Jeffrey A. Harper and Katherine M. Harper v. Commissioner, T.C. Memo. 2023-57

In a recent tax court, the Tax Court denied a motion for summary judgment from the IRS against a construction firm claiming the R&D tax credit.

The Case

Jeffrey Harper and Katherine Harper claimed credits through section 41 for a total of $46,656 and $778,610 for the tax years 2012 and 2013, respectively. The credits were claimed for work conducted through their S corporation, Harper Construction Co. (HCC). These credits were disallowed by the IRS which issued a notice of deficiency to the Harpers in 2016 and alleged the activities outlined as R&D fail to meet the definition of a “business component”. 

The Harpers promptly filed a petition, assigning errors to all parts of the IRS’ notice. As such, the matter was brought before the Court for a Partial Summary Judgment.

Legislation

The IRS follows a four part test as outlined in IRC 41(d)(1), (2)(B). This four part test includes:

1. The Section 174 Test
2. The Discovering Technological Information Test
3. The Business Component Test
4. The Process of Experimentation Test

In order to meet the Business Component test, the taxpayer must intend to apply the information being discovered to develop a new or improved business component of the taxpayer. For these purposes a business component can refer to any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, license or used in a trade or business of the taxpayer.

Backgrounds and Arguments

HCC is a privately owned design builder and general contractor that has worked on residential, commercial, and industrial projects. They also specialized in military design-build projects, including over 30 military housing projects.

Over the two years in question, the company reported 53 separate projects including work on the construction of aircraft hangars, maintenance facilities, military recruit barracks and living quarters, college buildings, medical clinics, instructional facilities, fitness centers, parking garages, training facilities, a 200,000-gallon solar-powered water tank, a photovoltaic renewable energy generation system, a multi-megawatt renewable energy system for use in South Africa, and a specialized energy solution in Las Vegas, Nevada.

HCC outlined activities performed for each project including system studies, design meetings, and more.

The IRS argued the construction firm’s designs and drawings failed the business component test for various reasons including:

1. The buildings and facilities constructed by HCC never belonged to HCC, yet only these structures (and no the designs created by HCC) were “new or improved”;
2. HCC’s designs were not “products”, as that word is intended in the statute, but rather “tangible manifestations[s] of construction services”;
3. Neither HCC’s designs nor the facilities it constructed were ever “held for sale” by HCC;
4. HCC did not “use” its designs in the sense intended by the statute, because Congress meant for taxpayers’ use of business components to be “meaningful” and so “affect the way a business operates to some degree”.

Findings

The Tax Court repeatedly rejected the IRS’ arguments, stating that by designing its clients’ buildings and structures, the taxpayer has conducted research that satisfies the business component test. 

In response to each alleged failing, the Tax Court found:

1. The contention that the designs were never “new or improved”  is contradicted by the record. HCC evidently engaged in a lengthy, multi-step process of conceptual design and development for each project to achieve some level of functional improvement.
2. The Court agrees that HCC’s designs were not “products” as the legislation most often denotes a product as a tangible or physical product. However, the designs could constitute processes, techniques, or inventions – all of which are included in the definitional list of business components.
3. After a review of the associated contracts, HCC held firm that the facilities built by HCC were “built to be sold to the ultimate owners”. The Court ultimately determined there were no “products” to be sold, and the developed processes, techniques, and potential inventions were used in HCC’s business, removing the need to resolve ownership of the buildings and other structures. 
4. The fourth argument hinges on the idea that “HCC’s day-to-day operations were not changed by its designs”, as alleged by the IRS, which suggests the component would require habitual availment. The Court feels the precise definition of “use” being implied by the IRS is too specific while the legislation has no indication that the word should be restricted to this definition. The Court rejected the specialized definition of the word “use”, negating this final argument.

This finding sides with the company, validating their technical work product as being the technical activity and therefore meeting the Business Component test. The court’s opinion validates design firms’ technical work product as being the technical activity Congress sought to encourage when creating the R&D tax credit and as good candidates for the credit today.

The full memo can be found here.

Are you developing new technology for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.

Leonard L. Grigsby et al. v. The United States (No. 19-00596-BAJ-SDJ)

The United States filed a civil suit against Leonard Grigsby, seeking the return of an erroneously issued tax refund. The Government further moved that the company did not conduct any qualified research activities, and so the credit is ineligible from the start.

The Erroneous Refund

Cajun Industries, LLC & Subsidiaries (Cajun) claimed an R&D tax credit for the tax year 2013, wherein the entity elected to be treated as an S Corporation. During this year, Leonard Grigsby was a member of Cajun. 

Leonard and Barbara Grigsby filed multiple tax returns, including amended returns following Cajun’s amended return. This return filing history is outlined here:

• Leonard and Barbara Grigsby filed a timely filed return for 2013, claiming an overpayment carryforward to tax year 2014 of $239,310;
• Leonard and Barbara Grigsby filed a second joint federal income tax return for 2013, claiming an overpayment carryforward of $259,962 to the 2014 tax year
• Cajun filed an amended federal tax return around October 3, 2016 which claimed $1,341,420 of research credits
• After this, Leonard and Barbara Grigsby filed another amended 2013 federal income tax return, claiming a tax refund in the amount of $576,756.
  • This amount was attributable to the portion of the Cajun R&D tax credit allocable to Leonard Grigsby as a shareholder.

On September 18, 2017, the IRS processed the individual’s second 2013 return as an amended return, allowing the additional overpayment of $20,652 claimed on that return. The IRS then processed the third return, erroneously allowing the $576,756 refund claimed on that return. On September 15, 2017, the IRS erroneously issued to Leonard and Barbara Grigsby a refund in the amount of $671,071.38, which reflected the amount of the refund claimed by the Grigsbys on their Third 2013 Return, plus statutory overpayment interest of $73,663.38. 

Qualified Research

Cajun is a civil construction company which contracts with hundreds of private and public clients to provide a range of construction services in numerous markets. With consultation from AlliantGroup, the company identified 105 research projects in their 2012 tax year, which ended September 30, 2013. They amended their tax return, claiming a tax credit in the amount of $1,341,420.

In review of the credit, Cajun and the Government agreed that a sampling of four of Cajun’s projects for the tax year ending September 2013 would be sufficient to determine the outcome of the dispute. The company provided brief descriptions of each representative project.

Each project was subcontracted work and, upon review of contracts and service agreements, the Government identified the following key contract terms and details:

• Each contract was a fixed-fee with a capped payment; however, each contract also contained provisions wherein Cajun may receive additional compensation in stated circumstances such as if the scope of work is changed or expanded.
• Each contract stated that work was subject to approval by the hiring entity, with different outcomes for how this would impact payment (if at all).
• Three of the contracts outlined IP and Work Product rights, asserting that any IP or Work Product developed is the property of the hiring entity.

Outcomes and Learnings

The devil is in the details, especially when it comes to contracts and service agreements. At first glance, each of these subcontracted projects were fixed-base and the financial risk would be placed on Cajun. However, reading the detailed contract terms highlighted that there were provisions and clauses that would ensure Cajun was compensated in almost every instance that would create financial risk. The contract allowed the taxpayer to receive compensation for “all loss, damages or risks … connected with … the work.” This included unanticipated amounts for inspection and testing.

This level of protection financially favored Cajun, protecting them well in business but ultimately removing the right to the tax credit. What was good for business is not necessarily suitable for tax.

The Government also found, and reinforced, that “Works Made for Hire” are funded. Cajun did not retain rights to the research, work product, or IP in 3 of the 4 representative projects. Since the final product benefitted the hiring entity, it would be considered funded research, again removing Cajun’s eligibility for the credit.

The Government found that Cajun’s credit was ineligible and was denied. Similarly, the court ruled in favor of the US in the civil suit against Grigsby, requiring the erroneous refund to be recollected.

The lesson here is understanding eligibility and financial risk is essential to determining who has rights to the credit. A simple overview of a contract is not always sufficient and diligence is crucial.

The full case can be found here.

Are you developing new technology for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.

Desert NewCo, LLC, GoDaddy Inc., Tax Matters Partner, V. Commissioner Of Internal Revenue

Desert NewCo LLC, a partnership and the parent company of GoDaddy, has petitioned the U.S. Tax Court for help in securing $16.3 million in research and development tax credits, stating their software and product development expenses qualified for a now-expired tax break.

The company originally made this request more than two years ago but the IRS has since failed to make a decision. In response to this lacking decision, Desert NewCo filed their petition, asking the Tax Court to intervene.

Their claim indicates an expenditure of $174.8 million on research expenses in 2017 which qualified under Section 174 of the Internal Revenue Code (IRC). This resulted in an R&D tax credit claim under Section 41 in the amount of $16,256,374. The claim suggested the following:

• The largest source of research expenses for GoDaddy came from wage, contract expenses, and computer leasing costs
• $1 million in costs came from securing the rights to use computers to conduct qualified research
• GoDaddy had unrealized gains in property due to interest transfers between it and GoDaddy that should have resulted in an additional $37,000 in deductions

Desert NewCo asked the IRS, in December 2020, for an administrative adjustment granting the credits on its amended 2017 return. This request was never allowed nor acted upon.

With the petition filed, the company now awaits a response to determine how these partnership items can be adjusted. The full petition highlights further details pertaining to the partnership and the company’s requests.

Are you developing new technology for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.