Oatman v. Commissioner and the Trade or Business Requirement

Oatman v. Commissioner, T.C. Memo. 2017-17, concerned individual income-tax deductions, including employee expenses and charitable contributions. Its recognition that performing services as an employee can constitute a trade or business was not a holding that employee research automatically qualifies under Section 41. Oatman should not be presented as a foundational R&D credit case.

The statutory basis for an employer’s qualifying wage expenses is Section 41(b). Eligibility depends on the taxpayer’s business, the research performed, the employee’s services, and the applicable expense rules. Closely held companies and businesses employing their owners must satisfy those requirements; an employee’s separate trade-or-business status does not establish the employer’s credit.

Charitable acknowledgment and appraisal requirements arise under Section 170. They do not become research-credit requirements merely because both types of tax benefit require substantiation. Lim v. Commissioner, T.C. Memo. 2023-11, concerned charitable contributions and appraisal defects, rather than the Section 41 experimentation test. These cases offer only a general reminder to apply the documentation rules governing the particular tax benefit.

Evolution of the Trade or Business and Substantiation Standard

Little Sandy Coal and the Substantially All Requirement

Little Sandy Coal involved claimed expenses for 11 first-in-class vessels. The Seventh Circuit affirmed the credit’s disallowance in 2023, although it disagreed with aspects of the Tax Court’s reasoning. The evidence did not support a principled allocation of employee activities to experimentation. Building a novel vessel or labeling it a prototype was insufficient.

The Substantially All Fraction and the Inclusion of Supervision

The court rejected categorical exclusion of pilot-model production costs from the numerator. Direct support, supervision, and production work require analysis of the underlying activities; their inclusion is not automatic. The decision did not change the 80% threshold or establish that all retrospective estimates are invalid.

Comparison of the Substantially All Fraction

The Technical Mechanics of the Four-Part Test

Section 41(d) applies the research requirements separately to each business component. Satisfying one requirement does not establish the others, and statutory exclusions must also be considered.

The Research Expenditure Test

For tax years beginning after 2024, Section 41(d)(1)(A) refers to expenditures treated as domestic research or experimental expenditures under Section 174A. Earlier years require the applicable historical law, including the former Section 174 framework. Technical uncertainty concerns capability, method, or appropriate design; commercial risk alone is insufficient.

The Technological Information Test

The work must rely on physical or biological sciences, engineering, or computer science. It need not advance knowledge throughout the industry. However, information being unfamiliar to a taxpayer does not by itself make an activity qualified research.

The Business Component Test

The information must be intended for a new or improved product, process, software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s business. The permitted purposes concern function, performance, reliability, or quality.

The Process of Experimentation Test

At least 80% of the relevant research activities must constitute elements of experimentation, measured by cost or another consistently applied reasonable basis. The process evaluates alternatives to resolve technical uncertainty and can involve modeling, simulation, or systematic trial and error. Routine checks and a finished design alone do not demonstrate that process.

The Shrink-Back Rule

Treasury Regulation Section 1.41-4(b)(2) starts the analysis with the discrete business component. If it fails, the requirements apply to the most significant subset of its elements, continuing until a subset qualifies or the most basic element fails. This is not permission to select disconnected favorable tasks or count the same expense more than once.

A practical documentation approach is to identify major systems and the work performed within them. For example, an aircraft development file might distinguish avionics from wing structures. The percentages below are illustrative assumptions, not findings from Oatman or Little Sandy Coal. Passing the percentage test alone does not establish a credit.

Application of the Shrink-Back Rule in a Hypothetical Engineering Project

Funded Research and the Allocation of Financial Risk

Section 41(d)(4)(H) excludes research to the extent funded by another person. Under Treasury Regulation Section 1.41-4A(d), substantial rights and payment terms matter. Research is fully funded if the performer retains no substantial rights. Where rights are retained, noncontingent funding generally reduces otherwise qualified expenses; qualifying excess expenses may remain. Payments contingent on research success are not treated as funding.

In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, the Tax Court denied the IRS’s motion for partial summary judgment in January 2025. Its analysis considered Indiana law incorporated into the purchase orders, including remedies for failure to deliver conforming products. The order addressed the funding argument; it was not a final determination that all claimed expenses qualified.

Smith v. Commissioner also requires attention to procedural history. The January 2025 ruling denied summary judgment rather than finally awarding the claimed credits. The subsequent opinion, T.C. Memo. 2026-50, filed June 16, 2026, found that payments under the six sample contracts were not contingent on research success. The firm retained substantial rights under four contracts, permitting potential partial credits under the funding regulations. The precise amounts, if any, remained unresolved. The court also found the partners’ total claimed 2008 compensation reasonable under the applicable Section 174 standard.

Distinguishing Funded vs. Unfunded Research under Modern Rulings

The column labels describe funding outcomes only. An unfunded activity must still satisfy every other credit requirement.

For a contract review, collect the complete agreement, purchase orders, incorporated terms, amendments, acceptance provisions, and relevant intellectual-property clauses. The label “fixed price” or “time and materials” is not a substitute for examining enforceable rights and the facts.

Employee Roles and Executive Supervision

Section 41(b)(2)(B) covers engaging in qualified research and directly supervising or supporting it. Treasury Regulation Section 1.41-2 distinguishes immediate supervision from higher-level management and direct support from general administrative services. A job title or senior position does not establish qualifying services.

In Moore v. Commissioner, T.C. Memo. 2023-20, affirmed by the Seventh Circuit in 2024, the evidence did not establish the claimed qualifying portion of the president and chief operating officer’s work. The appellate decision emphasized that substantial involvement in product development did not adequately demonstrate qualified research expenses.

An executive may personally conduct qualified research, directly supervise it, or perform nonqualifying management duties during the same year. Separate those activities and substantiate the allocation. Useful evidence may include technical review notes, test decisions, project calendars, and explanations of who supervised the research team. These examples are documentation practices, not a mandatory list of forms.

The Cohan Rule and Evidence-Based Estimation

The Cohan rule permits estimation in appropriate circumstances when the evidence establishes an expense but its precise amount is uncertain. It does not prove that research met Section 41’s substantive requirements.

United States v. McFerrin, 570 F.3d 672 (5th Cir. 2009), recognized estimation of qualifying expenses supported by testimony and other evidence. It is therefore misleading to state that courts universally prohibit estimates or retrospective research-credit studies. The reliability of the evidence, the applicable legal standard, and the jurisdiction matter.

A defensible study explains how estimates were developed and reconciles them with available records. Unsupported percentages based only on job descriptions or general recollection remain vulnerable. Contemporaneous evidence can strengthen an analysis, but a particular timekeeping system is not a universal statutory prerequisite.

Administrative Review and Research Credit Refund Claims

IRS claim-validity review should be distinguished from an examination of substantive eligibility. The source’s description of a new automated “Classifier system” is not established by the cited rules. IRS procedures do provide for classification and review of claims.

The IRS’s research-credit refund-claim FAQs require identification of business components, research activities for each component, and total qualified employee wage, supply, and contract research expenses. Effective June 18, 2024, the IRS waived submission of individual researchers’ names and the information each sought to discover with the refund claim. Those details may still be requested during an examination. The transition period allowing 45 days to perfect an eligible deficient claim extends through January 10, 2027.

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. Exceptions include qualifying small businesses making the specified payroll-credit election and original-return filers meeting both the $1.5 million QRE and $50 million average-gross-receipts limits, applying the instructions’ rules. Required filers generally provide detail for components covering at least 80% of QREs, capped at 50 components, and aggregate the remainder. This disclosure threshold differs from the experimentation test.

Key Documentation Requirements for Modern R&D Refund Claims

The TCJA, Section 174 Amortization, and Section 174A

The Tax Cuts and Jobs Act generally required capitalization of research expenditures for tax years beginning in 2022 through 2024, with five-year amortization for domestic research and fifteen-year amortization for foreign research, using the midpoint convention.

Public Law 119-21, enacted July 4, 2025, added Section 174A. For tax years beginning after 2024, domestic research or experimental expenditures generally may be deducted currently, with an elective capitalization alternative. Foreign research remains subject to fifteen-year amortization under Section 174. Transition rules address remaining domestic balances, and eligible small businesses received a retroactive-election option subject to procedural requirements and deadlines.

Deduction treatment and credit qualification remain separate analyses. An expenditure within the domestic research deduction rules is not automatically a Section 41 qualified expense. Coordinate the deduction and credit under the applicable Section 280C rules, and apply the law for the tax year concerned rather than assuming that the historical five-year domestic rule still governs every year.

Implications for Future R&D Applications

A useful research-credit study connects the business component, technical uncertainty, alte