The federal research and development tax credit under Internal Revenue Code Section 41 requires more than technically demanding work. Engineering and architectural activities must satisfy the statutory qualification tests, and taxpayers must support both the activities and the associated expenses.
The case identities matter. Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, concerns an engineering firm’s research activities. Smith v. Commissioner, Docket Nos. 13382-17, 13385-17, and 13387-17, concerns separate architectural research-credit litigation. The materials supporting this study do not substantiate a related research-credit decision named Lomax v. Commissioner. Accordingly, the analysis below attributes the relevant findings to Phoenix Design Group and distinguishes the separate funded-research proceedings.
The Statutory Architecture of the Research and Development Credit
For the historical tax years involved in Phoenix Design Group, Section 41(d)(1)(A) incorporated the research and experimental expenditure standard under Section 174. That standard asks whether the taxpayer undertook investigative activities to eliminate uncertainty concerning capability, method, or appropriate design. General business uncertainty, cost concerns, or the possibility of later design revisions do not establish that standard by themselves.
The four-part test also requires technological information, an intended new or improved business component, and a qualifying process of experimentation. The technological information need not be new to the industry or expand the common knowledge of qualified professionals. Applying existing engineering principles can qualify when the actual activities meet the tests.
| Component of the Four-Part Test | Statutory and Regulatory Basis | Judicial Interpretation in 2024-113 |
|---|---|---|
| Research expenditure and uncertainty test | Section 41(d)(1)(A), incorporating Section 174 for the years at issue; Treasury Regulation Section 1.174-2. | PDG failed to establish specific uncertainty and investigative activities sufficient to meet the test for the trial projects. |
| Technological information test | Section 41(d)(1)(B)(i); Treasury Regulation Section 1.41-4(a)(4). | The parties stipulated that the technological-in-nature requirement was satisfied; it was not an independently contested failure. |
| Business component and permitted purpose | Sections 41(d)(1)(B)(ii), 41(d)(2), and 41(d)(3). | The parties stipulated to permitted purpose. Identifying the relevant business component remained important to evaluating the disputed tests. |
| Process of experimentation test | Section 41(d)(1)(C); Treasury Regulation Section 1.41-4(a)(5)u2013(6). | PDG did not demonstrate an adequate evaluative process for resolving the asserted uncertainties. |
The substantially-all rule generally requires at least 80% of a taxpayer’s research activities for a business component, measured on a cost or other consistently applied reasonable basis, to constitute elements of a process of experimentation for a permitted purpose. The remaining activities must satisfy the other applicable requirements. This is not a simple comparison of experimental expenditure with all project spending, nor does it automatically make 80% of project costs creditable. Expense eligibility is a separate question.
Tax-year distinctions are also essential. Legislation enacted in 2025 added Section 174A for domestic research and experimental expenditures, and the current Section 41 expenditure cross-reference reflects that change. The historical Section 174 discussion in this study should not be treated as a complete statement of current deduction and capitalization rules.
Procedural Context of the Phoenix Design Group Litigation
Phoenix Design Group was a multidisciplinary engineering consulting firm designing mechanical, electrical, plumbing, and fire protection systems. Its claim involved credits generated during 2013u20132016 and used during 2015u20132019. A consultant identified 238 potentially qualifying projects; the court considered three selected trial projects.
The December 23, 2024 opinion found no qualified research in those three projects. The parties agreed that the findings would not bind the remaining 235 projects, although the analysis could help them resolve the broader dispute. Describing the opinion as a final rejection of every project therefore overstates its scope.
| Trial Project Name | Facility Type | Claimed Technical Uncertainty |
|---|---|---|
| Gerald Champion Military Psychiatric Unit | Healthcare facility | Asserted uncertainty concerning appropriate MEPF design. The court did not find sufficient proof of qualifying uncertainty and investigation. |
| Baptist Memorial Health North Mississippi Oxford | Hospital | Asserted uncertainty concerning the facility’s MEPF systems. Project-specific design demands did not themselves establish qualified research. |
| Vanderbilt University Engineering and Science Building | University engineering and laboratory building | Asserted uncertainty concerning MEPF design for the building. The evidence did not establish the disputed qualification requirements. |
A third-party credit study does not replace evidence of what engineers actually investigated. Equally, using a consultant or preparing a study after the work occurred does not automatically invalidate a claim. The relevant question is whether reliable evidence establishes the legal requirements.
Deconstructing the Technical Uncertainty Threshold
Technical uncertainty depends on the information objectively available when the relevant development work begins. The taxpayer should identify what that information did not establish about capability, method, or appropriate design, and explain the investigative work intended to resolve the gap.
PDG’s assertion that its designs might change during construction did not, by itself, establish qualifying uncertainty. The court distinguished investigation from calculations using information already available. Calculating duct size from known airflow requirements illustrated why an unresolved numerical answer is not necessarily an unresolved research question.
This distinction does not exclude engineering performed with established formulas or standard software. Those tools may support experimentation when used to evaluate alternatives under genuine technical uncertainty. The taxpayer must show that connection instead of relying on project complexity or the engineers’ professional credentials.
The Process of Experimentation
A qualifying process evaluates one or more alternatives to achieve a result where capability, method, or appropriate design is uncertain at the outset. Modeling, simulation, and systematic trial and error are recognized approaches under Treasury Regulation Section 1.41-4(a)(5).
In Phoenix Design Group, calculations and communications about design decisions did not adequately demonstrate the required evaluative process. The lesson is to explain how the work tested alternatives and addressed uncertainty. There is no universal requirement to label every activity with a formal hypothesis, follow a prescribed number of iterations, or produce a failed design.
- Identify the uncertainty affecting the particular business component.
- Describe the alternatives considered and the technical basis for evaluating them.
- Preserve the modeling, simulations, calculations, or tests used in the evaluation.
- Explain how the results informed design decisions or further investigation.
A sequence of ordinary design stages is neither sufficient proof of experimentation nor an automatic disqualification. The analysis concerns the activities within those stages.
The Evidentiary Standard and the Cohan Rule
Treasury Regulation Section 1.41-4(d) requires records in sufficiently usable form and detail to substantiate eligible expenditures. Contemporaneous technical and accounting records often provide stronger evidence than unsupported recollections, but the regulation does not universally mandate one specific time-tracking system.
The Cohan estimation principle does not relieve a taxpayer of establishing that qualifying research occurred. A reasonable estimate requires a credible evidentiary foundation. It is misleading to state that courts categorically prohibit estimates for research credits, or to attribute general IRS audit-guide criticisms of reconstructed wages to findings specifically made in Phoenix Design Group.
The shrinking-back rule permits evaluation of the most significant subset of elements of a business component when the larger component fails the qualification requirements, continuing as appropriate to smaller subsets. It does not automatically save an unsupported claim. Taxpayers need evidence connecting the relevant uncertainty, experimentation, and expenses to the subset being evaluated.
| Required Documentation Type | Purpose under Section 41 | Failure in Phoenix Design Group |
|---|---|---|
| Project narratives or equivalent technical records | Identify the component, the uncertainty, and the investigative work. | The trial-project evidence did not sufficiently establish the disputed research requirements. |
| Activity and cost records | Support the connection between qualified services, expenses, and business components. | The trial focused on whether activities qualified; it should not be recast as a holding that all salary estimates are prohibited. |
| Evaluation and test records | Explain the alternatives evaluated and the process used to address uncertainty. | Descriptions of calculations and resulting designs did not adequately establish the required process. |
| Contractual provisions and governing law | Evaluate financial risk and substantial rights under the funded-research exclusion. | A funded-research failure was not the basis of this trial-project ruling; contract funding is a separate inquiry. |
These categories describe useful evidence rather than universally mandated document titles. Existing engineering records can satisfy the evidentiary purpose if their content reliably supports the claim.
Funded Research and the Economics of Risk
Section 41(d)(4)(H) excludes research to the extent funded by another person. Treasury Regulation Section 1.41-4A(d) addresses whether payment is contingent on successful research and whether the researcher retains substantial rights in the results. The entire contractual arrangement matters, including governing law.
The December 18, 2024 summary-judgment order in Smith concerned architectural work by Adrian Smith + Gordon Gill Architecture, LLP. It rejected the IRS’s request for judgment on funded-research grounds at that stage; it did not award all disputed credits. The contracts and applicable foreign law left issues requiring further consideration. That procedural order must not be presented as a final merits disposition.
System Technologies, Inc., Docket No. 12211-21, involved a separate industrial finishing-systems business. Its contract analysis concerned Indiana law and remedies for total breach, including recovery of payments if performance failed. The Indiana-law reasoning should not be attributed to Smith or Phoenix Design Group.
A fixed-price label alone does not settle the funding question, and an express clause using the words u201cresearch successu201d is not invariably required. Rights need not be exclusive, but merely incidental experience or institutional knowledge may be insufficient. Contract review should evaluate the actual entitlement to payment and the enforceable ability to use research results.
Accuracy-Related Penalties
Section 6662 can impose a 20% penalty on the portion of an underpayment attributable to specified grounds, including negligence or a substantial understatement. It is not an automatic surcharge on every denied research credit.
In Phoenix Design Group, the parties’ agreement connected the penalty outcome to whether qualified research was found in any trial project. That case-specific stipulation is essential context; it should not be converted into a general rule governing all engineering claims.
Outside that stipulation, applicable penalty requirements and defenses must be considered, including reasonable cause and good faith under Section 6664(c). Reliance on an adviser is evaluated on the facts and does not provide an automatic defense. Neither a rising enforcement trend nor a universal penalty-approval practice can be inferred from this opinion alone.
Refund-Claim Review and Form 6765
Research-credit refund claims have procedural requirements in addition to substantive eligibility. IRS screening for a sufficiently detailed claim is distinct from an examiner’s determination that the research qualifies. The cited court proceedings do not establish that the IRS introduced an automated u201cClassifieru201d system or that such a system supplies a new legal standard.
The December 2025 instructions for Form 6765 state that Section G is optional for tax years beginning before 2026 and required for tax years beginning after 2025, subject to specified exceptions. These include certain qualified small businesses claiming the payroll-tax credit and certain original-return filers meeting both the $1.5 million qualified-research-expense and $50 million average-gross-receipts limits.
For filers required to complete Section G, the instructions generally require component-level detail covering at least 80% of total qualified research expenses, with no more than 50 components listed individually; remaining components are aggregated. This filing convention is distinct from the substantive 80% experimentation test. Amended-return refund claims have separate requirements. Filing information does not replace supporting records or determine eligibility by itself.
Comparison of Judicial Precedents
The cases below illustrate different qualification and proof issues. They do not establish a categorical prohibition on credits in the listed industries or a single new u201cLomax standard.u201d
| Case Name | Industry Focus | Primary Reason for Denial |
|---|---|---|
| Leon Max v. Commissioner | Fashion design | The claimed activities failed applicable qualified-research requirements; aesthetic and style objectives were significant issues. |
| Siemer Milling Co. v. Commissioner | Flour milling | Insufficient proof of a qualifying process of experimentation for the claimed projects. |
| Little Sandy Coal Co. v. Commissioner | Shipbuilding | Insufficient proof that substantially all relevant research activities constituted elements of experimentation. |
| Phoenix Design Group, Inc. v. Commissioner | MEPF engineering | Failure to establish the disputed uncertainty and experimentation requirements for the three trial projects. |
| Betz v. Commissioner | Industrial systems | Failure to substantiate qualifying research, with funded-research issues also affecting the claims. |
Technical skill and commercial creativity do not establish credit eligibility without the statutory connection to qualified research. Conversely, the law does not require an industry-wide scientific breakthrough. Project-level facts and evidence explain the different outcomes.
Strategic Implications for Future R&D Tax Credit Applications
Businesses can strengthen claims by integrating technical evidence and cost support into normal project workflows. A retrospective study can still organize and evaluate reliable existing records; its value depends on the underlying evidence and the accuracy of its legal analysis.
Identification of Technical Uncertainty at Project Inception
Record the specific uncertainty affecting capability, method, or design. Explain what was known, what remained unresolved, and why investigation was needed. A project-opening memorandum is one useful approach, but the law does not prescribe that particular document or require proof that established scientific principles were inadequate.
Documentation of Experimental Evaluation
Preserve alternatives, evaluation criteria, modeling results, test outputs, and design revisions. Explain why a revision reflects investigation rather than a customer’s changed preference or ordinary coordination. For example, an HVAC simulation may support qualification when it evaluates uncertain design alternatives; the fact that simulation software was used is not enough.
Activity-Level Cost Support
Maintain reliable links between employees’ activities, business components, and claimed wages or other expenses. Time records can help, supplemented where appropriate by project files and credible testimony. Separate routine services from qualified research and distinguish the experimentation calculation from the rules for qualified wages, including direct supervision and direct support.
Contract Review for Economic Risk and Research Rights
Review payment terms, acceptance conditions, remedies, intellectual-property provisions, and governing law. Assess the substance of the arrangement rather than relying on fixed-price or [{“@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 that are benefiting from the credit are typically receiving a minimum in the tens of thousands of dollars of federal tax credits each year so don’t pass up this chance to significantly lower your tax liability and improve your cash flow call swanson read representative today for an assessment”},{“@context”:”https://schema.org”,”@type”:”AccountingService”,”name”:”Swanson Reed”,”description”:”One of the largest Specialist R&D Tax Credit advisory firms in the United States, exclusively providing R&D Tax Credit claim preparation and audit compliance solutions for over 30 years.”,”url”:”https://www.swansonreed.com”,”logo”:”https://swansonreed.com/logo.png”,”image”:”https://www.swansonreed.com/wp-content/uploads/2025/03/Swanson-Reed-Specialist-RD-Tax-Credit-Advisors-is-the-largest-in-the-United-States.jpg”,”telephone”:”+1-800-986-4725″,”email”:”damian@swansonreed.org”,”priceRange”:”$195 – 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