Swat-Fame v. OTA: A Case in Fashion and R&D
Swat-Fame, Inc. OTA Case Nos. 1801072, 1812114, & 18012115
Swat-Fame Inc. an S-corp apparel designer for women and girls clothes also develops and refines new and improved garments. Because of this design development, they have claimed R&D tax credits under section 41. These claims were made through amended tax returns for the years 2008 through 2011. These claims were denied and promptly appealed by the company.
Swat-Fame claimed the research activities involved product design and development through a design team, focusing on new and improved silhouettes and fabrics for their upcoming seasonal line. Substantive documentation was provided through feedback from designer departments, hand sketches and drafts in computer aided modeling programs (CAD), and a narrative outlining the concept phase and fabrication phases (eg. Different materials, cuts etc).
The projects specifically pertained to development of bermuda shorts, dresses with adjustable straps, two-piece set of leggings and skirts, and a two-piece set with sundress and shrugs.
Basic Facts
The claims were denied as the Franchise Tax Board (FTB) did not agree that the activities were qualified research under R&TC section 23609.
- FTB claimed the company failed to demonstrate that substantially all of the activities related to each of the sample projects reviewed by the OTA (Office of Tax Appeals) constituted a “process of experimentation” for a qualified purpose.
- FTB claimed the company failed to demonstrate that 80% or more of Swat-Fame’s activities for any of the four projects reviewed constituted elements of a process of experimentation for a qualified purpose.
- FTB claimed the company failed to show their activities were more than simple trial and error, or proving they engaged in a scientific method
- FTB claimed the company’s activities pertained to the style or aesthetics of the garment as opposed to a qualified purpose relating to the function, performance, quality, or reliability.
Specifically, the FTB claimed that each solution used to overcome any development issues were achieved through known methods and nothing new or innovative was created for the industry. They were further unconvinced that the company successfully substantiated their claims. The FTB denied a total of $2.4M in claims spread over the 4 years.
Court’s Decision
In review of the appeal, the OTA found that the original FTB claims were upheld, with no new methods or designs being produced. For instance, one garment faced issues wherein pockets were ripped during stonewashing. The solution eventually used was using extra bar tack stitching – the application of a known solution. The OTA confirmed the denial of tax credits.
Learnings
Documentation is the key component to substantiating your claims. Even when your research might be questioned, the supporting documentation is the key to making your argument. In this case, Swat-Fame failed to accurately document its systematic process of experimentation, showing no trail of methods tested in temperature wash trials. They could not differentiate between developments that contributed to functional enhancement over aesthetics and style. In addition, they lacked documentation showing that multiple and iterative testing methodologies were used and therefore could not support a process of experimentation.
In addition, it’s important to understand the types of projects that the R&D tax credit considers qualifying. These research components must be rooted in hard sciences – think: engineering, chemistry, physical sciences. So aesthetics and style modifications often do not qualify. But that’s not to say apparel companies should count themselves out – in fact clothing and apparel companies often have R&D that they don’t even recognize. For instance: integrating prototype machinery or equipment, enhancing manufacturing processes, designing new fabric blends for strength or durability etc.
The IRS has historically acknowledged (See SOI Tax Stats – Corporation Research Credit, Table 2: Corporations Claiming a Credit, by Manufacturing Subsector) the eligibility of apparel and textile companies and manufacturers in claiming the R&D tax credit – but it still comes down to substantiating your claims.
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