This study examines Cleveland v. Commissioner and the evidence needed to support a federal research credit. Cleveland addressed research deductions under former Section 174, decades before the research credit was enacted. Modern Section 41 cases address separate questions about qualified activities, employee services, experimentation, and funded research. These authorities should be read together without treating every adverse decision as a new legal test. The discussion also reflects the domestic research deduction changes enacted in 2025.

The Jurisprudential Foundations of Section 174 and the Cleveland Precedent

Historically, Section 174 allowed taxpayers to elect current deductions for research and experimental expenditures connected with a trade or business. Cleveland v. Commissioner, 297 F.2d 169 (4th Cir. 1961), illustrates how a taxpayer’s legal relationship with a researcher affects that connection. Research deductibility and credit eligibility remain distinct: Section 41 imposes additional requirements, and its current expenditure test refers to Section 174A for domestic research.

The Factual Context of Cleveland v. Commissioner

Richard F. Cleveland, an attorney, financed inventor and chemist Hans Kerla’s work on an inorganic binder called Kerloid and assisted its commercial development. The disputed deductions concerned 1955 and 1956. A written agreement was executed on April 20, 1956, although it purported to operate from December 31, 1954.

The Fourth Circuit upheld the treatment of earlier advances as loans. It concluded that the executed agreement created a joint venture and allowed qualifying experimental expenditures made on or after April 20, 1956. The decision was affirmed in part, reversed in part, and remanded. It did not recognize the claimed earlier informal venture for deduction purposes.

Impact on the Scope of Research and Development

Cleveland illustrates the importance of an actual business relationship; financial assistance alone did not establish the claimed deductions. In Snow v. Commissioner, 416 U.S. 500 (1974), the Supreme Court later held that a venture’s lack of current sales did not bar a research deduction. Snow emphasized the broader language of former Section 174 compared with Section 162. Neither decision automatically establishes eligibility for a Section 41 credit.

The Modern Regulatory Environment and the Four-Part Test

Section 41(d) requires qualifying research expenditures, technological information useful in developing or improving a business component, and a process of experimentation for a permitted purpose. The permitted purposes concern function, performance, reliability, or quality. The credit also has separate expense rules and exclusions; deductibility alone is insufficient.

The Research Expenditure and Uncertainty Test

Research must address uncertainty about a product’s development or improvement. Uncertainty concerns capability, method, or appropriate design based on information available to the taxpayer. Older cases apply the historical Section 174 framework; current Section 41(d)(1)(A) refers to expenditures that may be treated as expenses under Section 174A.

In Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, the Tax Court rejected the engineering firm’s research-credit claims on the evidentiary record. Design revisions and technical complexity did not, by themselves, establish qualifying uncertainty and experimentation. Engineering firms should identify what was uncertain and how their activities evaluated alternatives rather than relying solely on the existence of successive drawings.

The Technological in Nature Requirement

The research must fundamentally rely on physical or biological science, engineering, or computer science. Using established engineering principles does not automatically fail this requirement: the regulations do not demand an advance beyond knowledge generally available in the field. A technological activity can nevertheless fail the uncertainty or experimentation requirements.

The Business Component Test

A business component may be a product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used in the taxpayer’s business. The research must be intended to develop or improve its function, performance, reliability, or quality. Tests generally apply separately to each business component. An entire vessel may be a proper starting component; the shrinking-back rule applies when the larger component fails the qualification requirements.

The Process of Experimentation and the 80% Threshold

Substantially all of the relevant research activities must constitute elements of a process of experimentation for a qualified purpose. The regulation defines this as 80% or more, measured on a cost or other consistently applied reasonable basis. A supported time-based method may be appropriate. This is an activity test, not a requirement that 80% of a product’s physical features be new, and its denominator is not automatically every project cost.

Analyzing Little Sandy Coal, Inc. v. Commissioner

In Little Sandy Coal Co. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), the court affirmed denial of the shipbuilder’s credit because the evidence did not substantiate the required experimental activities. The court rejected unsupported allocations but also rejected categorical reasoning that would automatically exclude pilot-model construction activities from experimentation.

The court explained how the existing regulatory fraction applies:

Numerator: Research activities constituting elements of a process of experimentation for a qualified purpose.

Denominator: The component’s research activities within the applicable research-expenditure standard and not excluded by Section 41(d)(4). For the historical years in Little Sandy Coal, that standard was Section 174. Supply costs are not themselves activities in this fraction.

Producing a pilot model can be part of experimentation when its construction helps evaluate alternatives and resolve uncertainty. Merely calling a finished vessel a prototype does not establish this. The court required a supported connection between the activities, the experimental process, and the allocations claimed; it did not prescribe a single mandatory record format.

The Shrinking-Back Rule

If the requirements are not met at the business-component level, the shrinking-back rule applies the tests to the most significant subset of elements, continuing to smaller subsets as necessary. It does not permit arbitrary selection of favorable costs. Records must support the relevant subset’s research activities and expenditures.

Substantiating Executive Compensation: Moore v. Commissioner

Executive wages qualify only to the extent they meet the same qualified-services rules applicable to other employees. Section 41(b)(2)(B) covers employees:

Engaged in the actual conduct of qualified research.

Engaged in the direct supervision of qualified research.

Engaged in the direct support of qualified research.

The “One-Up” Rule for Supervision

In Moore v. Commissioner, T.C. Memo. 2023-20, the taxpayer failed to substantiate the claimed 65% allocation of the chief operating officer’s wages. Direct supervision means immediate supervision of qualified research, not general management or supervision of managers who supervise researchers. A senior title alone establishes neither qualification nor disqualification.

Moore also illustrates why time spent on new product development cannot automatically be treated as time spent on qualified research. The evidence must identify qualifying services and support their extent. Time records and technical project records can help, but there is no universal rule that only contemporaneous timesheets can substantiate the credit.

The 80% Wage Rule for Individuals

A separate employee-level rule in Treasury Regulation Section 1.41-2(d)(2) generally permits all wages to be treated as qualified when at least 80% of the employee’s services are qualified services. Below that threshold, the qualifying portion must be determined. This wage rule differs from the business-component experimentation test. Reasonable estimates need an evidentiary foundation; unsupported percentages remain vulnerable.

Funded Research and the Allocation of Intellectual Property Rights

Section 41(d)(4)(H) excludes research to the extent funded by another person. For a contractor claiming the credit, payment risk and retained rights must be considered separately. Either an entitlement to payment regardless of research success or a failure to retain substantial rights may prevent qualification under the applicable funded-research rules.

The Economic Risk and Substantial Rights Tests

The determination of whether research is funded hinges on two criteria:

Economic Risk: Determine whether the contractor’s entitlement to payment depends on successful research. Labels such as fixed price or time-and-materials are not conclusive; review the agreements as a whole, including acceptance terms, remedies, and governing law.

Substantial Rights: Determine whether the contractor retains substantial rights to use the research results in its business. Exclusive ownership is not required, but incidental experience or institutional knowledge alone does not establish substantial rights.

In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, the Tax Court’s funded-research analysis considered Indiana law and the customer’s ability to recover payments if the promised product was not delivered. The court denied the IRS’s partial-summary-judgment motion. The proceedings illustrate why contract remedies can matter even without express language conditioning payment on research success; they do not establish that every warranty transfers the relevant economic risk.

The Role of Architectural and Engineering Contracts

The AS+GG dispute was litigated as Smith v. Commissioner, involving shareholders of Adrian Smith + Gordon Gill Architecture. At the summary-judgment stage, unresolved questions about agreements and governing foreign law prevented the IRS from obtaining judgment on funded research. That procedural result did not itself award the credits. Milestone payments and intellectual-property provisions require analysis of enforceable rights and obligations; neither milestone billing nor copyright retention is an automatic safe harbor.

Legislative and Administrative Shifts: Sections 174 and 174A

The Tax Cuts and Jobs Act required capitalization of specified research expenditures for tax years beginning after December 31, 2021. Public Law 119-21, enacted July 4, 2025, subsequently restored current deductions for domestic research through Section 174A for tax years beginning after December 31, 2024.

Domestic and Foreign Research Treatment

For tax years beginning in 2022 through 2024, the TCJA generally required five-year amortization of domestic research costs and fifteen-year amortization of foreign research costs, beginning at the midpoint of the taxable year. Under current law, qualifying domestic costs are generally deductible under Section 174A, while foreign costs remain subject to fifteen-year amortization under Section 174. Research expenditures and Section 41 qualified research expenses are not interchangeable.

Enacted Relief and Transition Rules

Section 174A is enacted law, not pending legislation. Eligible taxpayers may elect accelerated recovery of remaining unamortized domestic costs from 2022–2024 over one or two years, and qualifying small businesses have a separate retroactive election subject to statutory eligibility and deadlines. Revenue Procedure 2025-28 provides implementation procedures. Form 3115 is not mandatory in every situation; the applicable procedure may permit a statement or other prescribed filing. Section 280C coordination must also be considered.

The table preserves the original comparison headings. “Post-2021 Treatment” describes the 2022–2024 regime; the column originally labeled “Proposed Future (H.R. 1)” now describes enacted law.

IRS Refund-Claim Information Requirements

The IRS announced five information items for research-credit refund claims in 2021. Effective June 18, 2024, it waived two employee-specific items at filing. Three categories remain required for the affected refund claims, although additional information may be requested during examination.

The Requirements for a Valid Refund Claim

Business Component Identification: The taxpayer must list all business components that form the basis for the credit.

Activity Description: For each business component, a description of the research activities performed is required.

Personnel Listing: Names of individuals performing each activity are waived at filing under the June 18, 2024 change, but may be requested on examination.

Information Sought: The information each individual sought to discover is likewise waived at filing, but may be requested on examination.

Cost Detail: The total qualified employee wage, supply, and contract expenses related to the activities.

The transition period currently runs through January 10, 2027. During that period, taxpayers notified of deficient research-credit refund claims generally have 45 days to supply missing information. Merely repeating statutory language is insufficient; submissions must describe the taxpayer’s activities. These claim-validity procedures do not replace substantive credit eligibility requirements.

Connecting Activities to Expenditures

The practical lesson is to connect the claimed costs to qualifying research activities and employee services. General-ledger totals demonstrate spending but do not establish experimentation. Usable project records, supported allocations, and credible explanations should substantiate the claim. This reflects the underlying burden of proof, not a blanket new rule requiring daily time entries.

State-Level Implications: The Ohio R&D Investment Tax Credit

Ohio’s research and development investment credit is a nonrefundable credit against Commercial Activity Tax (CAT). It applies to eligible taxpayers and is not limited to corporations. Its connection to Section 41 makes the federal definition of qualified research relevant to identifying eligible Ohio expenditures.

Mechanics of the Ohio Credit

The Ohio credit, authorized by Code Section 5751.51, is generally equal to 7% of the amount of qualified research expenses incurred in Ohio that exceed the taxpayer’s average investment over the preceding three taxable years. Key features include:

Applicability: The credit is used to offset Commercial Activity Tax (CAT) liability.

Ohio Location: Only qualifying expenses incurred for research in Ohio enter the state calculation; a taxpayer’s separate out-of-state activities do not automatically disqualify its Ohio research.

Carry-forward: Unused credits can be carried forward for up to seven years.

Federal Alignment: Ohio Revised Code Section 5751. incorporates the federal qualified-research-expense definition, subject to the state statute and applicable conformity rules. Federal case law can inform the analysis but does not replace Ohio law.

Supporting an Ohio Claim

Records should establish the Ohio location and amount of qualifying research, the preceding three years’ expense base, and any carryforward. Preserve supporting records for all relevant open years and carryforward periods. CAT recei