What is “Research and Development?”

Starting with the understanding that expenses incurred for “research and development” are generally deductible under Section 174, lets expand a bit on what exactly constitutes R&D.

With some expenses, it’s quite obvious that they represent “research and development” as intended by the Code:

Costs incurred to perform clinical trials on a promising new anti-depressant drug? Clearly R&D.

Costs incurred to develop a fat-free yogurt that doesn’t let you down in the flavor department like so many others? R&D.

Costs incurred to house three semi-conscious transients in your basement in hopes of  creating your very own human centipede in time for Halloween? R&D, but most certainly in violation of several Federal and state statutes.  

But what about the costs to design and implement a complex tax shelter? Not quite as clear, is it?

One could certainly argue that a tax shelter is a “product,” no different than an electric car or the Shake Weight. Wouldn’t it follow that the hours spent researching tax strategies and potential law changes in hopes of finding a “legal shelter” constitute the type of research and development costs contemplated by Section 174 of the Code?

According to the Tax Court and its decision on Wednesday in  The Heritage Organization LLC,[1] the answer is no.

Facts of Heritage Organization LLC

I’ll spare you many of the facts, as they’re a bit lengthy and exceedingly convoluted. All that’s relevant is this: An LLC (Heritage) was in the business of selling tax shelters. A related entity did the necessary legwork: searching for opportunities in the Code, developing the products, and researching via public information those individuals who may be prospective candidates for the shelter. Heritage would then sell the shelter and be compensated accordingly.

In the late 1990’s, Heritage began to market and sell the “Son of Boss” transaction,  a complex tax shelter necessitating the establishment of trusts, corporations and partnerships, the end result of which was to allow wealthy clients to take advantage of certain “built-in losses.” When the dust settled on Heritage’s tax shelters, the LLC was required to pay $550,000 to each of 11 corporations it had created to implement the Son of Boss. Heritage then deducted the $6,050,000 on its 2001 tax return as “research and development expenses.”

Relevant Law

To review, Section 174 and the related regulations define “research or developmental expenditures” as:

…expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”[2] The term generally includes all such costs incident to the development or improvement of a product.

The term “product” includes “any pilot, model, process, formula, invention, technique, patent or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale”.[3]

The expenditures may qualify as research and development expenses in “the experimental or laboratory sense” if they are incurred for activities to “eliminate uncertainty concerning the development or improvement of a product.”[3] Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the design of the product.

Taxpayer Argument and Tax Court Decision

 Heritage argued that the $,00,000 constituted “research and development” expenses under the meaning of Section 174, as they were incurred by Heritage to develop a set of shelf corporations with embedded losses.

The Tax Court disagreed, holding that the expenses did not qualify as R&D expenses. [4] In reaching its decision, the court focused on the fact that tax shelters are neither scientific, nor developed in an experimental or laboratory sense. Perhaps more importantly, any problem inherent in a tax shelter could not be remedied by the “developer” of the shelter, but rather only by a change in the tax law. The Tax Court explained its position as follows:

The payoff amounts fail to meet the section 174 requirement that the expenditures be for research in the experimental or laboratory sense. The payments were not made for scientific activities.

Further, the payoff amounts do not qualify as research and development expenses as they were not incurred to eliminate uncertainty concerning the development of a product. The uncertainty Heritage wished to eliminate was whether the tax planning structure created would be useful in a tax system without the generation skipping transfer tax exemption. The uncertainty on Heritage’s part would be resolved by a change in the tax law, not by any actions undertaken by Heritage.

Moral of the Story?

In order for an expense to qualify as a research and development expense under Section 174, the expense: 

• Should be incurred for scientific and laboratory based activities;
• The costs should be incurred to develop a product, or eliminate uncertainty concerning the development or improvement of a product;
• The activities of the taxpayer must be intended to discover information not otherwise available regarding the capability of the product.