The federal research and development tax credit under Section 41 of the Internal Revenue Code rewards qualifying research expenditures. Eligibility depends on the activities performed, the applicable statutory exclusions, and evidence connecting qualified activities to claimed costs. Decisions including Siemer Milling, Little Sandy Coal, Phoenix Design Group, and Moore illustrate the importance of substantiation. They do not establish a blanket prohibition on estimates or require every qualifying project to advance the state of an entire scientific field.

Luu v. Commissioner and the Limits of the Administrative Analogy

Luu v. Commissioner, T.C. Memo. 2022-126, decided December 28, 2022, concerned a whistleblower award under Section 7623. Felix Luu challenged the award determination arising from information about family businesses operating a supermarket and poultry farm. The Tax Court sustained the Whistleblower Office’s determination after reviewing the administrative record for abuse of discretion. The case citation is T.C. Memo. 2022-126, rather than T.C. Memo. 2022-2.

Luu did not decide an R&D credit claim and did not change the standard for adjudicating Section 41 deficiencies. In an ordinary deficiency proceeding, the Tax Court generally determines the correct tax liability de novo; the taxpayer normally bears the burden of proving entitlement to a credit, subject to applicable exceptions. The taxpayer need not establish that an IRS credit disallowance was arbitrary or capricious, and the court is not generally confined to the audit record. The practical lesson is to maintain reliable evidence, while recognizing that whistleblower proceedings and credit litigation follow different procedural rules.

The Four-Part Test Under Section 41

Qualified research must satisfy the statutory requirements separately for each business component. Qualifying purposes include improvements to function, performance, reliability, or quality. A business component can be a product, process, software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s business.

The 2025 legislation changed Section 41(d)(1)(A) to reference Section 174A, generally for expenditures in tax years beginning after December 31, 2024, subject to transition provisions. Historical discussions of immediate deductibility under Section 174 should therefore not be treated as a complete statement of current law.

Treasury Regulation Section 1.41-4 recognizes uncertainty about capability, method, or appropriate design. It allows reliance on existing scientific and technological principles. Newness to the taxpayer may be relevant; discovery of information exceeding the field’s common knowledge is not required. Uncertainty about customer preferences alone does not establish qualifying technological uncertainty.

Documentation and Systematic Evaluation: Siemer Milling

In Siemer Milling Co. v. Commissioner, T.C. Memo. 2019-37, the Tax Court disallowed research credits for the flour miller’s 2011 and 2012 tax years. The projects involved flour products and milling processes. Engaging an accounting firm to prepare the credit studies did not establish that the underlying activities met the statutory tests.

The record included contemporaneous material, so describing the case as a complete absence of contemporaneous documentation is inaccurate. The deficiencies concerned what the evidence proved about the projects, including their technological basis and systematic evaluation of alternatives. General labels such as new product development did not fill those evidentiary gaps.

Systematic trial and error can qualify. Neither particular scientific formulas nor a formal academic research protocol are universal prerequisites. A useful study explains the uncertainty, the alternatives evaluated, the work performed, and the results, supported by reliable records and knowledgeable testimony.

Shipbuilding and the Substantially All Rule: Little Sandy Coal

Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15, was affirmed by the Seventh Circuit in 2023. The claim covered work on 11 vessels, with a tanker and dry dock selected for trial. Novelty and substantial construction activity did not by themselves establish qualified research.

The Seventh Circuit rejected categorical exclusion of direct support and supervision from the numerator of the substantially all calculation. Such activities can count when they meet the relevant research requirements and constitute elements of experimentation. Inclusion is not automatic, and the court did not reduce the 80% threshold.

For the historical rules applied in the case, the fraction compared research activities constituting elements of experimentation with nonexcluded research activities whose expenditures met Section 174. Activities must be measured consistently, using cost or another reasonable basis under the regulation. This is not a ratio of innovative physical parts to total parts.

The taxpayer still lost because the evidence did not establish the relevant proportions. The lesson is to substantiate the experimental role of design, production, support, and supervision, instead of assuming that an entire first-of-kind vessel qualifies.

Phoenix Design Group and Engineering Services

In Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, decided December 23, 2024, the Tax Court examined three sample projects involving mechanical, electrical, plumbing, and fire protection systems. It found no qualified research in those trial projects. The sample was nonbinding as to the remaining projects, and the opinion did not itself calculate all deficiencies.

The court rejected reliance on a general six-stage design process without sufficient evidence of project-specific uncertainty and experimentation. Possible later design revisions and routine calculations did not establish that the entire system’s design was uncertain.

This was not a categorical rejection of design uncertainty or engineering services. The relevant distinction is between uncertainty about capability, method, or appropriate design and ordinary information gathering or adjustments unsupported by evidence of experimentation. Engineering firms should explain how their actual alternatives and evaluations satisfy the tests, rather than relying on the profession’s general problem-solving methods.

Funded Research and Contractual Risk: Smith and System Technologies

Section 41 excludes research to the extent another person funds it. Treasury Regulation Section 1.41-4A(d) requires analysis of payment contingency and substantial rights. Customer payment does not automatically eliminate every potential credit: where substantial rights remain, qualifying expenditures exceeding funding may still be eligible. Conversely, retaining only incidental experience or requiring unrestricted customer permission to reuse results can be insufficient.

The December 18, 2024 Smith order denied the IRS summary judgment because disputes remained over the contracts and governing law. It did not finally award credits or establish that milestone billing necessarily transfers research risk to the contractor.

The later merits decision, Smith v. Commissioner, T.C. Memo. 2026-50, issued June 16, 2026, materially qualifies the earlier procedural result. The court found that two sampled projects lacked substantial rights. For four others, substantial rights remained, but payment was not contingent on research success. Potential eligibility was limited to qualifying expenditures exceeding the funding received, subject to proof. Progress or phase payments did not alone establish the required contingency.

In System Technologies, Inc. v. Commissioner, an order issued January 3, 2025, denied the IRS partial summary judgment motion on funding. The company engineered industrial finishing systems, including automotive coating applications. Applying Indiana law incorporated into the agreements, the court found that customers retained remedies for total breach, including repayment if the required product was not delivered. That supported its conclusion on payment contingency. The order did not establish that every other research-credit requirement had been met.

Executive Wages and Direct Supervision: Moore

In Moore v. Commissioner, T.C. Memo. 2023-20, Nevco allocated 65% of its president and chief operating officer’s compensation to research. The Tax Court rejected the disputed allocation. The Seventh Circuit affirmed on April 30, 2024, emphasizing the failure to establish what portion of his work involved qualified research and experimentation.

The result cannot accurately be reduced to a categorical finding that all executive work is two levels removed. Treasury Regulation Section 1.41-2 defines direct supervision as immediate supervision of qualified research and excludes higher-level management in that capacity. An executive can still perform qualifying research or other qualified services personally. Eligibility follows the work actually performed and substantiated, rather than job title or a general allocation to product strategy.

The Shrinking-Back Rule

When the requirements are not met for an entire business component, Treasury Regulation Section 1.41-4(b)(2) applies the tests to its most significant subset, continuing to smaller subsets as appropriate. This is a structured qualification analysis, not permission to select arbitrary project fragments or treat every cost as research.

Phoenix Design Group considered smaller systems and subcomponents but still found the evidence insufficient. A study should therefore retain enough detail to evaluate discrete uncertainties and related activities below the overall project level. Smaller scope does not dispense with any statutory test or exclusion.

Loper Bright and Judicial Interpretation

In Loper Bright Enterprises v. Raimondo, decided June 28, 2024, the Supreme Court overruled Chevron and held that courts must exercise independent judgment on statutory interpretation under the Administrative Procedure Act. Statutory ambiguity alone does not require deference to an agency’s interpretation. Agency reasoning may still have persuasive value, and valid delegations of authority remain relevant.

Loper Bright did not invalidate all Treasury regulations, automatically broaden Section 41, or erase prior decisions sustaining agency action. The older common-knowledge discovery requirement had already been removed from the research-credit regulations long before this decision. In the 2026 Smith opinion, the Tax Court rejected the challenge to the funded-research regulations. Taxpayers should assess a specific legal argument and controlling precedent instead of assuming a general relaxation of credit requirements.

Implications for Future R&D Credit Claims

The cases support a practical approach centered on the applicable tax year, identifiable activities, and evidence that connects the credit calculation to those activities.

Reliable Evidence and Defensible Estimates

Use project records, design revisions, test results, employee explanations, and accounting data to substantiate the work and expenses. Contemporaneous tracking is valuable, but the law does not impose one universal timesheet format or categorically prohibit reasonable estimates. Estimates require an evidentiary foundation; interviews alone do not prove that the underlying work qualifies. There is no basis here for asserting that a new IRS classifier system makes all retrospective estimates invalid.

Business Components and Shrinking Back

Identify business components under the statutory definition and apply the tests at the appropriate level. Maintain the relationships between whole projects, systems, and subcomponents so that any shrinking-back analysis is supported. Avoid blanket claims based on novelty or total engineering effort.

Contractual Risk and Research Rights

Review payment terms, acceptance conditions, breach remedies, termination provisions, governing law, and rights to use research results. Document both funding and costs where partial funding may matter. A milestone clause or fixed price is not, by itself, a reliable answer to the funded-research question.

Technological and Design Uncertainty

Describe what was uncertain at the outset, which alternatives were considered, and how they were evaluated. Distinguish experimentation from customer preference changes, routine compliance, and ordinary production. Appropriate design uncertainty can qualify when supported by the facts.

Consistent Records and Procedural Accuracy

Reconcile the study with payroll, financial records, project documentation, and contractual obligations. Internal disclosures can lead to tax scrutiny, but a whistleblower award case does not establish the review standard for a research-credit deficiency. Prepare evidence that proves credit entitlement under the correct procedure.

Final Thoughts

A defensible R&D credit study connects qualifying activities, costs, and retained research rights to the law for the relevant year. These cases show the limits of generalized narratives and unsupported allocations while preserving the possibility of qualifying industrial experimentation, design work, and properly substantiated estimates. The most useful response is accurate component-level analysis and reliable supporting evidence, with careful attention to the scope and procedural posture of each judicial decision.