Betz v. Commissioner

July 6, 2023 | Judge Nega | United States Tax Court | Docket Nos. 21587-18, 21588-18

Short Summary 

The case involved Mark Betz, Christine Betz, Dennis Lincoln, and Julia Lincoln, shareholders in Catalytic Products International, Inc. (CPI), an S corporation that designs air pollution control systems. They claimed a federal research tax credit for 2014 based on certain production costs and employee wages, arguing these were qualified research expenses. The IRS challenged the claim, questioning whether the costs and wages met the requirements for the credit, and whether some research was ineligible because it was “funded” by customers. The Tax Court ultimately sided with the IRS, finding the shareholders did not prove their projects qualified as pilot models, nor that the wages were for qualified research, and also determined that for five projects, CPI did not retain substantial rights in the research. As a result, the claimed credits were denied. 

Key Issues

• Did the taxpayers provide enough evidence to substantiate that their production costs and wages were actually qualified research expenses (QREs)? 

  The Court needed to decide whether the shareholders had sufficient documentation and proof to show that the amounts they claimed for production costs and employee wages were genuinely spent on research activities that meet the requirements for the R&D tax credit. This included evaluating whether their methods for estimating employee time and categorizing costs were reliable and supported by records 

• Were the products developed “pilot models” under the law? 

  One requirement for certain expenses to qualify is that the items produced must be “pilot models” created for research purposes, not just regular products made for sale. The Court had to determine if the systems at issue met this standard. 

• Did the S corporation retain “substantial rights” in the research, or was the research “funded” by customers? 

  If a company’s research is fully funded by a customer and the company doesn’t retain significant rights to the results, those expenses do not qualify for the credit. The Court had to review whether CPI retained enough rights in five of the projects to make the research creditable. 

Primary Holding 

The court ultimately decided against the taxpayers on all three main issues. First, it found that the production costs and wages claimed as qualified research expenses were not properly substantiated, as CPI relied on unsupported estimates rather than actual records or reliable tracking methods. Second, the court concluded that the systems produced were not “pilot models,” but rather regular products made for customer orders, so their costs did not qualify for the research credit. Third, for five projects, the court determined that CPI did not retain substantial rights in the research results, since the contracts gave customers exclusive ownership or control, making these projects ineligible due to being “funded research.” As a result, the court denied the research credits and upheld the IRS’s penalties, mainly because the taxpayers failed to meet the legal requirements and provide sufficient proof for their claims 

Specific Rulings 

1. Substantiation of Qualified Research Expenses (QREs) 

   • Ruling: The court denied the taxpayers’ claimed research expenses for both production costs and wages. 
   • Reasoning: The court found that CPI did not have actual records or reliable tracking of employee time or specific research activities. Instead, the company used rough estimates and after-the-fact interviews to allocate time and costs. The court said this was not enough to prove that the claimed expenses were truly related to qualified research. Without credible documentation, the claimed expenses could not be allowed. 
     

2. Whether the Products Were “Pilot Models” 

   • Ruling: The court decided that none of the products produced in the 19 projects qualified as “pilot models. 
   • Reasoning: Under the law, only the costs of making experimental prototypes (pilot models) for research can qualify for the credit (not the costs of regular products sold to customers). The court found that CPI’s systems were designed and built as finished products for customer orders, not as experimental prototypes. Therefore, the associated costs did not meet the “pilot model” standard required for the credit.
     
     

3. Retention of “Substantial Rights” / Funded Research 

   • Ruling: The court found that for five of the projects, CPI did not retain substantial rights in the research results, so those projects were considered “funded research” and not eligible for the credit. 
   • Reasoning: The contracts for these projects either gave customers exclusive ownership of the intellectual property or included terms that restricted CPI’s rights to use the research results. Because CPI did not keep substantial rights, the court said the work was essentially done for the customers, not for CPI’s own research, making these expenses ineligible for the R&D credit. 

Helpful Takeaways for Taxpayers 

 

• Keep detailed and accurate records 

  Maintain thorough documentation of employee time, research activities, and expenses. Reliable and contemporaneous records are essential if you want to claim research credits. 

• Use systematic tracking methods 

  Implement time-tracking systems or other formal processes to capture how much time employees spend on qualified research, rather than relying on estimates or after-the-fact interviews. 

• Understand the “pilot model” requirement 

  Make sure that any products or prototypes you claim as research expenses are truly experimental and created for research purposes, not just standard products made for sale. 

• Review contract terms with customers 

  Carefully examine your agreements to ensure your business retains substantial rights to the results of any research. If customers own or control the research results, related expenses may not be eligible for the credit. 

• Seek professional guidance early 

  Work with qualified tax professionals or consultants familiar with the R&D credit rules to help design proper documentation systems and review eligibility criteria before filing a claim.