Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, illustrates the evidence needed to establish qualified research under Internal Revenue Code Section 41 in an engineering practice. Decided on December 23, 2024, the case concerned mechanical, electrical, plumbing, and fire protection (MEPF) design. It applied existing statutory and regulatory requirements; it did not establish a new rule excluding professional engineering or incremental improvements from the research credit.
The engineering dispute is Phoenix Design Group, not Pestcoe. Pestcoe v. Commissioner, 40 T.C. 195 (1963), is a separate case concerning the timeliness of an S corporation election. This study addresses the Phoenix Design Group engineering activities discussed in the source document.
The Statutory Architecture of the Research Credit and the Four-Part Test
Section 41 provides a credit for qualifying research expenditures, subject to detailed eligibility and computational requirements. The PATH Act of 2015 made the credit permanent. Eligibility depends on the actual activities and expenses, rather than an industry label or the sophistication of a finished design.
The four-part test applies separately to each business component. Where an overall component fails, the shrinking-back rule may permit consideration of a qualifying subset. Wages, supplies, computer-use costs, and contract research expenditures are subject to their own statutory limitations; passing the activity tests does not make every project expenditure eligible.
The Four Pillars of Section 41 Qualification
| Test Component | Legal Basis | Technical Threshold |
|---|---|---|
| Research expenditure test | IRC Section 41(d)(1)(A); historical Section 174 and Treasury Regulation Section 1.174-2 | For the years addressed in Phoenix Design Group, the expenditures had to satisfy the applicable Section 174 requirements, including activities directed at eliminating uncertainty about capability, method, or appropriate design. Current Section 41 refers to domestic research or experimental expenditures under Section 174A. |
| Technological Information Test | IRC Section 41(d)(1)(B); Treasury Regulation Section 1.41-4(a)(4) | The process must fundamentally rely on physical or biological science, engineering, or computer science. A discovery need not advance knowledge throughout the taxpayer’s industry. |
| Permitted Purpose Test | IRC Sections 41(d)(1)(B)(ii) and 41(d)(3) | The information must be intended to help develop a new or improved business component, with experimentation relating to function, performance, reliability, or quality. |
| Process of Experimentation Test | IRC Section 41(d)(1)(C); Treasury Regulation Section 1.41-4(a)(5) and (6) | At least 80% of the relevant research activities, measured on a cost or other consistently applied reasonable basis, must constitute elements of a qualifying process of experimentation. |
The historical law governing the disputed years must be distinguished from later statutory changes. Phoenix Design Group principally examined whether the taxpayer established qualifying uncertainty and the activities undertaken to resolve it.
Phoenix Design Group: Factual Background and the Engineering Context
Phoenix Design Group was a multidisciplinary engineering consulting firm whose projects included hospitals and university facilities. It described a six-stage workflow: basis of design, schematic design, design development, construction documents, bidding, and construction administration.
The research years were 2013 through 2016. Credits from those years affected the firm’s 2015 through 2019 tax liabilities. Describing 2015 through 2019 as the years in which all the underlying research occurred confuses the research years with the credit-use years. The claimed research expenditures were employee wages.
The Procedural Significance of Discovery and Sampling
The dispute involved more than 200 projects. The parties agreed to a nonbinding trial sample of three projects. The December 2024 opinion determined that none of those projects involved qualified research and addressed penalties under the parties’ stipulations. It expressly did not determine the ultimate deficiency amounts. The opinion should not be described as an automatic extrapolation of the trial results to every project.
A taxpayer’s internal sampling approach and the scope of evidence agreed for trial are different matters. Sampling does not remove the need to substantiate the underlying activities, and a selected project does not establish the eligibility of unrelated work merely because the same firm performed it.
| Trial Project Name | Nature of Facility | Engineering Complexity |
|---|---|---|
| Gerald Champion Military Psychiatry Unit | Healthcare expansion | Design and integration of MEPF systems with existing hospital infrastructure. |
| Baptist Memorial Health North Mississippi, Oxford | Hospital | MEPF systems serving departments with differing requirements, including surgical facilities. |
| Vanderbilt University Engineering and Science Building | University engineering and laboratory facility | Building systems with laboratory, ventilation, electrical, and utility requirements. |
These descriptions establish the engineering context, not credit eligibility. The decisive question was what the engineers actually did to investigate uncertainty and evaluate alternatives.
The Section 174 Test: Establishing Technological Uncertainty
For the historical years, uncertainty existed when information available to the taxpayer did not establish the capability or method for developing or improving the product, or its appropriate design. Project complexity, incomplete client instructions, and the possibility of later design changes do not independently establish qualifying uncertainty.
The Available Information Standard
The analysis focuses on the information available to the taxpayer and the investigation undertaken. It does not require information to be unavailable to every professional in the industry. Existing engineering principles can underpin qualified research when they are used in a qualifying investigation.
In the trial projects, the court found that general statements about design uncertainty did not adequately explain what technical information was missing or how the engineers investigated it. Some decisions were resolved through available information, ordinary calculations, or later choices by the client or architect. Emails and meetings can support a claim when their contents explain relevant investigative work; their existence alone proves little.
The Process of Experimentation: Evidence of Evaluating Alternatives
A qualifying process evaluates alternatives to resolve uncertainty about capability, method, or appropriate design. Modeling, simulation, and systematic trial and error can form part of that process. Neither a successful outcome nor the use of sophisticated software establishes experimentation by itself.
The Failure of the Six-Stage Design Narrative
The court did not accept a general description of the firm’s design workflow as proof that the engineers performed qualifying experimentation. Inconsistencies between time entries and the claimed stages further weakened that account. The taxpayer needed to explain the activities that connected a technical problem to its eventual solution.
References to the scientific method in the decision do not create a universal requirement for laboratory work or a document formally labeled a hypothesis. Records should identify the uncertainty, alternatives, evaluation, and results in terms that accurately describe the work.
The 80% Threshold and the Substantially All Rule
The relevant percentage concerns research activities for the business component, measured using costs or another consistently applied reasonable basis. It is not automatically experimental hours divided by all hours billed to a construction project. A defensible calculation must identify the correct component, research activities, numerator, denominator, and measurement method.
Failure to meet the test at the overall component level may require shrinking back to an appropriate subset. The decision does not supply a general numerical ratio showing that a particular percentage of PDG’s work was routine. Its central problem was insufficient evidence to establish the qualifying activities and their extent.
Comparative Jurisprudence: Suder, Siemer Milling, and Little Sandy Coal
Other research-credit cases reinforce the importance of specific evidence. They do not establish a simple progression from a lenient standard to a newly enacted scientific-method standard. Outcomes depend on the facts, the expenditure calculations, and the evidence supporting each requirement.
| Case Name | Year | Primary Reason for Disallowance | Impact on A&E Industry |
|---|---|---|---|
| Suder v. Commissioner | 2014 | Mixed result: research activity largely qualified, but compensation-related limitations reduced eligible wage expenses. | Incremental improvements can qualify when the statutory tests and eligible costs are established. |
| Siemer Milling Co. v. Commissioner | 2019 | The taxpayer failed to establish a qualifying process of experimentation for the claimed projects. | Technical descriptions must explain the evaluation process, rather than merely state objectives or outcomes. |
| Little Sandy Coal Co. v. Commissioner | 2021; affirmed in 2023 | Failure to substantiate the substantially-all experimentation requirement. | Developing a novel product or prototype does not make all associated work experimental. |
| Phoenix Design Group, Inc. v. Commissioner | 2024 | Failure to establish qualified research in the three trial projects at the relevant component and subset levels. | Engineering claims require evidence of specific uncertainty and investigative or experimental activities. |
The table’s disallowance column should be read with its qualifications: Suder was not a complete taxpayer loss, and the cases do not categorically exclude architecture or engineering.
Documentation and IRS Examinations
Documentation should connect technical activities to the business component and claimed expenses. Contemporaneous records are especially useful, but the regulations do not prescribe a single mandatory project-log format. Credible testimony and other evidence can matter; retrospective evidence is not automatically inadmissible or legally worthless.
Form 6765 and Business Component Information
Under the December 2025 Form 6765 instructions, Section G is optional for tax years beginning before 2026 and required for tax years beginning after 2025, subject to exceptions and the instructions’ scope rules. Amended refund claims have additional requirements. Taxpayers should use the instructions applicable to the filing year.
There is no substantiated basis here for claiming that an automated IRS classifier rejects credits merely because descriptions contain phrases such as electrical design. Accurate, specific descriptions are valuable because they explain the activities, not because substituting technical-sounding labels guarantees acceptance.
Implications for Future R&D Credit Applications in the USA
Architecture, construction, and engineering businesses should examine qualifying activities at the proper component level. A technically demanding project may contain both potentially qualifying investigation and substantial ordinary design, coordination, or implementation work.
The Shrink-Back Rule
The court did apply shrinking back to individual engineering systems; it was not wholly unable to use the rule. Further analysis encountered inadequate evidence linking activities and expenses to identifiable subsets. A subset must relate to the elements of the business component, rather than merely a chosen employee, time category, or design phase.
Practically, firms should preserve the information needed to examine significant subsystems when the overall component fails. Isolating hours labeled experimental does not, by itself, establish an eligible component or satisfy all four tests.
Funded Research and the Risk-Rights Balance
The funded-research exclusion requires separate examination of the contract, economic risk, and rights retained in the research results. A fixed-price label or payment milestone does not automatically establish that research is unfunded. Relevant terms include whether payment depends on successful research and whether the taxpayer retains substantial rights.
Procedural decisions denying summary judgment, including those discussed in connection with Smith and System Technologies, should not be described as final determinations that all the taxpayers’ research qualified. In any event, satisfying the funding rules does not substitute for proving the four-part test. Phoenix Design Group’s trial-project analysis did not require the court to decide the statutory exclusions.
Technical Uncertainty and Professional Expertise
Expertise and qualifying uncertainty are not opposites. Experienced engineers can conduct qualified research, but a claim must explain the investigation rather than assume that every exercise of judgment is experimental. Conversely, an unfamiliar task is not automatically qualified research.
| Element | Professional Expertise (Non-Qualifying) | Technological Uncertainty (Qualifying) |
|---|---|---|
| Knowledge Base | Available information establishes the answer and is applied without qualifying investigation. | Available information does not establish capability, method, or appropriate design, prompting qualifying investigation. |
| Action | Routine calculations or selections without a qualifying evaluative process. | Evaluation of alternatives through a qualifying experimental process. |
| Communication | Ordinary coordination or transmission of completed design results. | Records explaining technical uncertainty and the evaluation undertaken to address it. |
| Result | Meeting professional standards alone does not establish eligibility. | Success or failure can accompany qualifying research; the activities and other statutory requirements control. |
The table headings describe illustrative circumstances, not categorical rules. Professional expertise may be used in qualified research, and technological uncertainty alone is insufficient without the remaining requirements.
Practical Recommendations for R&D Tax Credit Compliance
Documenting Uncertainty, Alternatives, and Evaluation
A useful technical record should identify the business component, the uncertainty, and the work performed to resolve it. Records should accurately reflect the project rather than impose an artificial scientific narrative after completion.
- Describe the technical question and what the available information did not establish.
- Identify alternatives considered and explain how they were evaluated.
- Retain relevant calculations, modeling, simulations, tests, and design changes, with explanations of their purpose.
- Record results and explain how they informed subsequent decisions.
- Connect employees, dates, activities, and eligible costs to the relevant component or subset.
Avoiding the Persistent Uncertainty Trap
Do not assume that uncertainty continues throughout construction simply because a design could change. Track when particular technical questions arise and are resolved. A later issue may require separate analysis at the affected subset level; it does not automatically make the whole design uncertain again.
Labor Allocation and the 80% Rule
Time records should distinguish activities sufficiently to support a reasonable allocation. For example, a project containing routine drafting and airflow modeling cannot be evaluated merely by assigning all modeling hours to research. The model’s purpose, the alternatives evaluated, and the relevant component must first be established. Separate tracking supports that analysis but does not guarantee qualification.
The Role of External Advisors and Penalties
A research-credit study should accurately connect technical facts with the tax requirements. Technical staff should review descriptions and allocations, and advisors should receive complete information about the work and relevant contracts.
In Phoenix Design Group, liability for accuracy-related penalties followed the parties’ stipulation once none of the trial projects qualified. The opinion should not be presented as a separate adjudication rejecting a professional-advice defense. More generally, disallowance does not automatically establish a penalty; the statutory grounds and any reasonable-cause and good-faith defense require their own analysis.
The Relationship Between Research Credits and R&D Deductions
The source’s statement that all domestic research costs must now be amortized over five years is outdated. For tax years beginning after December 31, 2024, Section 174A generally permits an immediate deduction for domestic research or experimental expenditures, with an alternative capitalization election. Foreign research expenditures generally remain subject to 15-year [{“@context”:”https://schema.org”,”@type”:”VideoObject”,”name”:”What is the R&D Tax Credit?”,”description”:”The research and experimentation tax credit, most frequently known as the R&D tax credit, is a dollar-for-dollar reduction of your tax liability.”,”thumbnailUrl”:[“https://i.ytimg.com/vi/mzGRiA_MUl4/sddefault.jpg”,”https://www.dropbox.com/s/n1iyfxaeo6rm5tg/Fed%20-%20US%20Flag.jpg?raw=1″],”uploadDate”:”2019-10-14T00:00:00+00:00″,”duration”:”PT3M54S”,”contentUrl”:”https://www.youtube.com/watch?v=mzGRiA_MUl4″,”embedUrl”:”https://www.youtube.com/embed/mzGRiA_MUl4″,”publisher”:{“@type”:”Organization”,”name”:”Swanson Reed”,”url”:”https://swansonreed.com”,”logo”:{“@type”:”ImageObject”,”url”:”https://swansonreed.com/logo.png”}},”transcript”:”the research and experimentation tax credit most frequently known as the r d tax credit is a dollar for dollar reduction of your tax liability it was established in 1981 as an incentive for companies to invent create and innovate 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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