Phoenix Design Group, Inc. v. Commissioner

December 23, 2024 | Travis A. Greaves, United States Tax Court Judge | Docket No. 4759-22 

Short Summary 

Phoenix Design Group, a Tennessee-based engineering consulting firm, claimed substantial R&D tax credits for their work performed on over 200 projects in 2013 through 2016. The IRS audited the company and denied the credits, arguing that the work did not meet the requirements for “qualified research” under the federal R&D tax credit rules. The main issue was whether the firm’s engineering design process, specifically for three sampled projects, truly involved a process of experimentation or uncertainty that the law requires for R&D credits. After a detailed review, the Tax Court agreed with the IRS, finding that Phoenix Design Group’s activities did not qualify for the credit and upholding the penalties assessed for filing inaccurate returns. 

Key Issues 

• Did Phoenix Design Group’s engineering work meet the definition of “qualified research” for the R&D tax credit? 

  The central legal question was whether the company’s engineering activities on three representative projects met all the requirements of “qualified research” as defined in the tax code. This required the court to examine if there was genuine uncertainty about how to design or create each project, and whether the company’s engineers went through a process of experimentation to solve those uncertainties, rather than just following standard engineering practices. 

• Did Phoenix Design Group have enough documentation and evidence to support their R&D tax credit claim? 

  The court needed to decide if the company kept records and could clearly explain how its engineers’ day-to-day activities involved research and experimentation. This issue focused on whether the company could show exactly what its engineers did to resolve technical challenges, or if they simply made decisions based on experience without a structured research process. 

• Should Phoenix Design Group be penalized for inaccurately claiming R&D tax credits? 

  Because the IRS not only denied the credits but also assessed accuracy-related penalties, the court had to determine whether Phoenix Design Group acted carelessly or negligently in claiming these credits. The key question was whether the firm’s actions justified a penalty under tax law, especially since the company and IRS had agreed on when penalties would apply if the credits were disallowed. 

Primary Holding 

The court decided that Phoenix Design Group did not qualify for the R&D tax credits it claimed for its engineering design work. The main reason was that the company could not show its projects involved true technical uncertainty or a real process of experimentation. Instead, the court found that the engineers mostly used their professional judgment and existing knowledge to make decisions, rather than experimenting or testing different solutions in a scientific way. As a result, the court held that none of the sampled projects met the definition of “qualified research.” Because of this, the IRS was correct to deny the credits, and Phoenix Design Group was also liable for accuracy-related penalties, as the parties had agreed would be the case if the credits were disallowed. 

Specific Rulings

1. Did the engineering design work on the three sample projects count as “qualified research” for the R&D tax credit? 

   • Ruling: The court decided that none of the three projects qualified as “qualified research” under the law.
   • Reasoning: The court found that Phoenix Design Group could not show real technical uncertainty in how the projects would be designed, nor did the company document any process of experimentation. Instead, the engineers mostly relied on their professional experience and followed established practices, rather than testing new ideas or solving problems through research. The court explained that simply encountering challenges or making choices during a project does not meet the legal standard unless there is a structured process of experimentation to resolve genuine uncertainty.
     
     

2. Did Phoenix Design Group provide enough documentation and evidence to support its R&D credit claims? 

   • Ruling: The court found the company’s evidence and records were not detailed enough to support the credits.
     
   • Reasoning: The company’s timesheets and project records described work in very general terms, without showing what specific problems were investigated or how engineers worked through a process of experimentation. The court noted that, without clear records or explanations tying activities to research and experimentation, it could not verify that the claimed work met the requirements for the credit.
     
     

3. Should Phoenix Design Group be liable for accuracy-related penalties for the denied credits? 

   • Ruling: The court held that the company was liable for the penalties.
     
   • Reasoning: The parties had agreed that if none of the sampled projects qualified, then penalties would apply. Since the court ruled against the company on the main issue, it found that Phoenix Design Group was responsible for the accuracy-related penalties as specified by their agreement with the IRS.

Helpful Takeaways for Taxpayers

• Document your research activities in detail. 

  It’s not enough to simply state that you faced challenges or that engineers worked on a project. You need to keep detailed records that explain what technical problems you encountered, what information was missing or uncertain, and how you tried to solve those problems. Good documentation should include project notes, test results, meeting records, and any other evidence showing how your team worked through the unknowns. This level of detail can make the difference if your claim is reviewed by the IRS or a court. 

• Show real technical uncertainty and experimentation. 

  For your work to qualify for the R&D tax credit, you must be able to point to genuine uncertainties (questions where the answer wasn’t known at the start) and demonstrate that your team used a systematic approach to find solutions. This usually means going through a process of testing different options, gathering data, evaluating results, and sometimes trying again. Routine decision-making or applying well-understood engineering solutions does not meet this standard. 

• Connect employee activities directly to qualified research. 

  Simply tracking hours or assigning project numbers isn’t enough. You should be able to show exactly what each employee was doing that counted as research, such as designing an experiment, analyzing unexpected test results, or developing a new solution. Clear, descriptive time entries and narratives help prove that wages claimed for the credit were spent on qualified activities, not just general project work. 

• Don’t rely solely on titles or general project descriptions. 

  The court in this case emphasized that having “engineers” or professionals involved is not by itself proof of qualified research. What matters is the substance of what those employees did. Your documentation should go beyond job titles or vague descriptions. Explain the specific tasks, challenges, and research processes involved in each part of the project.

• Work proactively with your advisors and review IRS guidance. 

  The R&D tax credit rules can be complex, and court decisions often clarify or tighten what counts as qualified research. Regularly check in with your tax advisors and stay updated with IRS guidelines and recent case law. This proactive approach can help you structure your projects, document your work correctly, and reduce the risk of credits being denied or penalties being assessed.