Phoenix Design Group v. Commissioner (Dec. 2024)
Intro
In December 2024, the U.S. Tax Court issued a pivotal opinion in Phoenix Design Group, Inc. v. Commissioner that should serve as a wake-up call to every company claiming the R&D tax credit. The court disallowed credits across multiple engineering projects and imposed a 20% accuracy-related penalty, citing a lack of contemporaneous documentation and no demonstrable process of experimentation under §41(d). While Phoenix Design Group was not our client, this ruling underscores the high bar taxpayers must clear to substantiate credits and the significant financial consequences of failing to do so.
Key Takeaways
- Case: Phoenix Design Group, Inc. v. Commissioner, T.C. Memo 2024-113, Opinion Issued: December 23, 2024
- Result: No qualified research found in the three sampled projects; 20% accuracy-related penalty under IRC §6662 upheld per the parties’ stipulation
- Why: Insufficient contemporaneous, activity-level documentation; failure to show objective technical uncertainty; and no systematic process of experimentation under §41(d)
- Fix: Map activities to §41(d), apply the shrinking-back rule to subcomponents where support exists, and document iterative tests as they happen
Case Facts
- Court: U.S. Tax Court
- Opinion Issued: December 23, 2024 (Dkt. No. 4759-22)
- Firm: Phoenix Design Group, Inc. (PDG), a mechanical, electrical, plumbing, and fire protection (MEPF) engineering firm
- Sampled Projects: Gerald Champion Military Psychiatric Unit; Baptist Memorial Hospital–North Mississippi (Oxford); Vanderbilt University Engineering and Science Building
- Issue: §41 research credit, engineering design activities (tax years 2013–2016)
- Outcome: No qualified research proven in the sample; penalties sustained.
- Full opinion (Leagle)
The Four-Part Test Under §41(d)
1. Permitted Purpose (Business Component Test)
Definition: Work must relate to developing a new or improved product, process, technique, invention, formula, or software for the taxpayer.
What examiners look for: Clear mapping of activities to a business component and evidence of intended improvement.
PDG outcome: Many activities were routine design or adaptation, not tied to new or improved components.
2. Elimination of Uncertainty (Section 174 Test)
Definition: Research must be undertaken to resolve uncertainty about capability, method, or design at the outset.
What examiners look for: Documentation showing technical uncertainty existed, not just business or economic unknowns.
PDG outcome: Relied on standard calculations and historical data; no credible demonstration of real technical uncertainty.
3. Process of Experimentation
Definition: Work must involve a systematic process such as modeling, simulation, or testing where alternatives are evaluated to resolve uncertainty.
What examiners look for: Evidence of iterative testing, hypothesis formation, and evaluation of results.
PDG outcome: The firm’s six-stage design process was linear, not iterative. The court held that performing routine calculations on available data does not constitute experimentation because the necessary information was already known.
4. Technological in Nature
Definition: Activities must fundamentally rely on principles of physical or biological sciences, engineering, or computer science.
What examiners look for: Documentation of how scientific or engineering principles were applied.
PDG outcome: Some activities lacked evidence of reliance on engineering principles.
Why the Sampled Projects Failed
- Much of PDG’s work was routine engineering or code compliance, not qualifying research.
- The six-stage process was linear, not iterative or hypothesis-driven.
- No contemporaneous, activity-level records linked employee time to qualified research.
- The court considered the shrinking-back rule (evaluating subcomponents) but could not apply it because the record lacked the documentation necessary to support eligibility even at the subcomponent level.
The Shrinking-Back Rule Explained
If an entire project does not qualify, the IRS and courts may “shrink back” to the most significant subcomponent to test eligibility. For example, if a hospital project fails, a single HVAC system design could be examined. In Phoenix Design Group, the court noted the rule but could not apply it due to inadequate documentation.
Qualified vs. Non-Qualified Activities
Qualified activities include:
- Iterative, hypothesis-driven testing
- Documented technical uncertainty
- Systematic evaluation of alternatives
- Reliance on engineering or scientific principles
Non-qualified activities include:
- Routine design or drafting
- Code compliance or standard calculations
- Adapting prior designs without experimentation
- Business or administrative tasks
How To Make Your R&D Credit Audit-Ready
- Map every activity to the §41(d) test.
- Apply the shrinking-back rule when whole projects fail, but support subcomponents with documentation.
- Capture contemporaneous records of hypotheses, alternatives, tests, and results.
- Link time and expenses to specific research activities.
- Audit your process annually to close gaps before filing.
Learn more about audit-ready R&D credit support
Penalties and Consequences
The Tax Court sustained a 20% accuracy-related penalty under IRC §6662. This ruling reinforces that poor documentation not only disallows credits but also creates additional tax exposure.
FAQs
Does a design phase automatically qualify as a process of experimentation?
No. Without iterative, documented testing, design is insufficient.
Can routine engineering or code compliance be claimed as R&D?
Generally no, unless coupled with technical uncertainty and experimentation.
Is after-the-fact documentation sufficient?
No. The court required contemporaneous, project-level records.
What if only part of a project involves technical uncertainty?
Only that portion may qualify. The shrinking-back rule may apply if properly supported.
Sources and Further Reading
- Phoenix Design Group, Inc. v. Commissioner, T.C. Memo 2024-113 (Leagle)
- IRS R&D Tax Credit Guidelines (ATG)
- 26 U.S.C. §41 - Qualified Research
