The Machise Litigation: Employee Status and Its Limited Relevance to Section 41

Bealor considered arrangements under which partnerships purported to supply personnel to Machise. The employee-status discussion examined the practical employment relationship rather than accepting contractual labels alone. General research-credit documentation requirements arise independently from the Internal Revenue Code, Treasury regulations, and cases that actually address Section 41.

The Common Law Employer Test and Section 41 Eligibility

Qualified research expenses can include wages for employees who conduct qualified research or directly supervise or support it. Treasury Regulation Section 1.41-2(c) generally uses the common law employee concept, with special rules for certain owner-employees. Identifying the employer is therefore relevant when personnel work through leasing companies, payroll providers, or related entities.

In the Machise arrangements examined in Bealor, the partnerships’ contractual reservations of control did not establish that they operated as the workers’ employers. Machise continued directing the employees’ activities. The broader common law inquiry considers the right to control and the circumstances of the relationship; it is not limited to who processes payroll or gives daily instructions. The Illinois Department of Revenue’s filing in the PepsiCo litigation cites Bealor for this point, but that filing is a party’s argument, not itself a judicial holding.

For research-credit purposes, employee status must be considered alongside the wage rules, the nature of the services, and any applicable controlled-group or third-party payer provisions. A professional employer organization arrangement neither automatically creates nor eliminates a research credit. Intercompany arrangements require their own analysis rather than an assumption that operational supervision alone resolves entitlement.

Substantiation, Tax Returns, and Missing Records

A completed return or Form 6765 does not, by itself, establish that the underlying research occurred or that the claimed amounts qualify. Treasury Regulation Section 1.41-4(d) requires records sufficient to substantiate eligibility and amount. An R&D credit study should explain the relevant business components, activities, expenses, and supporting evidence rather than merely repeat statutory language.

Allegations of fraudulent filings involving Alan Fabian and disputes over hurricane-damaged records arise in unrelated litigation, not in a Machise research-credit decision. Nor is there a universal judicial rule that electronic records can always be reconstructed. When records are missing, taxpayers should document the loss and make reasonable efforts to obtain reliable replacement evidence.

Contemporaneous technical and financial records are valuable, but Section 41 does not impose a universal requirement to use a particular real-time tracking system. Credible testimony and reasonable reconstructions may be relevant, depending on the evidence and governing authority. Retrospective interviews are neither automatically sufficient nor categorically inadmissible. Uncorroborated recollections and unexplained estimates can leave material gaps.

The Technical Framework: The Four-Part Test for Qualified Research

The Section 41 tests apply separately to each business component: a product, process, computer software, technique, formula, or invention intended for sale, lease, license, or use in the taxpayer’s trade or business. Satisfying these tests does not override statutory exclusions or establish that every associated expenditure is a qualified expense.

The Research Expenditure and Uncertainty Test

For the historical years addressed in many research-credit cases, Section 41 referred to Section 174. Following the 2025 legislation, Section 41(d)(1)(A) refers to domestic research or experimental expenditures under Section 174A. The applicable version of the law must be used for the year under examination.

The uncertainty inquiry concerns whether information available at the outset establishes the capability or method for developing or improving the business component, or its appropriate design. General commercial risk, an unfinished design, or customer indecision does not alone establish qualifying technical uncertainty.

In Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, the Tax Court rejected research-credit claims involving engineering design work because the taxpayer failed to establish the relevant uncertainty and experimentation requirements. Applying engineering calculations to available information was insufficient on that record. The decision does not categorically exclude engineering design or require an advance beyond knowledge available throughout an entire industry.

The Technological Nature Test

The activity must rely on physical or biological science, engineering, or computer science. Research in the social sciences, arts, or humanities is excluded. Technical terminology or the involvement of qualified engineers does not, without evidence about their activities, establish compliance.

The Business Component and Permitted Purpose Test

The intended improvement must concern function, performance, reliability, or quality. Research related to style, taste, cosmetic appearance, or seasonal design factors is excluded. Leon Max v. Commissioner illustrates the limitations of treating fashion-design activity as qualified research; technical activity in any industry still requires analysis of its actual purpose and method.

The Process of Experimentation Test

Substantially all of the relevant research activities must constitute elements of a process of experimentation for a permitted purpose. Treasury Regulation Section 1.41-4(a)(6) sets an 80% threshold, measured by cost or another consistently applied reasonable basis. This is a business-component inquiry, not a rule that 80% of all company operations must be research.

A qualifying process identifies uncertainty, considers alternatives, and evaluates them through methods such as modeling, simulation, or systematic trial and error. Repeated adjustments alone do not establish experimentation. Records should make the evaluative process understandable and connect it to the uncertainty being addressed.

Documentation and the 80% Threshold: Lessons from Little Sandy Coal

Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15, affirmed at 62 F.4th 287 by the Seventh Circuit in 2023, involved research-credit claims associated with shipbuilding. The taxpayer failed to provide a principled basis for determining the share of activities that constituted elements of experimentation. Novelty and broad employee allocations did not establish the required percentage.

Direct Support, Supervision, and Pilot Models

The Seventh Circuit rejected the Tax Court’s categorical exclusion of certain pilot-model production activities from the numerator of the substantially-all fraction. Direct support and supervision can enter the analysis when the underlying activities satisfy the relevant research and experimentation requirements. Their labels do not automatically make them qualifying or nonqualifying.

Calling an entire vessel a pilot model did not cure the evidentiary gaps. Taxpayers must explain the connection between the claimed activities and the evaluative process, and provide a reasonable basis for allocating costs or time. This experimentation fraction is distinct from the separate employee-wage rule that may treat all of an employee’s wages as qualified when substantially all services qualify.

Applying the Shrink-Back Rule

If the requirements are not met at the overall business-component level, Treasury Regulation Section 1.41-4(b)(2) provides for applying them to the most significant subset of elements, and then progressively smaller subsets where necessary. This rule can identify qualifying portions of a larger project, but does not excuse missing evidence or permit arbitrary selection of favorable activities.

Systematic Versus Simple Trial and Error

Systematic trial and error evaluates alternatives to resolve technological uncertainty. Routine changes made solely to achieve a preferred appearance do not qualify merely because several options were tried. Likewise, routine troubleshooting may fall outside Section 41, while a genuinely experimental investigation must be assessed on its facts.

The Funded Research Exclusion: Contractual Risk and Rights

Section 41(d)(4)(H) excludes research to the extent funded by another person or governmental entity. Treasury Regulation Section 1.41-4A(d), incorporated through Section 1.41-4(c)(9), requires consideration of the relevant agreements. Two central questions are whether payment depends on research success and whether the researcher retains substantial rights in the results.

Financial Risk and Milestone Payments

Fixed fees, milestones, warranties, and potential cost overruns do not independently establish that research is unfunded. The enforceable payment terms and the risks associated with unsuccessful research must be examined. Funding can be partial: where substantial rights are retained, otherwise qualified costs exceeding the relevant funding may remain eligible under the regulations.

The earlier Smith proceedings did not conclusively establish credit eligibility. A December 2024 summary-judgment ruling allowed disputed funding issues to proceed; it did not finally establish credit eligibility. The later decision, Smith v. Commissioner, T.C. Memo. 2026-50, issued in June 2026, found that phase or progress payments were not contingent on research success. For four sample projects with retained substantial rights, only qualifying expenses exceeding funding could potentially support a credit. Two other projects failed the substantial-rights requirement.

The January 2025 System Technologies proceedings concerned the IRS’s motion for partial summary judgment and the legal effect of contract terms, including Indiana law. They should not be described as a blanket ruling that customer remedies or milestone payments establish eligibility. A procedural ruling on funding also does not resolve every other element of a research-credit claim.

Retention of Substantial Rights

Substantial rights need not be exclusive, but incidental experience gained from performing work is not enough. Contracts that restrict later use or transfer all meaningful rights can defeat eligibility. Contract silence requires analysis of governing law and the whole arrangement, rather than an assumption that rights remain with the researcher.

The 2026 Smith outcome demonstrates why payment risk and retained rights must be evaluated separately. Favorable treatment on one issue does not settle the other. Taxpayers should retain complete agreements, amendments, acceptance provisions, payment records, and relevant intellectual-property terms.

IRS Information Requirements for Research Credit Refund Claims

The IRS introduced specific information requirements for research-credit refund claims filed from January 10, 2022, following FAA 20214101F. Those administrative requirements are separate from the merits of the credit and do not derive from Bealor or a Machise substantiation doctrine.

The Current Filing Checklist

The original requirements covered five items. Effective June 18, 2024, the IRS waived the upfront requirements to identify the individuals performing each activity and the information each individual sought to discover. The change was broader than merely permitting job titles instead of names. The remaining filing information is:

• The business components to which the refund claim relates.
• The research activities performed for each business component.
• Total qualified wage, supply, and contract research expenses for the claim year.

The waived employee-level information may still be requested during an examination. The IRS’s published transition period extends through January 10, 2027, during which taxpayers generally receive 45 days to perfect a deficient research-credit refund claim. Filing deadlines and the specific IRS notice remain important.

Validity Review and Substantive Examination

The IRS reviews refund claims for required information. A narrative that merely reproduces legal definitions may be insufficient. Passing that review does not establish that the research or expenses qualify, and an examination can require further evidence. Conversely, administrative screening should not be described as a universal system that rejects vaguely defined “weak” claims without regard to the applicable procedures.

Legislative Changes: TCJA and the 2025 Restoration of Domestic Expensing

Research expenditure deductions and the Section 41 credit are related but separate benefits. A deductible research expenditure is not automatically a qualified research expense for the credit. Section 280C coordinates the benefits to limit double tax benefits.

The TCJA Amortization Rules for 2022–2024

Before the TCJA capitalization requirement took effect, Section 174 generally permitted an election to deduct qualifying research or experimental costs currently. For taxable years beginning after December 31, 2021, the TCJA required capitalization and amortization over five years for domestic expenditures and fifteen years for foreign expenditures, beginning at the midpoint of the year.

For a full twelve-month year, the five-year midpoint convention generally produced a first-year deduction equal to 10% of domestic costs. This delayed deductions and could increase current taxable income.

Domestic Expensing Under Section 174A

Public Law 119-21, enacted July 4, 2025, added Section 174A and generally restored current deductions for domestic research or experimental expenditures in taxable years beginning after December 31, 2024. An election permits capitalization and amortization over at least 60 months. Foreign research expenditures generally remain subject to fifteen-year amortization under Section 174.

The legislation also provided elections concerning unamortized domestic costs from 2022–2024 and retroactive treatment for qualifying small businesses. Revenue Procedure 2025-28 sets out implementation procedures. The general deadline for the small-business retroactive election was July 6, 2026, with an earlier refund-limitations deadline potentially controlling. As of September 2026, it should not be described as an unrestricted opportunity still available to every eligible business.

Form 6765 Business-Component Information

Under the December 2025 Form 6765 instructions, Section G is optional for tax years beginning before 2026 and generally required for years beginning after 2025, subject to exceptions and completion guidelines. Exceptions include certain qualified small businesses claiming the payroll-tax credit and certain original-return filers within the specified qualified-expense and gross-receipts limits. Refund-claim requirements must be considered separately. These form changes are IRS administrative requirements, not a universal sampling-plan mandate enacted by the 2025 legislation.