qualified research expenses/QREs Archives

Pilot models at scale: What George v. Commissioner teaches about the research credit

The US Tax Court’s recent decision in George v. Commissioner, T.C. Memo. 2026-10, addressed the application of the Section 41 research credit to supply qualified research expenses (QREs), focusing on whether chickens used in drug trials can qualify as “supplies.” The case provides useful insight into how courts evaluate technical uncertainty under Section 174 for purposes of the Section 41(d)(1)(A) subtest to qualified research, as well as the process of experimentation requirement under Section 41(d)(1)(C) in determining QREs.

Background

George’s of Missouri, Inc., the taxpayer’s S corporation, raises chickens from hatch to processing and handled the live production side of a large poultry operation. In commercial poultry production, “breeders” are hens that produce eggs while “broilers” are chickens raised for processing and sale. Once hatched, broilers are placed on farms and raised under tightly managed conditions, with producers managing feed composition, vaccines, and medications. To keep flocks healthy and profitable, George’s routinely tested different combinations of drugs, vaccines, feed additives, and the chickens themselves, often across entire flocks in real-world conditions, to evaluate their effectiveness. The dispute in George centered on whether these large-scale, production-level trials to develop a healthier, more uniform chicken qualified the chickens as supply QREs.

The Tax Court’s analysis

The Court examined whether the taxpayer faced the requisite uncertainty with respect to the development of a business component (here, a healthier chicken). In George, vendor testing occurred in controlled, “sterile” environments designed to eliminate external variables, whereas the taxpayer’s operations involved fluctuating temperatures, differing farm conditions, and complex biological interactions that could materially affect outcomes. The Court recognized that successful results in one real-world setting do not necessarily translate to another setting with different production environments, inputs, or biological conditions. As a result, prior success (whether in the lab or in other operational contexts) does not thereby eliminate taxpayer-specific uncertainty as to that setting. Thus, the Court found that taxpayer-specific uncertainty depends on whether the taxpayer faces uncertainty regarding performance under the specific operating conditions at issue.

The Court also addressed the type of trials performed by the taxpayer. The taxpayer did not run controlled lab tests; it raised broilers to full weight under actual production conditions to determine whether treatments worked. The Court found that this real-world testing could satisfy the technical uncertainty standard under Section 174. While additional requirements must be met for property to qualify as a “supply” for research credit purposes, satisfying the Section 174 standard allowed the taxpayer to treat the chickens as pilot models – and thus the chickens themselves, along with feed and other associated costs – as eligible inputs in the QRE analysis. That finding supports the notion that large-scale, production-level testing can qualify as experimentation under Section 174, even where it occurs outside a controlled laboratory setting.

In addition to addressing the Section 174 uncertainty standard, the Court rejected the Internal Revenue Services’ attempt to impose rigid substantiation requirements for the “substantially all” standard under the process of experimentation requirement. The taxpayer did not maintain detailed logs [...]

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Tax Court Says Pollution Control Systems Are Not Pilot Models, Rejects Tax Research Credits

On July 6, 2023, the US Tax Court issued its decision in Betz v. Commissioner, T.C. Memo. 2023-84. Betz considers the application of the pilot model supply rule to expenses incurred by a designer (CPI[1]) of made-to-order air pollution control systems called oxidizers. At issue was approximately $500,000 of research and development tax credits pursuant to Internal Revenue Code (IRC) Section 41 on wage and supplies expenses for 19 different oxidizers that CPI produced under various purchase agreements or purchase orders. Generally, IRC Section 41 grants qualifying taxpayers federal income tax credits for increasing research activities, calculated with respect to the amount of “qualified research expenses” (QREs) incurred by the taxpayer during the tax year over a base amount. The statute is complex and has been the subject of substantial controversy between the Internal Revenue Service (IRS) and taxpayers since its enactment in 1981.

In Betz, CPI generally oversaw the component fabrication process and the assembly of the systems at its subcontractor facilities and then installed or oversaw installation of the oxidizer at the customer’s location. Testing of the oxidizers generally occurred after assembly or after installation. The supply expenses generally included the major components of the various oxidizers, all of which were fabricated by subcontractors. CPI claimed the credit based on a study performed by a tax consultancy group, the fees for which were capped at a percentage of the research credits identified.

The IRS challenged whether the taxpayer met the test in IRC Section 41 that the research must be research “with respect to which expenditures may be treated as expenses under [IRC] section 174.” (See IRC Section 41(d)(1)(A).) The Tax Court found that CPI failed to substantiate that the claimed wages and supplies constituted IRC Section 174 “investigative” activities. CPI’s primary evidence was in the form of testimony from CPI executives and supervisory personnel whom the Tax Court found to be “vague, in conflict with the record, and lacking in credibility[.]” Alternatively, the Tax Court found that, even assuming CPI engaged in IRC Section 174 research activities that gave rise to IRC Section 41 creditable expenses, five of the projects constituted funded research given CPI’s complete transfer of rights in the results of any such research to its customers.

Regarding the supply QREs, the Tax Court held that taxpayer intent was essential to determining whether its efforts to create a pilot model satisfy the “uncertainty” standard in IRC Section 174 regulations. In that regard, the taxpayer had to show “that its purpose in producing that representation or model was to evaluate and resolve uncertainty about the product (i.e., to obtain unavailable information necessary to establish capability, method, or appropriate design).” The taxpayer failed to make this showing. The Tax Court pointed to the lack of “early-stage” testing as an indication that the oxidizers were not used as pilot models but were, in fact, final products.

Practice Point: Betz demonstrates that the IRS continues to scrutinize claims of qualified research expenses. The Tax Court’s [...]

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