The Statutory Genesis and the Congressional Intent of Section 41

Congress introduced the federal research credit in the Economic Recovery Tax Act of 1981. The credit encourages research investment by reducing tax liability, subject to the applicable calculation and credit limitations. A deduction instead reduces taxable income. A qualified research expense is an input to the credit calculation; it does not generate a dollar of credit for every dollar spent.

Research must satisfy the four-part test separately for each business component. Business components include products, processes, software, techniques, formulas, and inventions held for sale, lease, or license or used in the taxpayer’s trade or business. Qualified purposes include improvements to function, performance, reliability, or quality. Technical complexity alone does not establish eligibility.

The law applicable to Union Carbide referred to Section 174. For tax years beginning after December 31, 2024, Section 41(d)(1)(A), as amended by Public Law 119-21, refers to domestic research or experimental expenditures under Section 174A. The historical case should therefore be distinguished from the statutory framework applicable to a current claim.

The Four-Part Test for Qualified Research Activities

Meeting these tests does not override statutory exclusions, including funded research, foreign research, routine quality-control testing, and certain adaptation or duplication activities. Eligibility of an activity and eligibility of the expenses attributed to it are separate questions.

The Hahnville Projects: A Technical Review of the Disputed Research

Union Carbide sought additional credits for manufacturing process improvement projects. The Tax Court examined representative projects, and the appeal concerned three projects at two production plants in Hahnville, Louisiana: Amoco Anticoking, UCAT-J, and Sodium Borohydride.

Detailed Breakdown of Representative Research Projects

In the anticoking project, Union Carbide pretreated furnace coils twice. Both runs produced a normal amount of ethylene. The company discontinued the research after determining that the treatment did not reduce coke formation.

The UCAT-J catalyst was tested in 19 runs. Compared with the existing catalyst, the runs used approximately the same quantities of ethylene, hexene, and butene, although less hydrogen was required. Operational problems and increased off-grade polyethylene led Union Carbide to discontinue the project. These facts supported separating ordinary production inputs from additional costs attributable to research.

The “Used in the Conduct” Doctrine: Linguistic vs. Functional Statutory Interpretation

Union Carbide argued that materials employed during an experimental production run were supplies used in qualified research, even when the company would have purchased them for ordinary manufacturing. The Second Circuit read the statutory phrase in context and rejected that broad interpretation.

The court distinguished supplies used to conduct the research from supplies used in the production process on which research was performed. It accepted the exclusion of costs that would have been incurred without research and treated the disputed costs as indirect research expenditures. In this factual setting, additional research-related supplies could qualify, while the ordinary production materials could not.

Comparative Definitions of Supply Costs in Research

Treasury Regulation § 1.41-2(b)(2) excludes indirect research expenditures and general and administrative expenses from qualifying supply expenditures. Union Carbide does not create an absolute division between cost of goods sold and qualified research expenses. The purpose and use of the supplies, the business component under development, and the governing rules must be examined.

The Process of Experimentation and Systematic Evaluation

The Sodium Borohydride project illustrates a separate qualification problem. Union Carbide conducted a two-week test and adopted the treatment for use during shutdowns of its normal acetaldehyde-removal system. The Tax Court nevertheless found that the evidence did not establish a qualifying process of experimentation, including because the company did not perform post-testing analysis or comparisons of the collected data. The Second Circuit affirmed on the Tax Court’s reasoning.

Under Treasury Regulation § 1.41-4(a)(5), a process of experimentation evaluates alternatives to resolve uncertainty about capability, method, or appropriate design. Modeling, simulation, and systematic trial and error can qualify. The regulations do not require every project to follow a rigid laboratory protocol, use a document labeled “formal hypothesis,” or undergo repeated unsuccessful tests.

Elements of a Qualifying Process of Experimentation

• Identification of technical uncertainty: Describe what was uncertain at the beginning of the work and why available information did not establish the capability, method, or appropriate design.
• Evaluation of alternatives: Identify the alternatives considered and how they were evaluated to resolve that uncertainty.
• Systematic testing and analysis: Explain the modeling, simulation, testing, or systematic trial-and-error method used.
• Results and decisions: Preserve evidence of observations, analysis, and resulting design or process decisions. Further refinement is relevant when it occurs, but success on an early test does not itself defeat eligibility.

Routine validation and quality-control testing are distinguishable from an evaluative process directed at technical uncertainty. Iteration alone does not prove qualified research, but describing an activity as trial and error does not automatically disqualify it either.

The Shrink-Back Rule: A Narrowing Path for Complex Systems

Treasury Regulation § 1.41-4(b)(2) provides a shrinking-back rule. If research associated with an entire business component fails the qualification requirements, the analysis proceeds to the most significant subset of its elements and continues until a qualifying subset is reached or the most basic element is tested. The rule does not cure missing evidence.

Union Carbide’s product-versus-process distinction arises from Section 41(d)(2)(C), which treats a commercial production process as a separate business component from the product produced. Research on a process does not automatically make all production activities research. This statutory separation should not be described as a standalone shrinking-back holding or as an allocation method that converts ordinary inputs into qualified supplies.

Application of the Shrink-Back Rule in Recent Jurisprudence

Little Sandy Coal Co. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), emphasizes the need to substantiate the experimental character of activities. The substantially-all test concerns activities measured on a permitted basis, not simply the percentage of a product’s physical features that are new. Pilot-model construction and direct-support activities require careful analysis; construction labels alone do not resolve the fraction.

Substantiation Standards: From the Cohan Rule to Project Evidence

The Cohan doctrine can permit reasonable estimates when evidence establishes that qualifying expenditures occurred and supplies a reasonable basis for estimating their amount. It does not establish that an activity was qualified research. Testimony may be relevant, but unsupported percentages or broad recollections can fail to connect costs with qualifying activities.

Contemporaneous records are valuable because they show the uncertainties, alternatives, tests, and costs as the work occurred. Neither a consultant’s retrospective study nor a particular timekeeping format automatically determines eligibility. Treasury Regulation § 1.41-4(d) requires records sufficiently usable and detailed to substantiate the claim.

Required Documentation for Modern R&D Claims

Phoenix Design Group was decided in December 2024, not 2023. Meyer, Borgman & Johnson, Inc. v. Commissioner, affirmed by the Eighth Circuit in 2024, principally concerned funded research and contractual payment risk. It should not be characterized merely as a decision requiring better time logs. The contract’s allocation of research risk and rights can defeat a claim even where technical work is well documented.

The IRS Response: Directives, Form 6765, and the Path to 2026

The ASC 730 directive and revised Form 6765 address administration and substantiation of research credits. They should not be presented as statutory codifications of Union Carbide or as proof that the case caused each subsequent IRS policy change.

The ASC 730 LB&I Directive

The IRS introduced its ASC 730 directive in 2017 and revised it in 2020. It applies to eligible LB&I taxpayers with assets of at least $10 million that meet additional requirements, including specified U.S. GAAP certified audited financial statements and use of those statements for Schedule M-3 reconciliation. Asset size alone is insufficient.

The directive provides an administrative approach under which examiners generally accept properly computed Adjusted ASC 730 Financial Statement R&D amounts, subject to required certifications, adjustments, and records. It is not an official pronouncement of law. Financial-statement research expense is not automatically a qualified research expense; taxpayers must follow the directive’s actual calculations and separately support amounts outside it.

The Evolution of Form 6765: Section G

The December 2025 instructions for Form 6765 make Section G optional for tax years beginning before 2026 and required for tax years beginning after 2025, subject to exceptions. The relevant distinction is the tax year’s beginning date, not merely when the return is filed.

Required filers generally list business components in descending QRE order until reaching at least 80% of QREs, subject to a maximum of 50 components, and enter the remainder in aggregate. Wage details distinguish direct research, [{“@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 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