Historical Foundations of Research and Experimental Expenditure Deductions

Before Section 174 was enacted in 1954, research expenditure treatment depended on ordinary business-expense and capitalization principles under predecessor tax law. Section 162, also enacted as part of the 1954 Code, generally permits ordinary and necessary expenses of carrying on a trade or business. That standard requires an operating business, but does not invariably require current sales or profits. Pre-operational research therefore presented particular deduction difficulties for inventors and new enterprises.

The introduction of Section 174 in 1954 was a deliberate move by Congress to eliminate this “pre-opening” barrier. By using the broader phrase “in connection with [the taxpayer’s] trade or business,” the statute allowed taxpayers to deduct or capitalize R&E costs even if they were not yet “carrying on” a trade or business in the Section 162 sense. The legislative intent was to stimulate innovation and place small, nascent companies on an equal tax footing with established firms that could already deduct research costs as part of their ongoing operations.

The Influence of Snow v. Commissioner

The first major judicial interpretation of this “in connection with” standard came in 1974 with Snow v. Commissioner (416 U.S. 500). In Snow, the Supreme Court ruled that a limited partner in a partnership formed to develop a “trash burner” could deduct his share of the partnership’s research losses despite the partnership having made no sales in the year of the deduction. The Court emphasized that Section 174 was intended to encourage “search and experimentation” by small, new enterprises and should be read expansively.

After Snow, courts considered whether research partnerships were developing businesses of their own or merely financing the businesses of others. These decisions limited the reach of Section 174 without making pre-revenue status itself disqualifying. A genuine profit motive does not, by itself, establish a trade or business.

Detailed Analysis of Kantor v. Commissioner

The case of Kantor v. Commissioner emerged from a deficiency determination involving a partnership known as PCS, Ltd., which was formed in 1981 to develop computer software. The partnership’s objective was to convert a software program called PRO-IV to run on IBM computers.

The Contractual Framework of PCS, Ltd.

PCS, Ltd. and the separate research firm, PCS, Inc., executed a Research and Development Agreement and a Technology Transfer Agreement in 1981. The partnership also issued a Private Placement Memorandum (PPM) describing its financial and commercial expectations.

The partnership claimed a deduction of $3,150,000 for research and development on its 1981 tax return. The Commissioner disallowed this deduction, asserting that the expenditures were not made “in connection with” a trade or business of the partnership’s own, as required by Section 174.

The Tax Court and 9th Circuit Rulings

The Tax Court concluded that, when the expenditures were incurred in 1981, PCS, Ltd. lacked a realistic prospect of conducting its own business with the software. The Ninth Circuit affirmed the deduction disallowance. The low-cost option arrangement made it likely that commercially valuable software would be marketed exclusively by the research firm; the theoretical possibility that rights might return to the partnership was insufficient.

The Ninth Circuit required objective intent and capability to enter a business. The PPM acknowledged insufficient capital for direct marketing if the research firm declined to market the software. However, the general partner, Edwin Hubert, had more than 12 years of computer-industry experience and participated in the project. The court considered that involvement consistent with protecting an investment, rather than proof of a business conducted by the partnership.

Defining the Realistic Prospect Test: Intent and Capability

Kantor articulated the Ninth Circuit’s objective-intent-and-capability formulation of a realistic prospect test, building on earlier cases. It should be applied in light of the relevant facts, jurisdiction, statutory provision, and tax year. It is not a universal checklist requiring every startup to maintain a particular staffing or premises model.

The Objective Intent Requirement

Objective intent is evaluated through agreements, financial arrangements, business plans, and conduct. In Kantor, the combination of the exclusive marketing arrangement and the partnership’s expected royalty income supported the finding that another entity would conduct the business. Royalty income or licensing does not automatically establish passive-investor status in every case.

For startups, plans and commercial arrangements should support a credible business conducted by the taxpayer. Outsourced research, a later sale, or a licensing strategy does not automatically defeat eligibility. The practical rights retained and the taxpayer’s actual and intended activities require examination.

The Capability Requirement

Capability concerns whether the taxpayer could realistically conduct the contemplated business if the research succeeded. Relevant evidence can include expertise, resources, access to facilities, contractual rights, and financing. The draft’s statements that Kantor found no employees, no office, and no technical expertise are not a reliable account of that opinion. In particular, Hubert had substantial relevant experience.

In Scoggins v. Commissioner, 46 F.3d 950 (9th Cir. 1995), the court allowed Section 174 deductions for research involving epitaxial reactors. The experienced inventors actively directed the work, committed resources, and retained commercially meaningful opportunities under their agreements. Common ownership of the partnership and research corporation was part of the circumstances, not an automatic qualification rule.

Comparative Jurisprudence: Related Trade or Business Decisions

Cases preceding and following Kantor distinguish a taxpayer’s own research-related business from an investment in another entity’s activities.

Levin, Diamond, and the Question of Control

Levin v. Commissioner, 832 F.2d 403 (7th Cir. 1987), and Diamond v. Commissioner, 930 F.2d 372 (4th Cir. 1991), preceded Kantor. They examined the economic substance of research and exploitation arrangements rather than relying solely on formal ownership or contractual language. Their reasoning supports evaluating whether a taxpayer has a practical business opportunity of its own.

Harris v. Commissioner and the Substance-Over-Form Doctrine

Harris v. Commissioner, 16 F.3d 75 (5th Cir. 1994), concerned research arrangements involving cement technology. The court rejected the claimed Section 174 deduction because the partnership lacked the necessary connection to its own trade or business. Later activities do not automatically establish eligibility for an earlier year; they matter only insofar as they illuminate the circumstances when the expenditure was incurred.

Zink and Spellman: The Role of Nominal Options

Zink v. United States, 929 F.2d 1015 (5th Cir. 1991), and Spellman v. Commissioner, 845 F.2d 148 (7th Cir. 1988), also addressed the distinction between an investment and a realistic prospective business. Spellman is particularly relevant to nominally priced acquisition options. These decisions do not establish a universal requirement that every option be nonexclusive or priced at fair market value. Pricing, scope, timing, and the taxpayer’s remaining commercial opportunities must be considered together.

The Interplay with the Section 41 R&D Credit

Kantor decided a Section 174 deduction issue, not a Section 41 credit or time-record substantiation dispute. Section 41 imposes additional requirements. For taxable years beginning after December 31, 2024, Section 41(d)(1)(A) refers to expenditures that may be treated as expenses under Section 174A. Section 41(b) separately addresses research expenses incurred in carrying on a trade or business, with a special rule for certain in-house research expenses of startup businesses under Section 41(b)(4). A deduction does not automatically establish credit eligibility.

The Funded Research Exclusion and Substantial Rights

Section 41(d)(4)(H) excludes research to the extent funded by another person. For a research provider, the regulations examine payment contingencies and substantial rights in the research results. These requirements are distinct from the business-connection issue in Kantor, although both make the parties’ actual commercial arrangements important.

In Tangel v. Commissioner, T.C. Memo. 2021-1, the Tax Court granted partial summary judgment concerning research performed under a particular contract because the contractor lacked substantial rights in the research results. Ownership and use restrictions were central to that determination. A work-made-for-hire label should not be treated as a substitute for examining the full agreement and applicable rights.

Legislative Shifts: From Expensing to Amortization and the OBBBA

The TCJA and the 2025 legislation changed the timing of research deductions. They did not make business connection irrelevant or merge the deduction and credit tests.

The TCJA Amortization Mandate (2022-2024)

Before taxable years beginning in 2022, former Section 174 generally permitted taxpayers to elect current deductions for eligible R&E expenditures; it did not cover every cost described commercially as R&D. For taxable years beginning in 2022 through 2024, the TCJA generally required capitalization and amortization of specified research or experimental expenditures over five years for domestic research and 15 years for foreign research, beginning at the midpoint of the taxable year, subject to subsequent statutory transition relief.

For a full 12-month taxable year, $10 million of eligible domestic costs subject to the five-year midpoint convention ordinarily produced a $1 million first-year amortization deduction. Compared with full expensing, this could increase taxable income or reduce a tax loss. It did not necessarily create tax liability for a company with no taxable income from other sources. The timing calculation is separate from whether the expenditure qualifies under the applicable provision.

The Restoration of Expensing: Section 174A and OBBBA 2025

Public Law 119-21, enacted July 4, 2025 and commonly called the One Big Beautiful Bill Act (OBBBA), added Section 174A. It generally restores current deductions for domestic R&E expenditures paid or incurred in taxable years beginning after December 31, 2024. Section 174A also permits an election to capitalize and amortize qualifying costs over at least 60 months, beginning when benefits are first realized.

Section 174A retains a connection-to-the-taxpayer’s-trade-or-business requirement. Earlier decisions such as Kantor therefore remain relevant by analogy, but Kantor did not interpret the new statute. Restoration of expensing alone does not substantiate a prediction that the IRS will increase startup audits.

Modern Litigation Trends and IRS Administrative Guidance

In recent years, the IRS and the Tax Court have applied more granular standards to both Section 174 and Section 41, often focusing on documentation and the role of local law.

IRS Notice 2023-63 and 2024-12: The SRE Product Right

Notice 2023-63 and Notice 2024-12 supplied interim guidance for the TCJA Section 174 regime, including rules for research providers and rights to use or exploit resulting SRE products. These notices must be read with their reliance conditions and the law applicable to the year under review; they should not be presented as an unchanged statement of post-2024 domestic deduction timing.

Under that interim framework, a provider’s financial risk can cause its research costs to be SRE expenditures even without rights to exploit the resulting product. A provider with no financial risk may nevertheless have SRE costs if it retains a relevant product right. Notice 2024-12 clarifies exceptions for separately acquired rights and rights limited to performing research for the recipient. Absence of product rights alone does not establish a Section 162 deduction; other applicable deduction and capitalization rules still matter.

Smith and System Technologies: The Role of Local Law

Early-2025 proceedings in Smith v. Commissioner and System Technologies, Inc. v. Commissioner addressed IRS summary-judgment challenges involving funded research. They should not be characterized as final awards of all claimed credits or as identical rulings that contract silence establishes retained intellectual-property rights.

In Smith, disputes involving contract interpretation and applicable foreign law prevented summary judgment for the IRS. In System Technologies, Indiana-law remedies for failure to deliver were material to whether payments depended on successful performance. The practical lesson is to analyze contracts together with governing law. Milestone payments alone do not prove that research is unfunded, and these decisions do not decide Kantor’s prospective-business test.

Little Sandy Coal and Phoenix Design Group: Documentation as a Fatal Flaw

Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15, affirmed at 62 F.4th 287 (7th Cir. 2023), illustrates the need to substantiate the substantially-all process-of-experimentation test. The regulatory threshold is generally 80% of research activities measured by cost or another consistently applied reasonable basis. Analysis begins at the business-component level; the shrinking-back rule may apply to subsets if the component does not qualify. It is not simply a test of the percentage of novel physical parts.

Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, likewise illustrates that technical engineering work does not automatically establish qualified research. The taxpayer must substantiate the relevant uncertainty and an evaluative process satisfying Section 41. Treasury Regulation Section 1.41-4(d) requires sufficiently usable records to establish eligibility and amount; it does not prescribe a universal timesheet system or demand documentation with scientific precision. Contemporaneous records are valuable, but the sufficiency of testimony and other evidence depends on the facts.

Implications for Future R&D Tax Credit Applications

A sound research-tax analysis separately addresses business connection, qualifying activities, contractual funding, eligible costs, substantiation, and the deduction rules for the relevant year.

Structuring Future R&D Partnerships

To withstand IRS scrutiny under the Kantor standard, pre-revenue partnerships and startups should ensure their organizational structure reflects an active business intent rather than a passive investment posture.

Review License Options: Assess whether pricing, exclusivity, timing, and practical incentives leave the taxpayer a realistic opportunity to conduct its own business. A fair-market-value price or nonexclusive license is not an automatic safe harbor.

Maintain Meaningful Business Involvement: Document the taxpayer’s commercial role and actual oversight where relevant. Independent-contractor status and contractor control of personnel do not by themselves defeat eligibility; changing boilerplate without changing the facts does not resolve the issue.

Document Capability: Preserve evidence