R&D Tax Credits Disallowed in Leon Max v. Commissioner

Thoughtware Alert Published: Jan 03, 2022
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In Leon Max v. Commissioner, Leon Max, Inc. (LMI) is a clothing design company specializing in women’s apparel, and its designs are sold online, in nationwide clothing retailers, and in LMI’s own stores. The S corporation is wholly owned by Mr. Leon Max.

Case Facts

LMI engaged alliantgroup to conduct a research and development (R&D) tax credit study for tax years 2009 through 2012. As a result, the company filed an amended tax return for 2011 claiming $426,255 in research credits and an amended return for 2012 claiming $496,462 in research credits. The IRS disallowed all the research credits in June 2016, and the case went to trial in fall 2019. LMI argued that its multistep process of designing garments, making patterns, producing garment prototypes, testing fabrics and fits, and assuring quality standards constituted R&D activities. The IRS argued that the activities did not qualify as research activities as described in Internal Revenue Code (IRC) Section 41, stating that the processes were “nontechnical, typical of the industry, and concerned more with style, taste, and seasonality.” In court, both sides relied on expert witnesses to testify on their behalf with regard to science and technology in the fashion industry. Ultimately, the court ruled in favor of the IRS, stating that the activities put forth as research activities by LMI were simply “common solutions to common problems.”

Issues

The case centered on the issue of what constitutes qualified research as described in IRC §41. The tax court engaged in a detailed analysis of the taxpayer’s activities as they related to the four-part test as described in §41, namely 1) the §174 test, 2) the technological in nature test, 3) the process of experimentation test, and 4) the business component test.  

Analysis

The court first examined whether LMI’s expenses qualified as §174 expenses, which the IRC defines as expenses “intended to discover information that would eliminate uncertainty concerning the development or the improvement of a product.” The taxpayer argued that its team faced multiple uncertainties when tasked with executing a design, including uncertainties regarding fabric selection, prototype quality issues, pattern sizing, and fit. However, the court ruled that LMI’s research expenses did not qualify as §174 expenses, citing legislation that limited §174 expenses to those “of an investigative nature.” The court said LMI “had the requisite information to solve problems as they arose,” and the uncertainties described by the company were uncertainties it faced regularly. The court even pointed to company job postings requiring that new hires prove they could accomplish these types of tasks before being hired. Finally, the court addressed the company’s quality control activities, stating that they were ordinary, required by the industry, and undertaken to assure quality, not to eliminate uncertainty.

Next, the court addressed the technological component of LMI’s research activities. The taxpayer argued that fit testing and fabric alignment relied on material science and engineering, while colorfast and shrinkage tests relied on the principles of chemistry. The company described the complexities of working with fabrics of different composition, grain, weight, and patterns. However, the court cited the dictionary definitions of engineering, materials science, and chemistry, and stated that although LMI employees may be interacting with science when draping or dyeing fabric, the science is operating in the background; LMI employees don’t implement or rely on that science. The court referred to the testimony of an expert witness for the IRS, who contrasted LMI’s activities with a fabric manufacturer in Nepal who developed a DNA test to prove the purity of its cashmere products. The court concluded that LMI did not use “high technology activities” when carrying out its design and production processes.

The third test, the process of experimentation, requires that “substantially all of the research activities constitute elements of a process of experimentation for a qualified purpose.” The court stated that this test consists of three elements: (1) the qualified purpose element, (2) the process of experimentation element, and (3) the “substantially all” element, and the court addressed each of these tests separately. First, the court stated that Leon Max did not prove its research was for a qualified purpose, stating that “a purpose is not qualified if it relates to style, taste, cosmetic, or seasonal design factors.” Secondly, the court held the trial-and-error process that LMI described did not constitute a true process of experimentation, stating that “is not sufficient that the taxpayer use a method of simple trial and error to validate that a process or product change meets the taxpayer’s needs.” The court further expounded that taxpayers “should use a formalized scientific method to address uncertainties,” and that LMI did not use “true experimentation in the scientific or laboratory sense.” Finally, the court said that LMI did not meet the “substantially all” test because it did not pass the previous two tests, failing to demonstrate that its activities were undertaken scientifically and for a qualified purpose.

The fourth and final test requires that qualified research expenses be undertaken with the intention to develop a new or improved business component. Because Leon Max failed to satisfy the court in meeting the requirements of the previous three tests, the court did not evaluate this final requirement. 

Implications

IRC §41(d)(3)(B) specifically excludes research related to “style, taste, cosmetic, or seasonal design factors.” That is not to say the apparel industry is wholly excluded from the R&D tax credit. In fact, the trial showcased the Nepalese cashmere company’s DNA test as an example of qualified research within the industry. However, in 2020, the California Office of Tax Appeals issued a similar decision in another court case involving clothing designer Swat Fame, Inc. for many of the same reasons outlined in the Leon Max case. It follows that taxpayers in the apparel industry need to carefully evaluate their research activities before claiming the credit.  

A broader-reaching issue is the tax court’s definition of the process of experimentation. Per the court, “to be a true process of experimentation, the project must use the scientific method.” Prior to the LMI case, courts had ruled that “simple trial and error” methodologies were not enough to qualify as a process of experimentation, but that “systematic trial and error” methodologies qualified, even without the use of the scientific method. Furthermore, T.D. 9104 also held that the process of experimentation does not require the use of the scientific method. However, in the Leon Max trial, the court’s repeated emphasis on the scientific method, along with its extremely thorough analysis, may be an attempt by the courts to narrow the definition of the process of experimentation. Taxpayers hoping to claim the R&D tax credit should be aware of the issues raised in this case and that the IRS may raise similar issues when examining returns. 

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