer. The facts must establish whether the activity is excluded adaptation or otherwise qualifying development.
Betz v. Commissioner, T.C. Memo. 2023-84, illustrates the importance of identifying objective uncertainty at the correct level of the product or subcomponent. It should not be used to revive a requirement for discovery beyond the common knowledge of skilled professionals. Customer-specific changes and technical novelty are neither automatic qualification nor automatic disqualification: the four-part test and applicable exclusions must be considered separately.
The Broader Impact on Innovation and Compliance
The practical implications below are recommendations drawn from the cases, rather than new legal requirements imposed on every engineering or architectural practice.
The Distinction Between Design Achievement and Qualified Research
A successful or innovative design does not establish eligibility without evidence of qualifying activities. Conversely, an unsuccessful attempt can qualify if the statutory and regulatory requirements are satisfied. Professional excellence and credit eligibility address different questions; documenting the technical process makes that distinction assessable.
Reliable Estimates and Quantitative Evidence
Little Sandy Coal rejected arbitrary allocations, not every possible estimate. A defensible allocation needs a reasoned foundation in evidence. Firms may improve support by linking time records, project milestones, technical files, and employee explanations. More sophisticated systems can help, but no particular platform guarantees a credit and these decisions do not mandate buying one.
The Strategic Use of Sampling
A sampling agreement should explain the population, selection method, issues being tried, and whether the result binds other projects. A representative statistical sample should not be manipulated to select only the strongest projects. Phoenix Design Group’s nonbinding sample must be distinguished from agreements that expressly extrapolate trial findings. Keeping evidence for the wider population remains prudent; the opinion does not establish a universal rule that a failed sample eliminates every claimed credit.
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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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Who We Are: Swanson Reed is one of the largest Specialist R&D Tax Credit advisory firm in the United States. With offices nationwide, we are one of the only firms globally to exclusively provide R&D Tax Credit consulting services to our clients. We have been exclusively providing R&D Tax Credit claim preparation and audit compliance solutions for over 30 years. Swanson Reed hosts daily free webinars and provides free IRS CE and CPE credits for CPAs.
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What is the R&D Tax Credit? The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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R&D Tax Credit Preparation Services Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states. If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725. Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.
R&D Tax Credit Audit Advisory Services creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.
Our Fees Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/services/our-fees/
Who We Are: Swanson Reed is one of the largest Specialist R&D Tax Credit advisory firm in the United States. With offices nationwide, we are one of the only firms globally to exclusively provide R&D Tax Credit consulting services to our clients. We have been exclusively providing R&D Tax Credit claim preparation and audit compliance solutions for over 30 years. Swanson Reed hosts daily free webinars and provides free IRS CE and CPE credits for CPAs.
Are you eligible?
Why choose us?
Pass an Audit?
What is the R&D Tax Credit? The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
Never miss a deadline again
Stay up to date on IRS processes
Discover R&D in your industry
R&D Tax Credit Preparation Services Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states. If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725. Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.
R&D Tax Credit Audit Advisory Services creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.
Our Fees Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/services/our-fees/
