Clothing Company's Design Process Doesn't Qualify for Research Credits

(Parker Tax Publishing April 2021)

The Tax Court held that a clothing company's multistep process of designing garments, fit testing, and fabric testing did not constitute research and experimentation under Code Sec. 41 and therefore the company's wages and expenses did not qualify for the research credit. The court found that the company's production process was nontechnical, typical of the industry, and concerned more with style, taste, and seasonality. Max v. Comm'r, T.C. Memo. 2021-37.

Background

Leon Max is a successful fashion designer who started Leon Max, Inc. (LMI) in the 1980s. The company began by selling its garments in high-end department stores and boutiques before opening its own retail shops in the mid-1990s. In 2011 and 2012, the years at issue, LMI was a women's clothing company specializing in apparel sold in department stores throughout the country, LMI's own stores, and online. In 2012, LMI manufactured between 800,000 and 1 million garments each month. Max was the sole shareholder, chief executive officer, and creative director of LMI, an S corporation.

LMI followed a structured process for conceptualizing, designing, and developing garments, referred to as the pre-production process or development. During the pre-production process, employees at LMI encountered problems and had to address a variety of issues with the designs and structures of garments. LMI found solutions to these problems as they arose. LMI had to determine the right trim, linings, and thread for each garment. LMI also had to create new patterns for plus-size garments, even if the garments' designs were also used for standard-size garments. The development team occasionally did not know how to execute certain design elements at the outset of the pre-production process. To combat this, LMI conducted a process of trial and error. LMI implemented quality assurance testing, which included testing fabric and garments to ensure they met quality standards based on customer requirements and past experience.

In 2013, LMI engaged alliantgroup, a tax consulting firm, to conduct a research and development tax credit study and, as part of this engagement, alliantgroup produced a federal research and development tax credit study for LMI in 2014. The study randomly sampled 35 garments produced by LMI from 2009 to 2012. As part of its analysis, alliantgroup interviewed LMI employees; reviewed its design sketches, prototype photographs, spec sheets, markers, and email correspondence; and analyzed its financial and tax documents. The consulting firm found that 32 of the 35 projects included activities that qualified for the research and experimentation tax credit under Code Sec. 41.

LMI claimed $426,255 of research credits for 2011 and $496,462 of research credits for 2012. Max claimed passthrough research credits on his individual returns for those years. In 2016, the IRS issued a notice of deficiency to Max disallowing all of the claimed research credits. Max took his case to the Tax Court.

Analysis

Code Sec. 41(a)(1) allows taxpayers to take a credit for increasing research activities. Under Code Sec. 41(b), qualified research expenses are (1) in-house research expenses, including wages for employees working on qualified research and costs paid or incurred for supplies for qualified research, and (2) contract research expenses. To be qualified research, the research must relate to a new or improved function, performance, reliability, or quality of the product or process. Certain activities cannot be qualified research. Code Sec. 41(d)(4) provides that qualified research does not include research after commercial production; adaptation or duplication of an existing business component; market research, testing, or development; or routine or ordinary testing or inspection for quality control.

Under Code Sec. 41(d), activities or projects must satisfy four tests in order to be treated as qualified research: (1) the Code Sec. 174 test, (2) the technological information test, (3) the business component test, and (4) the process of experimentation test. The Code Sec. 174 test requires research expenditures to be eligible for treatment as research and experimental expenditures under Code Sec. 174. Research and experimental expenditures are defined in Reg. Sec. 1.174-2(a)(1) as expenditures which represent research and development costs in the experimental or laboratory sense. Essentially, for there to be experimental expenditures, the taxpayer must show that (1) uncertainties exist regarding a capability or method, and (2) the taxpayer's research activities were meant to eliminate those uncertainties. Under the technological information test, an activity must be undertaken for the purpose of discovering information that is technological in nature. Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. The process of experimentation test requires that substantially all of the research activities constitute elements of a process of experimentation for a "qualified purpose." A purpose is not qualified if it relates to style, taste, cosmetic, or seasonal design factors. The business component test requires that research undertaken to discover information must be intended to be used to develop a new or improved business component of the taxpayer.

Max argued that LMI met the Code Sec. 174 test because it faced uncertainties throughout the development process, including how to cut and drape printed fabrics; fabric choices; thread sizes; details such as twists, pintucks, and pleating; modifying patterns for plus-size garments; fabric shrinkage; and the final fit of the garment. Max contended that LMI's in-house testing on textiles fell into the category of testing to determine if the design of the product is appropriate, and was thus not quality control. Max argued the technological information test was met because LMI fundamentally relied on science and engineering in its production process. He claimed that fit testing relies on engineering, fabric draping and fabric print alignment relies on material sciences, and fabric shrinkage and colorfastness tests rely on chemistry. With regard to the process of experimentation test, Max argued that many of LMI's activities related to the function of garments and thus were not undertaken for a disqualified purpose.

The Tax Court held that Max's design process did not constitute qualified research and that the expenses did not qualify for the research credit. The court found that LMI failed the Code Sec. 174 test because the uncertainties identified by Max were not uncertainties contemplated by Code Sec. 174. The court said that the proper thread size to use with a particular fabric and the proportions of a garment are well known and understood by the designers and patternmakers. The court reasoned that draping a particular fabric to achieve the desired aesthetic may be unknown, but the LMI garment makers already have the information necessary to address that unknown. Moreover, the court found that expenditures must be used for an investigative purpose to satisfy the Code Sec. 174 test and LMI's activities were not investigative in nature. In the court's view, LMI's process did not involve a systematic inquiry or careful study, but rather were common solutions to common problems. The court reasoned that LMI had previously encountered many of the "uncertainties" it faced in 2011 and 2012 because its employees knew how to align prints, alter standard patterns, fit garments, and cut fabrics along the proper grain. Further, the court noted that quality control testing is an activity that cannot qualify as research or experimental expenditures at all under Reg. Sec. 1.174-2(a)(3), and the court found that LMI's in-house testing on textiles was quality control. The court found that LMI had established parameters that textiles must meet to be used in garments, which LMI developed following prescribed standards from recognized industry organizations. The court noted that the tests were standardized, regular, and conducted to ensure the textile conformed to specific metrics. In the court's view, the tests were not undertaken to combat uncertainty but rather to ensure a high-quality product.

The court also found that LMI's activities did not meet the technological information test, The court said that, while LMI's employees had a working understanding of how different fabrics drape or how dyes affect materials, LMI did not use principles of hard sciences. The court further found that LMI failed the process of experimentation test because its design and creation activities were largely for cosmetic purposes, which are not a qualified purpose. The court noted that many of LMI's activities related to the function of garments but reasoned that most clothing design is inherently style driven. Moreover, the court found that LMI failed to establish that it followed a process of experimentation using a formalized scientific method to address uncertainties and not simply a trial and error process. The court found that LMI's process to create garments was not an experiment but a thorough integration of a creative development process. Further, the court found that LMI did not prove that substantially all of its garments underwent a process of experimentation. Finally, because Max did not satisfy any of the previous tests, the court did not address the business component test.

For a discussion of the research tax credit, see Parker Tax ¶104,900.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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