In Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, decided December 23, 2024, the United States Tax Court examined whether engineering design activities satisfied the research credit requirements of Internal Revenue Code Section 41. It held that none of the three trial projects qualified on the evidence presented and that the taxpayer was liable for accuracy-related penalties under the parties’ stipulation. The decision illustrates why technical complexity and professional expertise alone do not establish qualified research.
The scope of the holding matters: the parties tried a nonbinding sample of three projects. The opinion expressly states that its conclusions were not binding as to the remaining projects. It should therefore not be described as a binding judicial disallowance of every project in the claim or as a new statutory standard for engineering firms.
The Regulatory Framework of Section 41 and the Definition of Research
Section 41 requires qualifying activities to satisfy a four-part test, applied separately to each business component. A component may be a product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s trade or business. Separate expense, exclusion, and credit-computation requirements also apply.
For the years considered in Phoenix Design Group, the Section 174 test required research and experimental expenditures within the meaning of the law then in effect. The inquiry included whether information objectively available to the taxpayer left uncertainty concerning capability, method, or appropriate design, and whether the taxpayer undertook investigative activities intended to eliminate that uncertainty. The technological-in-nature requirement concerns reliance on physical or biological sciences, engineering, or computer science. The permitted-purpose requirement concerns improvement in function, performance, reliability, or quality.
The process-of-experimentation requirement calls for an evaluative process directed at resolving uncertainty, such as modeling, simulation, or systematic trial and error. At least 80% of the relevant research activities, measured on cost or another consistently applied reasonable basis, must constitute elements of that process for a qualified purpose. This is not a requirement that 80% of every employee’s total working time be experimental; the employee wage rule is a separate provision.
The opinion describes the Commissioner’s concessions as covering the technological information test and the business component test. The contested analysis centered on the Section 174 and process-of-experimentation tests, including whether particular activities served a permitted purpose. The concessions should not be expanded into a finding that every individual activity necessarily satisfied all other requirements.
| Component of the Four-Part Test | Statutory Reference | Requirement Description | PDG Outcome |
|---|---|---|---|
| Section 174 Test | IRC §§ 41(d)(1)(A) and 174, as applicable to the research years | Research and experimental activities directed at eliminating uncertainty about capability, method, or appropriate design. | Not established for the trial projects as a whole; narrower activities were also examined. |
| Technological in Nature | IRC § 41(d)(1)(B) | Reliance on physical or biological sciences, engineering, or computer science. | The Commissioner conceded the technological information test. |
| Process of Experimentation | IRC § 41(d)(1)(C) | At least 80% of relevant research activities must be elements of an evaluative process for a qualified purpose. | Not established for the relevant activities evaluated by the court. |
| Permitted Purpose | IRC § 41(d)(3) | New or improved function, performance, reliability, or quality; excludes style, taste, cosmetic, and seasonal factors. | The business component test was conceded; the court still considered permitted purpose when examining certain narrower activities. |
Procedural History and the Role of Sampling
Phoenix Design Group (PDG) was a Tennessee-based engineering firm specializing in mechanical, electrical, plumbing, and fire protection systems, particularly for hospitals and laboratories. It was treated as a C corporation during the 2015–2019 credit years. In 2017, it engaged alliantgroup to conduct a research credit study using project documentation for 2012–2016. The consultant identified 419 possible projects and reduced that group to 238 after excluding known nonqualifying and de minimis projects.
The claimed research credits related to 2013–2016 activities and were used in 2015–2019. The IRS examined the latter years and issued a notice of deficiency. The credits were attributable solely to employee wages. These research years, credit-use years, claimed credits, and determined deficiencies are distinct and should not be treated as interchangeable.
A discovery dispute preceded the merits trial. The taxpayer’s August 29, 2023 protective-order request was denied; selecting a limited set of trial projects did not automatically eliminate discovery obligations concerning the other claimed projects. More generally, taxpayers should distinguish an agreed trial sample from an agreement authorizing statistical extrapolation of its results.
The parties selected the Gerald Champion Military Psychiatric Unit, Baptist Memorial Health North Mississippi Oxford, and Vanderbilt University Engineering and Science Building projects. Trial concerned whether these projects involved qualified research, rather than the amounts of qualified research expenses. The court expected its reasoning to assist the parties in resolving the remaining projects, but expressly characterized the three-project sample as nonbinding for those projects.
Dissecting the Trial Projects: Engineering and R&D
The court examined both the overall MEPF systems and narrower systems or issues. Its analysis turned on the information available, the activities actually performed, and the evidence linking those activities to the claimed uncertainty.
The Vanderbilt University Engineering and Science Building
The Vanderbilt project involved complex HVAC, laboratory exhaust, pressure-control, electrical, and plumbing requirements. Work included plume-exhaust design and a steam distribution connection. The court did not deny that these were demanding engineering assignments. It found that PDG had not sufficiently established qualifying uncertainty and investigative or experimental activities at the claimed levels.
The steam-line issue illustrates the evidentiary problem. The factual record described repeated software analysis and design revisions, yet testimony about who performed that work conflicted with the time records. The court could not reliably isolate the activities for further shrinking back. The case therefore should not be summarized as a finding that no modeling or iteration occurred. The lesson is that modeling must be explained and linked to the relevant component, participants, and activities.
The Gerald Champion Military Psychiatric Unit
PDG designed and updated systems for renovations and an addition to an existing hospital. The project involved integrating new and existing systems, including choices affecting HVAC design. The court found that PDG had not identified what specific information was missing at the outset or shown that available diagrams and historical information failed to establish the systems’ basic design.
At the mechanical-system level, sizing calculations using historical information and communication of the resulting requirements did not establish a process of experimentation. The court also rejected the general proposition that a design remains technologically uncertain merely because changes may occur before construction ends. A later revision can introduce a narrower uncertainty, but its actual scope must be shown.
Baptist Memorial Health North Mississippi Oxford
The Oxford project involved a new hospital and issues concerning HVAC equipment, a hybrid operating room, electrical supply, and equipment selection. PDG pointed to these challenges as evidence of uncertainty across the MEPF systems. The court found that preliminary plans supplied a basis for the overall design and that PDG had not explained how discrete subsystem issues made the entire system uncertain.
Some uncertainties were resolved by the client’s equipment selections or by information from other parties. Waiting for a selection and rerunning load calculations did not, on this record, establish experimentation. Likewise, presenting utility-company options to the client did not demonstrate that PDG evaluated them through a qualifying experimental process. Client constraints or building codes do not categorically exclude research; the activities used to resolve the resulting technical questions remain decisive.
Technical Uncertainty and the Rejection of Design Flexibility
The court distinguished uncertainty about a system’s basic design from uncertainty about individual subcomponents. PDG’s general statements about interconnected systems did not demonstrate how a problem in one subsystem affected the design of the entire business component. A claimant needs to identify the scope of the uncertainty and explain any asserted technical interdependence.
An objective inquiry into information available to the taxpayer is not an industry-wide novelty requirement. Treasury Regulation § 1.41-4(a)(3)(ii) expressly provides that discovering information need not exceed or refine the common knowledge of skilled professionals. Existing technologies and engineering principles can support qualifying experimentation. Neither a scientific breakthrough nor successful development is required.
The following comparison is illustrative. No single factor determines eligibility, and a code-driven or client-driven project can contain qualifying activities if the statutory requirements are met.
| Factor | Routine Engineering (Non-Qualifying) | Qualified Research (Qualifying) |
|---|---|---|
| Origin of Goal | Implementing a client selection or compliance requirement without qualifying investigation or experimentation. | Improving function, performance, reliability, or quality through activities satisfying the four-part test. |
| Basis of Solution | Applying available information without a qualifying evaluation of alternatives. | Evaluating alternatives to resolve technical uncertainty, potentially using existing engineering principles. |
| Nature of Uncertainty | An unanswered question alone, where available information already establishes the answer. | Uncertainty about capability, method, or appropriate design based on information available to the taxpayer. |
| Outcome of Task | A completed design does not itself prove that qualifying research occurred. | Evidence establishes the qualifying process; success and a new-to-industry discovery are not required. |
Documentation: Records and Testimony
The opinion exposes gaps between general descriptions of an engineering process and evidence of the particular work performed. Treasury Regulation § 1.41-4(d) requires records in sufficiently usable form and detail to substantiate eligibility. It does not prescribe one universal timekeeping platform or require a specially titled uncertainty log.
The Narrative Gap in Timesheets
PDG maintained project time records with narrative entries, but many descriptions did not identify the specific issue or subcomponent being addressed. General design descriptions were insufficient to show what investigative activities occurred or to isolate relevant activities for the experimentation analysis. Project totals alone could not resolve these gaps.
Consistency of Oral Testimony
The court compared testimony about PDG’s six-stage design process with the hour sheets and found inconsistencies. Describing a workflow that resembles the scientific method was not enough to establish that employees actually performed a qualifying process of experimentation.
A practical response is to preserve technical analyses, design revisions, test results, correspondence, and reliable time-allocation evidence that explain the work together. Contemporaneous records are useful, but the decision does not create a categorical ban on testimony, retrospective explanations, or all reasonable estimates. The trial specifically excluded the quantification of qualified research expenses from its scope.
The Shrinking-Back Rule: Application and Limits
Treasury Regulation § 1.41-4(b)(2) directs application of the four-part test to the most significant subset of a business component’s elements when the component as a whole fails. The analysis continues at narrower levels as appropriate. A qualifying subcomponent may therefore exist within a larger nonqualifying project.
The court did apply this framework to the mechanical, electrical, and plumbing systems. It rejected shrinking back solely by design phase or individual employee because those categories did not identify the next most significant subset of the systems. Thus, saying the court was wholly unable to apply shrinking back is inaccurate.
Further narrowing was impeded by inadequate evidence identifying the particular activities and components involved. In several instances the court also identified substantive failures even at narrower levels. Maintaining component-level technical records and supportable expense allocations can help, but the opinion does not mandate a particular system-level accounting code for every taxpayer.
Financial Consequences: Deficiencies and Penalties
The court held PDG liable for accuracy-related penalties because the parties had stipulated to that result if none of the trial projects qualified, for credit years in which a deficiency was ultimately determined or agreed. It did not separately decide a reasonable-cause defense based on reliance on alliantgroup. The decision should not be presented as a general holding that hiring a consultant cannot support a penalty defense.
The table retains the source’s headings, but identifies the figures correctly. The second column contains deficiencies determined in the IRS notice, not research credits utilized. The final column adds those deficiencies and notice penalties; it is not a final adjudicated liability or a measure of fees, interest, or reputational harm.
| Tax Year | Credit Amount at Stake | Accuracy Penalty (20%) | Total Exposure (Excl. Interest) |
|---|---|---|---|
| 2015 | $55,504 deficiency in the notice | $11,101 | $66,605 notice deficiency plus penalty |
| 2016 | $47,811 deficiency in the notice | $9,021 | $56,832 notice deficiency plus penalty |
| 2017 | $219,177 deficiency in the notice | $43,835 | $263,012 notice deficiency plus penalty |
| 2018 | $68,147 deficiency in the notice | $13,629 | $81,776 notice deficiency plus penalty |
| 2019 | $71,102 deficiency in the notice | $14,220 | $85,322 notice deficiency plus penalty |
The 2016 penalty is reproduced as $9,021 from the opinion; it is not exactly 20% of the listed $47,811 deficiency. The table should not be used to infer that every dollar of each deficiency was subject to the penalty. The opinion left the remaining projects for subsequent resolution rather than setting out a final aggregate liability for all claims.
Comparative Jurisprudence: Little Sandy Coal and Betz
Phoenix Design Group relied on Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15, affirmed at 62 F.4th 287 (7th Cir. 2023), and Betz v. Commissioner, T.C. Memo. 2023-84. These authorities address the need to establish qualifying activities and the process-of-experimentation requirements with sufficiently specific evidence.
Little Sandy Coal emphasizes substantiation of the substantially-all calculation. Betz distinguishes identifying a design difficulty and its eventual solution from demonstrating the investigative work between them. Together, the cases illustrate the importance of evidence concerning the process and the proper component-level analysis. They do not establish that all engineering design, use of existing technology, or reasonable allocation methods are automatically disqualified.
The Future of R&D Applications: Legislative and Practical Shifts
The 2025 One Big Beautiful Bill Act added Section 174A, which generally permits current deductions for domestic research or experimental expenditures paid or incurred in tax years beginning after December 31, 2024. It is inaccurate to describe the change solely as restoring domestic expensing under Section 174. The legislation also amended Section 41’s expenditure cross-reference to Section 174A. The older Section 174 terminology remains relevant when analyzing the years litigated in Phoenix Design Group.
Foreign research expenditures generally remain subject to 15-year amortization under Section 174. Domestic transition relief and elections are addressed in IRS Revenue Procedure 2025-28. Deductibility of research expenditures and eligibility for the research credit remain separate questions; a deduction does not establish satisfaction of Section 41.
The IRS Instructions for Form 6765, revised December 2025, make Section G optional for tax years beginning before 2026. For tax years beginning after 2025, Section G is generally required subject to specified exceptions and completion rules. These include exceptions for certain qualified small businesses electing the payroll tax credit and certain original-return filers meeting both the qualified-research-expense and gross-receipts limits. It is therefore misleading to say every taxpayer already must provide detailed information about every business component. Amended research-credit refund claims also have separate information requirements.
Strategies for AEC Firms in 2026 and Beyond
- Describe the uncertainty: Identify what information was unavailable when the relevant research began and whether the uncertainty concerned the whole component or a narrower subsystem.
- Explain the evaluation: Preserve alternatives considered, modeling or testing performed, results, and reasons for revisions. Activity descriptions should accurately reflect the work, rather than merely adopt research terminology.
- Connect activities and expenses: Support employee participation and allocations with consistent project records. Distinguish direct research, d
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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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