Court Opinion

ID: 2996022
Source: CourtListenerOpinion
Date Created: 2015-09-24 19:24:26.714523+00
Date Added: 2024-06-11T15:02:41.128925
License: Public Domain

In the
 United States Court of Appeals
               For the Seventh Circuit
                         ____________

No. 01-4222
NICHOLAS E. EUSTACE, et al.,
                                        Petitioners-Appellants,
                               v.

COMMISSIONER OF INTERNAL REVENUE,
                                          Respondent-Appellee.
                         ____________
      Appeal from the United States District Court Tax Court
         Nos. 21088-96 et al.—Maurice B. Foley, Judge.
                         ____________
 ARGUED NOVEMBER 7, 2002—DECIDED DECEMBER 13, 2002
                    ____________

 Before BAUER, EASTERBROOK, and MANION, Circuit
Judges.
  EASTERBROOK, Circuit Judge. Applied Systems, a Sub-
chapter S corporation, develops and sells software that in-
dependent insurance agencies use to manage their busi-
nesses. During the early 1990s Applied Systems improved
its software package, and its investors (the taxpayers in
this case) want to take a tax credit under 26 U.S.C. §41
based on the amount by which Applied Systems increased
its R&D expenses during these years. Taxpayers who have
sought a credit under §41 for commercial software devel-
opment have been uniformly unsuccessful. See, e.g., Tax
& Accounting Software Corp. v. United States, 301 F.3d
1254 (10th Cir. 2002); Wicor, Inc. v. United States, 263 F.3d
2                                                No. 01-4222

659 (7th Cir. 2001); United Stationers, Inc. v. United States,
163 F.3d 440 (7th Cir. 1998); Norwest Corp. v. CIR, 110 T.C.
454 (1998). The only exception—on which the taxpayers in
this case principally rely—is the district court’s decision in
Tax & Accounting, 111 F. Supp. 2d 1153 (N.D. Okla. 2000),
which the tenth circuit reversed after they filed their brief.
Applied Systems’ claim is no better than the others.
  The evidence at trial in the Tax Court shows that Applied
Systems engaged in normal software development. Dur-
ing the early 1990s it enhanced its software package so
that it could handle additional ratings computations, so
that it could handle transactions between insurers and
agencies, so that multiple people could work on the same
customer file simultaneously without corrupting or over-
writing each others’ changes, and so that more functions
could be handled in a given amount of random access
memory. It discarded a word processing module licensed
from another vendor, replacing it with a simple text editor
with reduced memory demands but good form-letter-
generation features. These are not the only changes, but
they show the character of the work. None of it was pioneer-
ing; all of it entailed variations on themes long used by
other developers. The Commissioner conceded that this
work met many of the requirements in §41 but contested
several others, of which only two require attention: that the
research be “undertaken for the purpose of discovering
information which is technological in nature” (§41(d)(1)
(B)(i)), and that the activities “constitute elements of a
process of experimentation” (§41(d)(1)(C)). The Tax Court
concluded that Applied Systems flunked both tests—the
former because it did not produce an “innovation in under-
lying principle” and the latter because the research in
question was not designed to dispel uncertainty about
the technological possibility of developing software of this
kind. T.C. Memo 2001-66 (2001).
No. 01-4222                                               3

   Taxpayers concede that if §41 means what the Tax Court
thought, then they lose. Applied Systems has not tried to
show that its software embodies any leap in informa-
tion technology or that there was any doubt about the
technological ability to produce software of this kind. But
it contends that §41 does not set so high a standard and
that industrious development of software through a proc-
ess of trial and error meets the statutory standard. The
difficulty with this position is that the Tax Court did not
get its legal views out of thin air. This court announced
them in United Stationers, and Wicor declined an oppor-
tunity to revisit the subject. United Stationers held that
software development satisfies the statutory technological-
information requirement only if “the research is intended
to expand or refine existing principles of computer science”
and the resulting information is “of broad effect” (163 F.3d
at 444). As for experimentation, we held that the taxpayer
must formulate and test hypotheses in order to dissi-
pate uncertainty about the possibility of success, a stan-
dard that fine-tuning (or debugging) of computer programs
does not satisfy. Id. at 445-46.
  Although the word “experiment” has many shadings in
common speech, we held that as used in §41 it has the
scientific sense of forming and testing hypotheses rath-
er than the lay (or even engineering) sense of trial and
error. Galileo engaged in experiments about acceleration
when he rolled balls down an inclined plane. An auto
manufacturer trying different nozzles from those on hand
to find the one that applies the smoothest coat of paint
is not engaged in “experimentation” under this view, nor
is a software developer trying different methods to im-
plement a feature accompanied by maximum execution
speed and minimum demand on system resources such
as RAM. Tinkering differs from experimentation in the vo-
cabulary of research—and §41 is about research, and thus
about use of the scientific method. Authors and movie
4                                             No. 01-4222

makers playing with sentences and scenes to find what
most impresses the public are not doing scientific research
using “experimentation”. Just so with software. Developers
are authors too; that they write lines of code readable by
machines rather than lines of words readable by people
does not fundamentally change the nature of the task
and make one form of writing “experimentation” when the
other is not. Experimentation is a subset of all steps tak-
en to resolve uncertainty; otherwise searching for a place
to park a car would be a “process of experimentation”.
  The tenth circuit has disagreed with our understanding
of §41. It held in Tax & Accounting Software that the
technological-information requirement can be satisfied by
new knowledge that is less a step forward than United
Stationers required—but that “information must be sepa-
rate from the product that is actually developed.” 301 F.3d
at 1262. With respect to experimentation, the tenth cir-
cuit was not receptive to the idea that only hypothesis
formulation and testing fits, but it still held that the
taxpayer must establish that testing was designed to
overcome uncertainty about whether the desired end re-
sult was technologically feasible. Id. at 1264-68. Applied
Systems cannot meet these definitions any more than
those in United Stationers.
  In the long run, neither our view nor the tenth circuit’s
has staying power. Both United Stationers and Tax &
Accounting Software analyzed §41 without the benefit of
the regulations that are supposed to illuminate the path
to decision. Section 41’s predecessor was enacted in 1981,
and §41 has been on the books in its current form since
1986, but the Internal Revenue Service has yet to promul-
gate the regulations that are important to this statutory
design. (Section 41 refers ten times to regulations that
the Secretary of the Treasury is to develop and issue.) The
most recent draft was published almost a year ago, 66 Fed.
Reg. 66,362 (Dec. 26, 2001), and has not been made final.
No. 01-4222                                                 5

Applied Systems asks us to discard the approach of United
Stationers and use the one found in the draft regulations.
That would not be sound, for two reasons: first, proposed
regulations have no legal effect; second, the draft says
that when final the regulations will apply only to taxable
years ending on or after December 21, 2001. So Applied
Systems gets no solace from this source even if the reg-
ulatory approach would favor its position (which we
doubt, given that the regulations essentially track United
Stationers’ definition of “experimentation” as use of the
scientific method).
   One other line of argument requires only brief mention.
Applied Systems thinks that we should disregard Wicor
and United Stationers on the ground that the credit sought
by those taxpayers was covered by §41(d)(4)(E), which
disqualifies the costs of internal-use software except to
the extent allowed by (nonexistent) regulations. In both
Wicor and United Stationers the taxpayer contracted with
a consulting firm to develop software that the taxpayer
would use in its own business, while Applied Systems
developed software for sale to customers. Yet §41(d)(4)(E)
has nothing to do with the definitions in §41(d)(1), and
Wicor stopped there. United Stationers held that the tax-
payer lost under both §41(d)(1) and §41(d)(4)(E). That
an opinion contains multiple grounds of decision does
not justify disregarding any of them; it would be no more
sound to throw out United Stationers’ interpretation of
§41(d)(1) than to disregard its interpretation of §41(d)(4)(E)
(which was that contracting-out the development of soft-
ware for in-house use fits within the §41(d)(4)(E) disqual-
ification). Sections 41(d)(1) and (d)(4) are independent
rules, which deserve, and have received, independent con-
structions.
  Whether we apply the definitions articulated in United
Stationers or the competing interpretation from Tax
& Accounting Software, simple industrious software de-
6                                            No. 01-4222

velopment does not qualify for the §41 tax credit. Accord-
ingly, the judgment of the Tax Court is
                                               AFFIRMED.

A true Copy:
      Teste:

                       ________________________________
                       Clerk of the United States Court of
                         Appeals for the Seventh Circuit

                  USCA-02-C-0072—12-13-02