The federal research and development (R&D) tax credit under Section 41 of the Internal Revenue Code requires businesses to substantiate both qualifying activities and eligible expenses. The engineering litigation discussed in this study is Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, decided December 23, 2024. The source’s attribution to Oliver v. Commissioner is incorrect. Phoenix Design Group (PDG) was treated as a C corporation during the credit years, not as a limited liability partnership owned by the Olivers.
The decision illustrates the importance of explaining what engineers actually did to resolve technical uncertainty. It does not establish a blanket exclusion for engineering or architectural services, create a new statutory test, or shift the ordinary burden of proving entitlement to the credit. Together with Little Sandy Coal Co. v. Commissioner and Betz v. Commissioner, it underscores the distinction between sophisticated professional work and activities that satisfy the research credit requirements.
The Statutory Architecture of Qualified Research
Section 41(d) establishes four requirements for qualified research. The rules apply separately to each business component, subject to the shrinking-back rule and statutory exclusions. A business component can include a product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s trade or business.
The Core Pillars of Section 41(d) Eligibility
| Pillar | Statutory Requirement | Regulatory Objective |
|---|---|---|
| Section 174 Test | For the years in PDG, expenditures had to be eligible for treatment under the then-applicable Section 174 rules. | Identify research and development in the experimental or laboratory sense, directed at eliminating uncertainty about development or improvement. |
| Technological Nature Test | The research must fundamentally rely on physical or biological sciences, engineering, or computer science. | Require a technological basis without demanding an advance beyond the knowledge of skilled professionals. |
| Business Component Test | The information must be intended to help develop a new or improved business component; the experimentation must concern function, performance, reliability, or quality. | Connect the research to a permitted business purpose rather than style, taste, cosmetic changes, or seasonal design factors. |
| Process of Experimentation Test | Substantially all research activities must constitute elements of a process of experimentation for a qualified purpose. | Require evaluation of alternatives to resolve uncertainty about capability, method, or appropriate design. |
The historical Section 174 language must be read in its tax-year context. Public Law 119-21 added Section 174A for domestic research expenditures in tax years beginning after December 31, 2024, and amended the Section 41 cross-reference accordingly. Section 174A generally permits a current deduction for domestic research expenditures, with an alternative capitalization election. Deduction eligibility alone does not establish entitlement to the narrower Section 41 credit.
Analysis of the Phoenix Design Group Litigation
PDG designed mechanical, electrical, plumbing, and fire protection (MEPF) systems. Its consultant narrowed a larger project population to 238 potential projects for a research credit study. The litigation concerned research from 2013 through 2016 and credits used in 2015 through 2019. The parties agreed to try a nonbinding sample of three projects. That trial sample should not be confused with the consultant’s study sample.
The court held that none of the three trial projects involved qualified research, either as a whole or at the smaller component levels considered. It also imposed accuracy-related penalties under the parties’ stipulations. The opinion expressly did not determine the amounts of the tax deficiencies for the credit years; describing it as a final determination of every project and the entire credit overstates its scope.
The Section 174 Test: Defining the Threshold of Uncertainty
Under Treasury Regulation Section 1.174-2(a)(1), uncertainty exists when the information available to the taxpayer does not establish the capability or method of developing or improving a product, or its appropriate design. This concerns the information available when the relevant development activity occurs. It does not require uncertainty to persist throughout a project or imply that an established engineering technique can never be used in qualified research.
PDG argued that designs remained uncertain because revisions could occur before construction was complete. The court found that this general assertion did not establish qualifying uncertainty. Evidence needed to identify the missing technical information and explain the investigative work used to obtain it. In the BHNM Oxford hospital project, for example, incomplete information about equipment did not by itself establish uncertainty throughout the MEPF systems.
The practical distinction is between a project awaiting specifications and development requiring technical investigation. Client choices, aesthetic preferences, and ordinary coordination can cause repeated design changes without demonstrating qualified research. Conversely, an engineering activity using familiar tools can qualify when the taxpayer establishes the required uncertainty and experimental evaluation.
The Process of Experimentation and Routine Design
Treasury Regulation Section 1.41-4(a)(5) describes a process for evaluating alternatives where capability, method, or appropriate design is uncertain. Modeling, simulation, and systematic trial and error can qualify. There is no universal requirement for a laboratory setting, a formal hypothesis document, or a particular experiment log. The evidence must nevertheless establish the evaluative process actually performed.
The substantially-all requirement means at least 80% of the relevant research activities, measured on cost or another consistently applied reasonable basis, must constitute elements of experimentation. It is an activities test, not a calculation of how much of a finished product is new.
Experimentation percentage = (research activities constituting elements of experimentation for a qualified purpose ÷ total relevant research activities) × 100.
The numerator and denominator must be defined under the applicable regulations. For the historical cases, the denominator concerns research activities whose expenses satisfy Section 174, subject to the Section 41 exclusions; it is not simply all project spending or already-qualified Section 41 expenses. Supply costs do not themselves represent activities in this fraction. This test is also distinct from the separate employee wage rule under Treasury Regulation Section 1.41-2(d)(2).
PDG relied on its six-stage design process to explain experimentation. Standard phases and iterative revisions, however, do not establish what alternatives employees evaluated or how they evaluated them. A useful technical account connects a specific uncertainty with the work performed, evidence generated, and resulting decision.
Comparative Jurisprudence: Phoenix Design Group, Little Sandy Coal, and Betz
These cases apply related statutory requirements to different facts. Their lessons should be distinguished from claims that novelty is required or that every unsuccessful claim establishes a new documentation mandate.
| Case Comparison | Primary Industry | Core Judicial Finding | Impact on Future Claims |
|---|---|---|---|
| Little Sandy Coal | Shipbuilding | The novelty of vessels did not establish that substantially all research activities were experimental. | Support the experimentation percentage with a principled account of actual activities. |
| Betz v. Commissioner | Industrial Engineering | Describing customized systems and design problems did not adequately establish qualifying uncertainty and investigative activities. | Explain the uncertainty and the work undertaken to resolve it, rather than relying on the finished design. |
| Phoenix Design Group v. Commissioner | MEPF Engineering | The three trial projects failed qualification at the whole-system and shrinking-back levels examined. | Connect evidence to specific activities and components; standard professional design phases are insufficient by themselves. |
In Little Sandy Coal, 62 F.4th 287 (7th Cir. 2023), the appellate court rejected a categorical exclusion of direct support and supervision from the experimentation numerator. Such activities can enter both the numerator and denominator when they satisfy the relevant research requirements. This does not make every supervisory or production activity experimental, and the taxpayer still failed to substantiate the required percentage.
Documentation Standards and the Limits of the Cohan Rule
The Cohan principle permits reasonable estimation in appropriate circumstances when an evidentiary foundation establishes that qualifying expenditures occurred. It does not remove the need to establish qualified research or provide a reasonable basis for allocating costs. Neither PDG nor the related cases abolished estimation as a general matter.
From Unsupported Estimates to Reliable Evidence
An R&D study should explain its allocation methods and tie them to reliable evidence. General employee recollections and unsupported departmental percentages can be insufficient. Contemporaneous records are particularly useful, but the research credit regulations do not universally prescribe a single record format or require a dedicated timesheet system.
Useful supporting materials include:
- Time records or other reliable evidence separating qualifying services from routine work.
- Project records identifying technical uncertainties, alternatives, methods, and iterations.
- Technical studies, calculations, simulation outputs, test results, and design revisions that explain what was learned.
- Payroll, supply, and contract records supporting the expenses claimed and their connection to qualifying activities.
The source’s citation to Oliver v. Commissioner, T.C. Memo. 2022-120, is incorrect: that memorandum citation belongs to Castro v. Commissioner. It should not be used as authority for an R&D-specific restriction on Cohan estimates.
IRS refund-claim requirements must also be distinguished from substantive eligibility. Effective June 18, 2024, the IRS waived the initial requirement to submit the names of the individuals performing each activity and the information each individual sought to discover. Claimants must still identify relevant business components and research activities and provide the required totals for qualified wages, supplies, and contract research expenses. The waived details may still be requested during examination. There is no established basis for attributing the 2021 guidance to the misidentified Oliver case.
The Shrinking-Back Rule: Testing Smaller Components
Treasury Regulation Section 1.41-4(b)(2) provides a sequential approach when a business component does not satisfy the qualified research requirements. The tests are applied to the most significant subset of elements and then to progressively smaller subsets until a qualifying subset is reached or the most basic element fails. Shrinking back does not automatically rescue a claim or disregard statutory exclusions.
For an MEPF project, a smaller system or subsystem may warrant analysis when the overall system fails. A hypothetical air-filtration subsystem could qualify if its development satisfies the applicable requirements and the associated expenses are substantiated. Its novelty alone would not be enough. Records should permit the reviewer to identify both the relevant subset and the activities carried out for it.
Funded Research and the Allocation of Economic Risk
Section 41(d)(4)(H) excludes research to the extent funded by another person. Treasury Regulations Sections 1.41-4(c)(9) and 1.41-4A(d) require analysis of all relevant agreements, retained substantial rights, and whether payments depend on successful research. Where substantial rights remain but payments constitute funding, the regulations can permit otherwise qualifying expenses exceeding applicable funding. Where no substantial rights remain, the research is treated as fully funded.
Comparative Determinants of Funded Research
| Factor | Funded (Non-Eligible) | Unfunded (Eligible) |
|---|---|---|
| Payment Contingency | Payments earned irrespective of research success generally constitute funding to their applicable extent. | Amounts genuinely contingent on research success are not treated as funding; milestone labels alone do not establish this. |
| Intellectual Property Rights | No retained substantial rights results in full funding treatment. | Retained substantial rights support potential eligibility, subject to the payment analysis and other credit requirements. |
| Contractual Remedies | Routine professional obligations or general remedies do not automatically establish that payment depends on research success. | Enforceable repayment or nonpayment provisions can support contingency when the agreements and governing law connect them to failed research. |
The table headings describe funding treatment only; avoiding this exclusion does not by itself establish an allowable credit.
The earlier summary-judgment ruling in Smith v. Commissioner was a procedural development, not a final award of credits. The subsequent June 16, 2026 opinion, T.C. Memo. 2026-50, found no substantial rights in two sample projects and treated the other four as partially funded. For those four, potential eligibility depended on otherwise qualifying expenses exceeding the applicable customer funding. Progress payments and completion of design phases did not establish payment contingent on successful research. This later ruling makes the source’s unqualified description of Smith as a taxpayer victory misleading.
In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, the January 3, 2025 order denied the IRS’s motion for partial summary judgment. The court considered Indiana law allowing customers to recover payments if the promised product was not delivered and concluded that the payments were contingent on success for the issue presented. That ruling did not establish satisfaction of every research credit requirement. Its contract-specific reasoning should not be generalized into a rule that any refund remedy makes research eligible.
The Meaning of Technological in Nature
Treasury Regulation Section 1.41-4(a)(3), reflecting Treasury Decision 9104, does not require research to exceed the knowledge of skilled professionals in the field. Engineering and architectural businesses should therefore avoid both extremes: assuming that ordinary professional competence guarantees qualification, or assuming that only a world-first invention can qualify.
The relevant question is whether the particular development activities satisfy all applicable requirements. Technical complexity, professional licensing, custom design, and use of scientific principles are relevant context but do not replace proof of uncertainty, experimentation, a permitted purpose, and eligible expenses.
Strategic Implications for Future R&D Tax Credit Claims
The practical lessons concern how a business explains its work and supports its expenses. A defensible study should allow a reviewer to follow the technical development from the available starting information through the evaluation of alternatives and the resolution of uncertainty.
Establishing a Robust Compliance Framework
- Identify technical uncertainty: Record what was unknown about capability, method, or design when the relevant activity began, and distinguish it from missing client preferences.
- Describe actual work: Explain the alternatives considered, the evaluations performed, and the results. Labels such as testing or simulation help only when they accurately describe supported activities.
- Connect the evidence: Link technical narratives to calculations, revisions, tests, communications, and financial records. Explain how later recollections are supported.
- Preserve component detail: Organize evidence so that smaller systems can be evaluated under the shrinking-back rule if the larger component fails.
- Review contracts: Examine payment obligations, retained rights, governing law, and remedies. Contract language must reflect enforceable commercial terms; adding tax terminology does not establish eligibility.
IRS Review of Research Credit Refund Claims
The IRS reviews research credit refund claims for required information and may examine their merits. Published guidance does not substantiate the source’s description of a new automated Classifier system that rejects claims based on their narratives. Administrative classification should not be characterized as an artificial-intelligence decision system without supporting evidence.
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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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