The federal research and development tax credit under Internal Revenue Code Section 41 requires both qualifying research activities and qualifying expenses connected with the taxpayer’s business. Malmstedt v. Commissioner, 578 F.2d 520 (4th Cir. 1978), helps explain the distinction between expanding an existing business and investigating a new one. It was a real estate expense case, however, and did not decide eligibility for the research credit. This study considers its limited relevance alongside the statutory startup exception, research-expense rules, and later decisions addressing experimentation and funded research.
The Malmstedt Precedent: Defining the Boundaries of Business Expansion
Malmstedt concerned a real estate development partnership operating during 1958–1964. Its activities included residential development in Montgomery County, Maryland, and the proposed development of a luxury hotel on the nearby Gold Mine property. The Fourth Circuit rejected the view that residential and commercial development necessarily constituted separate businesses.
Factual Foundations and Financial Structures
The partnership acquired Gold Mine in November 1959 for $1 million, less a $30,000 commission. Financing involved a $375,000 first lien and a $750,000 second-lien note. The partners pursued rezoning, utilities, architectural plans, prospective hotel operators, and financing. The project ultimately failed and the property was foreclosed upon.
The appeal addressed the treatment of particular expenses, including interest, taxes, and a refinancing fee. It did not establish that every acquisition or development expenditure was immediately deductible. The court treated interest and taxes as business expenses in the circumstances before it, while explaining that the refinancing fee was amortizable over the loan’s life, with the remaining amount deductible upon the relevant foreclosure disposition.
The Fourth Circuit’s Business Expansion Analysis
The court applied earlier authority, including York v. Commissioner, to conclude that the hotel venture was a reasonable expansion within the partnership’s real estate development business. The relationship between the activities mattered more than differences in project size or the venture’s eventual failure.
This reasoning can inform a business-continuity analysis, but it neither overrides capitalization rules nor substitutes for Section 41’s independent requirements. Malmstedt predates the federal research credit and should not be described as a research-credit decision or as the origin of every business-expansion principle.
The Statutory Interplay: Sections 162, 174, 174A, and 195
Business status, deduction timing, and research-credit eligibility are separate questions. Historical decisions must be read under the law applicable to their tax years. In particular, the 2025 enactment of Section 174A changed the treatment of domestic research expenditures for tax years beginning after December 31, 2024.
Comparing Business Activity Standards
| IRC Section | Standard for Eligibility | Judicial Interpretation | Impact on R&D |
|---|---|---|---|
| Section 162 | Ordinary and necessary expenses incurred in carrying on a trade or business. | Business commencement and continuity depend on the facts; actual revenue is not a universal prerequisite. | Informs the general business standard, subject to research-specific provisions and capitalization rules. |
| Section 174 | Research expenditures connected with a trade or business; treatment depends on the tax year and research location. | Snow v. Commissioner, 416 U.S. 500 (1974), interpreted the historical provision to permit qualifying pre-operational research deductions. | For 2022–2024 tax years, the general rules required five-year domestic and fifteen-year foreign amortization, subject to later transition relief. Current Section 174 governs foreign research with fifteen-year amortization. |
| Section 174A | Domestic research or experimental expenditures connected with the taxpayer’s business. | A statutory deduction provision enacted in 2025; older cases did not interpret this section. | Generally permits current domestic research deductions for tax years beginning after 2024, with an elective amortization alternative and transition provisions. |
| Section 41 | Qualified research expenses incurred in carrying on a business, subject to specific exceptions. | Section 41(b)(4) expressly relaxes the business requirement for qualifying in-house research directed toward an active future business. | Pre-revenue status alone does not disqualify a startup. The four-part test, expense definitions, and exclusions still apply. |
| Section 195 | Qualifying expenditures to investigate or create an active business, or specified pre-opening activities. | Separates qualifying startup expenditures from ordinary operating expenses and costs governed by other provisions. | Provides a limited initial deduction and amortization once business begins; amounts deductible under the research provisions are excluded from its startup-cost definition. |
Malmstedt supplies an analogy for determining whether activities remain within an existing business. It is not a mechanism for bypassing Section 41 and is not the only route by which a startup or an expanding company can establish eligibility.
The Evolution of Section 195 and Startup Costs
Congress enacted Section 195 in 1980. Under its current rules, a taxpayer can generally deduct up to $5,000 of qualifying startup costs, reduced dollar for dollar when total startup costs exceed $50,000, and amortize the remainder over 180 months beginning with the month the active business starts. Applicable elections and regulations must also be considered.
Section 195 does not turn all early research into nondeductible startup costs. Its definition excludes amounts for which deductions are allowable under specified provisions, including Sections 174 and 174A under current law. Expenditures to acquire capital assets may also fall outside Section 195. Expansion costs therefore require classification by their actual character rather than a blanket deduction rule.
Implications for Modern R&D Tax Credit Applications
A sound eligibility analysis identifies the taxpayer, the research activities, the intended business use, and the applicable tax year before calculating the credit. Business continuity is relevant, but it is only one part of the inquiry.
Startup Eligibility
Section 41(b)(4) treats the business requirement as satisfied for in-house research expenses when the taxpayer’s principal purpose in incurring them is to use the results in the active conduct of a future business of the taxpayer or a person aggregated with it under Section 41(f)(1). This exception must not be generalized to every contract research expense.
Consequently, both an established software company and a pre-revenue startup developing a new platform may have qualifying expenses. Neither qualifies automatically: the activity, costs, purpose, and exclusions must be tested. Credit entitlement is also distinct from immediate utilization; eligible small businesses may elect the payroll-tax application under Section 41(h), subject to its separate conditions.
The Entity-Level Analysis
Entity identity matters, but a categorical rule requiring every subsidiary to be examined in isolation would be misleading. Section 41(f)(1) contains controlled-group and common-control aggregation rules, while partnership rules generally focus on the partnership’s business and include specified exceptions. An owner’s business experience alone does not establish a new entity’s eligibility.
Before restructuring research operations, examine which entity incurs the costs, who employs the researchers, who will use the results, and whether aggregation or partnership provisions apply. Incorporating a research subsidiary does not automatically create or destroy credit eligibility.
The 2024 Judicial Landscape: Business Status and Experimentation
Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, issued December 23, 2024, illustrates the importance of proving research activity. It applied existing statutory and regulatory requirements; it did not enact a new post-2024 documentation regime.
Analysis of Phoenix Design Group, Inc. v. Commissioner
Phoenix Design Group provided mechanical, electrical, plumbing, and fire-protection engineering services. Its credit study covered projects undertaken during 2013–2016, and disputed credit utilization extended into 2015–2019. The litigation examined three selected projects. The court found no qualified research in those projects; the parties’ arrangement did not make their substantive outcomes automatically binding on every remaining project.
| Project Name | Claimed Technical Challenge | Judicial Finding | Reason for Disallowance |
|---|---|---|---|
| Gerald Champion Military Psychiatric Unit | Design and integration of building engineering systems. | No qualified research established for the trial project. | The evidence did not establish qualifying uncertainty and investigative research sufficient to satisfy the applicable tests. |
| Baptist Memorial Health North Mississippi Oxford | Engineering systems for a hospital project. | No qualified research established for the trial project. | Design complexity and the completed solution did not demonstrate the required research activity. |
| Vanderbilt University Engineering and Science Building | Engineering systems for a university facility. | No qualified research established for the trial project. | The evidence did not substantiate the necessary uncertainty-resolution and experimentation requirements. |
The Substantially All Rule and Documentation
Treasury Regulation Section 1.41-4(a)(6) generally requires at least 80% of the relevant research activities, measured using cost or another consistently applied reasonable basis, to constitute elements of a process of experimentation for a qualified purpose. This is an activities test, not a test of how much of the finished product is new. The remaining activities must satisfy the conditions stated in the regulation.
Engineering complexity, compliance with building codes, and ordinary design revisions do not independently establish qualified research. Conversely, using established scientific principles or engineering tools does not automatically disqualify an activity. The question is whether the taxpayer actually faced the specified uncertainty and undertook a qualifying evaluation process. Customer adaptation is a separate statutory exclusion requiring its own analysis.
Quantifying the Financial Consequences
The following table preserves the disputed credit-utilization and penalty figures. Its last column is an arithmetic sum of those two figures, rather than a statement of a final adjudicated liability. The 2016 penalty shown is not 20% of the credit-utilization figure, so a credit amount must not be assumed to equal the relevant penalty base. Interest and other adjustments are not included.
| Tax Year | R&D Credit Utilized | Accuracy Penalty (20%) | Total Tax Exposure |
|---|---|---|---|
| 2015 | $55,504 | $11,101 | $66,605 |
| 2016 | $47,811 | $9,021 | $56,832 |
| 2017 | $219,177 | $43,835 | $263,012 |
| 2018 | $68,147 | $13,629 | $81,776 |
| 2019 | $71,102 | $14,220 | $85,322 |
| Total | $461,741 | $91,806 | $553,547 |
The penalty outcome in Phoenix also reflected the parties’ stipulation concerning the trial projects. It should not be treated as a universal finding that an unsuccessful research claim automatically attracts a penalty.
The Process of Experimentation: Judicial Standards and Technical Uncertainty
Treasury Regulation Section 1.41-4(a)(5) describes a process for evaluating alternatives when the capability, method, or appropriate design is uncertain at the outset. The process must fundamentally rely on physical or biological science, engineering, or computer science and address a qualifying improvement in function, performance, reliability, or quality.
Identifying Technical Uncertainty
Records should explain what information was available when the work began, what remained uncertain, and why further evaluation was necessary. General statements that a project was difficult or innovative are insufficient by themselves. An eventual successful design does not establish how uncertainty was resolved.
The Evaluate-Redesign Cycle
Modeling, simulation, and systematic trial and error can constitute experimentation. Useful evidence connects the uncertainty with alternatives, evaluations, results, and ensuing decisions. The law does not require every project to follow an identical laboratory format, and research need not succeed to qualify.
In Little Sandy Coal Co. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), the Seventh Circuit affirmed denial of shipbuilding research credits because the taxpayer failed to substantiate the required activity breakdown. It rejected unsupported shortcuts based on the novelty of vessels or broad employee percentages. The decision supports reliable activity allocation, rather than an absolute prohibition on all estimates.
The Role of Direct Support and Supervision
Little Sandy Coal rejected the categorical exclusion of certain supporting activities, including qualifying pilot-model production, from the experimentation numerator. Such activities may count when they satisfy the relevant research and experimentation requirements. The decision does not make every managerial or support activity experimental. Wage qualification under Section 41(b) and the activities test under Section 41(d) must be analyzed separately.
Funded Research and Retention of Rights: Evolving Case Law
Section 41(d)(4)(H) excludes research to the extent funded by another person. Under Treasury Regulation Section 1.41-4A(d), incorporated into the later research regulations, contract analysis considers both payment contingency and substantial rights in the research. Customer-funded work is not automatically wholly disqualified: where substantial rights remain, qualifying costs exceeding funding may warrant separate consideration.
Success Contingency and Financial Risk
In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, an order served January 3, 2025, denied the IRS’s motion for partial summary judgment on funded research. The court’s analysis involved Indiana law and remedies that could require repayment when the contractual remedy was inadequate. This was a ruling on a particular motion, not a general award of all claimed credits.
A warranty, fixed fee, acceptance clause, or milestone schedule does not by itself establish that payment is contingent on research success. Review the complete agreement, the actual performance obligations, available remedies, and applicable law. The possibility of losing profit is not necessarily the relevant economic risk.
Substantial Rights in Architectural and Engineering Design
The earlier summary-judgment proceedings in Smith v. Commissioner did not conclusively establish credit entitlement. The subsequent merits decision, T.C. Memo. 2026-50, issued June 16, 2026, examined six architectural projects. The court found substantial rights retained for four projects and absent for two. It found that the relevant payments were not contingent on research success. For the four projects with retained rights, potential qualifying expenses were limited to amounts exceeding the applicable funding, subject to proof.
Contracts transferring copyright, restricting reuse, or requiring client approval can materially affect the rights analysis. General institutional knowledge is not a universal substitute for legally retained rights to use research results. Each agreement requires its own assessment.
The Future of R&D Tax Credit Applications: Compliance and Technology
Digital project records and accounting systems can help connect qualifying activities with costs. They support the evidence-gathering process but cannot determine legal eligibility simply by labeling work as research.
Refund-Claim Review
The IRS reviews research-credit refund claims for sufficient information before examining their merits. Describing this as a new automated system designed specifically to deny claims would overstate the published guidance. No submission is guaranteed to withstand scrutiny.
Under the IRS guidance effective June 18, 2024, the filing information includes identification of the business components, the research activities for each component, and total qualified wage, supply, and contract research expenses. Names of individual researchers and the information each sought to discover are no longer required with the initial claim under that waiver, although the IRS may request them during examination. Applicable Form 6765 instructions and filing-year requirements must also be checked.
The Shrinking-Back Rule in Practice
Treasury Regulation Section 1.41-4(b)(2) applies the qualification tests first at the business-component level. If they are not satisfied, the analysis proceeds to the most significant subset of elements and continues as required. This rule does not cure a lack of evidence or permit taxpayers to select arbitrary project fragments. Records must support the qualifying subset and its activities.
Practical Improvements for Technical Taxpayers
The following comparison distinguishes weak approaches from stronger practices. The column headed “New Standard (Post-2024)” describes practical improvements, not newly enacted universal legal requirements.
| Compliance Element | Old Strategy | New Standard (Post-2024) |
|---|---|---|
| Documentation Timing | Reconstruct the entire claim only after an examination begins. | Retain records as work proceeds; corroborate later explanations with reliable evidence. |
| Evidence Type | Rely solely on generalized narratives or job titles. | Connect testimony with design versions, test data, correspondence, and accounting records. |
| Business Scope | Assume every activity within a whole project qualifies. | Apply the tests by business component and use shrinking back where appropriate. |
| Business Status | Assume existing revenue or an expansion label proves eligibility. | Analyze the actual business connection, statutory startup exception, and aggregation rules. |
| Financial Structure | Assume standard service terms or fixed pricing establish eligibility. | Review payment contingency, retained rights, funding amounts, and relevant contract law. |
Connecting Legal Requirements with Technical Evidence
The cases demonstrate that substantive qualification and substantiation must work together. The credit has not become merely an award for documentation: excellent records cannot transform excluded activities into qualified research, while qualifying activity still requires adequate supporting evidence.
Professional Judgment and Experimentation
Professional expertise can explain technical decisions and support credible testimony. It does not independently prove experimentation. Engineering and software businesses should distinguish routine implementation from activities that evaluate alternatives to resolve the uncertainty specified in the regulations.
Documentation and Penalty Exposure
Section 6662 can impose a 20% accuracy-related penalty on an applicable underpayment, subject to statutory conditions and defenses. Section 6664(c) provides a reasonable-cause and good-faith exception. Reliance on advice requires consideration of the adviser’s competence,
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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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