Research and development (R&D) tax incentives depend on both the nature of the work and its connection to the taxpayer’s business. Spellman v. Commissioner, 845 F.2d 148 (7th Cir. 1988), illustrates the distinction between financing another company’s research and incurring research expenditures for an existing or realistically prospective business of one’s own. Its reasoning remains relevant to business-nexus questions, although it does not decide every requirement for a research deduction or credit.

The statutory framework has changed since Spellman. Historical Section 174 permitted current deductions for qualifying research expenditures. The Tax Cuts and Jobs Act (TCJA) subsequently required capitalization for taxable years beginning after 2021. Legislation enacted on July 4, 2025, introduced Section 174A for domestic research while retaining separate treatment for foreign research. These changes require careful attention to the tax year, research location, contractual arrangements, and distinction between deductions and credits.

The Statutory Context and the Genesis of Section 174

Congress enacted Section 174 in 1954 to reduce uncertainty over the treatment of research and experimental expenditures and encourage research investment. Before its enactment, treatment depended on the circumstances, and capitalization could delay recovery. It is too broad to say that all research costs could be recovered only through a patent or abandonment. The provision was especially significant for emerging businesses that incurred development expenses before earning operating revenue.

The historical deduction applied to qualifying costs incurred “in connection with” the taxpayer’s trade or business. This differs from Section 162’s “carrying on” requirement for ordinary and necessary business expenses. An active business need not already have made sales, so revenue alone is not the dividing line under Section 162. In Snow v. Commissioner, 416 U.S. 500 (1974), the Supreme Court held that the absence of an existing operating business did not itself bar the research deduction.

The following comparison describes historical Section 174 as interpreted in Snow and Spellman. For domestic expenditures in taxable years beginning after 2024, Section 174A supplies the current deduction framework and retains the business-connection requirement.

Snow addressed timing without establishing that every research investment qualified. Later litigation examined whether partnerships funding research had a realistic prospect of exploiting the results in their own businesses. A contractual claim to royalties or technology could represent an investment rather than a business activity. Spellman arose in that setting.

Analysis of Spellman v. Commissioner: Facts and Findings

The Spellmans were limited partners in Elmer South Oil Partnership, which held a limited-partnership interest in Sci-Med. Sci-Med agreed to contribute $855,000 toward Teva Pharmaceutical Industries’ development of new penicillins. The dispute concerned pharmaceutical research, not cement technology or a Serv-Tech development arrangement.

The Contractual Framework

Teva received exclusive exploitation rights to the new penicillins. Sci-Med would receive royalties of 5% of revenues until recovering its contribution, then 1%. Sci-Med retained rights to research byproducts, but Teva could purchase those rights for $20,000. Sci-Med could also monitor the research.

The Seventh Circuit’s Reasoning

Judge Richard Posner’s opinion affirmed summary judgment denying the deduction. Sci-Med produced no evidence of staffing, relevant experience, or comparable preparations indicating a realistic future pharmaceutical business. Temporary ownership and monitoring rights did not establish that business connection.

The Economic-Reality Analysis

Teva would ordinarily exercise its option if the byproducts were valuable; less valuable byproducts would not justify Sci-Med building a pharmaceutical operation. This economic assessment supported the result. Spellman did not impose a universal prohibition on outsourced research or licensing.

The Progeny of Spellman and the Refining of the Test

Related appellate decisions examined whether contractual rights and practical capabilities supported a business of the taxpayer rather than a passive investment. Levin preceded Spellman; later cases applied similar reasoning to other research partnerships. Their outcomes depended on the arrangements and evidence before the courts.

Kantor v. Commissioner and the Ability to Commercialize

In Kantor v. Commissioner, 998 F.2d 1514 (9th Cir. 1993), a partnership financed adaptation of PRO-IV software for IBM computers. The developer could purchase, for $5,000, an option on an exclusive worldwide marketing license. The Ninth Circuit concluded that the partnership lacked objective intent and capability to enter its own software business when the expenditures were incurred. Its nominally priced option arrangement and limited resources supported that conclusion. The theoretical possibility that rights might return to the partnership was insufficient.

LDL Research and the Mere-Possibility Standard

LDL Research & Development II, Ltd. v. Commissioner, 124 F.3d 1338 (10th Cir. 1997), concerned acoustic and vibration testing equipment developed by Larson-Davis Laboratories. The contracts included a nonexclusive licensing option and a separate purchase option covering the technology. The court considered the agreements, offering materials, participants’ experience, and practical control over commercialization. It upheld denial of the deductions because the partnership’s activities amounted to investment rather than a realistic prospective operating business. Monitoring how contributed funds were spent did not resolve that deficiency.

The Nexus Between Research Deductions and the Section 41 Research Credit

Research-expense treatment and credit eligibility overlap but are separate inquiries. Section 41(d)(1)(A) now refers to domestic research or experimental expenditures under Section 174A. Earlier statutory versions referred to Section 174. The applicable version must be identified for the year under examination.

A qualifying deduction does not automatically establish a research credit. Section 41 also requires technological research, an intended new or improved business component, a qualifying process of experimentation, and compliance with exclusions and expense-category rules. Spellman itself decided a historical deduction question, not entitlement to a Section 41 credit.

The Carrying-On and Business-Connection Distinction

Section 41(b)(1) generally requires expenses incurred in carrying on the taxpayer’s trade or business. Section 41(b)(4) provides a specific exception for in-house research when the principal purpose is to use the results in the active conduct of a future business of the taxpayer or an eligible aggregated person. Pre-revenue status therefore does not automatically prevent a credit, and the statutory exception must be evaluated on its own terms.

The Funded Research Exclusion and Substantial Rights

Section 41(d)(4)(H) excludes research to the extent funded by another person. Treasury Regulation Section 1.41-4A(d), applied through Section 1.41-4(c)(9), examines payment terms and retained rights across the relevant agreements.

• Economic risk: Payments contingent on research success generally are not treated as funding. Progress payments, fixed fees, warranties, and remedies must be examined together.
• Substantial rights: A researcher retaining no substantial rights is treated as fully funded. Incidental experience alone does not establish substantial rights.

Exclusive ownership is not invariably necessary. Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), addresses rights to use research results even where another party also holds rights. Where substantial rights remain but payments constitute funding, the regulations may allow otherwise qualifying expenses above the applicable funding amount. These credit rules should not be described as a direct codification of Spellman or as an all-or-nothing test based solely on who owns a patent.

Recent Jurisprudence: Phoenix Design, Smith, and System Technologies

Recent cases illustrate distinct issues in research-credit litigation: proof of qualifying experimentation, the effect of contracts, and the procedural difference between resisting summary judgment and establishing the amount of a credit.

Phoenix Design Group and the Process of Experimentation

In Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, filed December 23, 2024, the Tax Court considered three sample engineering projects. It held that none entailed qualified research and imposed accuracy-related penalties under the parties’ stipulations. The decision demonstrates that sophisticated engineering and a standard design process do not, by themselves, establish the required research elements. It should not be described as creating a new universal documentation format, abolishing reasonable estimation, or extending Spellman’s business-nexus holding.

Smith and System Technologies: Contract-Specific Outcomes

The December 18, 2024 order in Smith denied the IRS’s summary-judgment motion; it did not finally establish entitlement to all claimed credits. A later merits opinion, Smith v. Commissioner, T.C. Memo. 2026-50, filed June 16, 2026, found that payments under all six sample contracts were not contingent on research success. The architectural firm nevertheless retained substantial rights under four contracts, leaving potential partial credits under the funding-allocation rules. The court could not determine the precise amounts, if any, on the evidence before it.

In System Technologies, Inc., a January 3, 2025 order denied the IRS’s motion for partial summary judgment on funded research. The dispute concerned industrial finishing systems. Indiana law’s remedies for failure to deliver the contracted product mattered to whether progress payments were contingent on successful performance. The order addressed the funding issue rather than conclusively proving every element of the claimed credits.

These outcomes do not establish a new exception to Spellman. They show why payment entitlement, usable research rights, applicable contract law, and the procedural scope of each ruling require separate analysis.

The One Big Beautiful Bill Act of 2025

Public Law 119-21, commonly called the One Big Beautiful Bill Act (OBBBA), was signed on July 4, 2025. Its research provisions restored a current-deduction framework for domestic research through new Section 174A. The legislation did not completely reverse the TCJA research rules: foreign research remains subject to mandatory capitalization and amortization.

Domestic Expensing Under New Section 174A

For taxable years beginning after December 31, 2024, Section 174A generally allows a deduction for domestic research or experimental expenditures in the year paid or incurred. An election permits capitalization and amortization over at least 60 months, beginning when benefits are first realized. Business-connection requirements and statutory exclusions remain applicable. The provision was newly enacted, rather than a restoration of an earlier section bearing that number.

Retroactive Relief and the $31 Million Threshold

The legislation allowed eligible small businesses to elect retroactive domestic research treatment for taxable years beginning after 2021 and before 2025. Eligibility uses the Section 448(c) gross-receipts test for the first taxable year beginning after 2024 and excludes specified tax shelters. For a taxable year beginning in 2025, the threshold is average annual gross receipts of $31 million or less, applying the statutory aggregation and related rules. Gross receipts alone do not establish eligibility.

A separate transition election allows remaining unamortized domestic research costs from the relevant 2022–2024 taxable years to be deducted in the first taxable year beginning after 2024 or ratably over that year and the next. This option is not restricted to large corporations and should not be called depreciation. Costs already deducted under another permitted route cannot be deducted again.

Domestic and Foreign Research

The place where research is performed affects the applicable cost-recovery rule. Section 174A uses the foreign-research definition in Section 41(d)(4)(F), which distinguishes research outside the United States, Puerto Rico, and U.S. possessions. A U.S. payer or U.S.-owned intellectual property does not by itself make overseas work domestic. Businesses conducting research in several jurisdictions need supportable allocations. Research location and the taxpayer’s business connection are separate questions.

Implications for Future R&D Tax Credit Applications

Practical analysis should distinguish the operating-business question, research-cost classification, credit eligibility, and procedural requirements. No single contract clause or label resolves all four.

SRE Product Rights and Research-Provider Costs

Notices 2023-63 and 2024-12 supplied interim guidance on specified research or experimental (SRE) expenditures under the TCJA framework. They did not simply formalize Spellman. Under that guidance, a research provider’s financial risk can cause its costs to be SRE expenditures even without retained product rights. A qualifying SRE product right can also affect classification when financial risk is absent. Notice 2024-12 excludes certain separately acquired rights and rights limited to performing research for the recipient from that latter analysis.

This guidance concerns classification of provider costs, rather than automatic entitlement to the Section 41 credit. Its relevance must be assessed against the tax year and the later statutory changes. Assignment of a research result to a customer does not, on its own, mean that the provider lacks a trade or business.

Substantiation and the Burden of Proof

Taxpayers must substantiate qualifying activities and expenses. Project records, technical alternatives, test results, design changes, payroll information, and reliable allocations can connect costs to the work performed. A general assertion that a project was innovative does not prove the statutory requirements.

Estimates and reconstructions are not categorically forbidden, but they need a credible evidentiary foundation and cannot replace proof that qualifying research occurred. Similarly, disallowance does not automatically impose a 20% penalty; the applicable statutory grounds, procedural requirements, and available defenses must be considered. Historical descriptions of research credits as a Tier I issue should not be presented as a current audit classification.

The Role of Software Development

Section 174A expressly treats software-development amounts as research or experimental expenditures, subject to the section’s other requirements. Section 41 does not automatically award credits for every software project. Its separate qualification rules and, where relevant, internal-use software restrictions still apply.

A startup’s intention to seek acquisition does not itself defeat a research deduction or credit. Spellman does not require every software startup to adopt a Software-as-a-Service model or promise to remain independent. The relevant question is whether the taxpayer’s actual activities, rights, and plans satisfy the applicable business and research requirements when costs are incurred.

Strategy for Small Business Retroactive Claims

Revenue Procedure 2025-28 set July 6, 2026, as the general deadline for the small-business retroactive election, reflecting the weekend and holiday rules. Earlier refun