Court Opinion

ID: 9374747
Source: CourtListenerOpinion
Date Created: 2023-02-23 20:01:15.542478+00
Date Added: 2024-06-11T16:49:00.383146
License: Public Domain

United States Tax Court

                               T.C. Memo. 2023-20

                   SCOTT MOORE AND GAYLA MOORE,
                             Petitioners

                                           v.

               COMMISSIONER OF INTERNAL REVENUE,
                           Respondent

                                     —————

Docket No. 18632-19.                                      Filed February 23, 2023.

                                     —————

Mark Chandler Goldenberg, for petitioners.

Britton G. Wilson and Stephen A. Haller, for respondent.

         MEMORANDUM FINDINGS OF FACT AND OPINION

        COLVIN, Judge:         Respondent determined deficiencies in
petitioners’ income tax of $68,263 for 2014 and $141,945 for 2015.
Petitioner Gayla Moore was the sole owner of Nevco, Inc. (Nevco), a
subchapter S corporation, during those years. Nevco claimed the section
41 1 credit for increasing research activities (research credit) on its 2014
and 2015 Forms 1120S, U.S. Income Tax Return for an S Corporation.
This credit flowed through to petitioners’ individual income tax returns
for 2014 and 2015.

      Mr. Robert was Nevco’s president and chief operating officer
(COO) during 2014 and 2015. After concessions, the issue for decision
is whether (and if so to what extent) Nevco is entitled to a research credit
under section 41 for compensation paid to Mr. Robert during 2014 and

        1 Unless otherwise indicated, all statutory references are to the Internal

Revenue Code, Title 26 U.S.C., in effect at all relevant times, all regulation references
are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant
times, and all Rule references are to the Tax Court Rules of Practice and Procedure.

                                 Served 02/23/23
                                         2

[*2] 2015. We hold that (1) Mr. Robert did not engage in direct
supervision or direct support (as provided by section 41(b)(2)(B)(ii)) of
persons who performed qualified services during 2014 and 2015 and
(2) even though he was extensively involved in new product
development, the record does not show the portion of Mr. Robert’s work
on new product development which meets the requirements of “qualified
research” under section 41(b)(2)(B)(i). Thus, Nevco cannot consider Mr.
Robert’s wages in computing the research credit for 2014 and 2015.

                             FINDINGS OF FACT

A.     Petitioners

       Mrs. Moore was the sole owner and chief executive officer of Nevco
in 2014 and 2015. 2 Nevco manufactures scoreboards for high school and
college athletic events, as well as LED video displays, score tables, and
other types of equipment for indoor and outdoor sports venues. Mrs.
Moore’s husband, Scott Moore, was the vice president of strategic
initiatives of Nevco during those years. Petitioners resided in Florida
when the Petition was filed.

B.     Nevco Personnel

       1.      Mr. Robert

       Mr. Robert was a software engineer early in his career. He later
was chief information officer at an electronics firm, vice president at
another electronics company where he focused on manufacturing
initiatives, manufacturing consultant at an international accounting
firm, and manufacturing consultant at his own consulting firm.

       Mr. Robert was an independent consultant at Nevco from 2004 to
2006 and an employee from 2006 to 2016. When he arrived at Nevco in
2004, the company was losing market share because Nevco’s product
line had fallen behind those of other companies. From 2004 to 2006 he
advised petitioners on Nevco’s personnel and inventory requirements
and sometime before 2014 he reorganized the entire staff. He held the
position of COO from 2006 to 2016 and was president and COO during
2014 and 2015. During all those years he reported to Mrs. Moore. The
Moores wanted Mr. Robert to focus on new product development. As a

        2 Mr. Moore testified that Mrs. Moore’s ownership of the stock was through a

trust, but the parties stipulated her direct ownership and we so find.
                                           3

[*3] result, Mr. Robert spent 50%–65% of his time working on new
product development. 3

       Mr. Robert’s base compensation was $85,092 in 2014 and
$178,956 in 2015. He also received (1) a “senior management bonus” of
$253,285 in 2014; and (2) a total bonus of $1,890,137 in 2015, comprising
$222,162 as a “senior management bonus” and $1,667,975 as an
“additional bonus.” The “additional bonus” was based on Nevco’s
increase in enterprise value as measured by a multiple of EBITDA
(earnings before interest, taxes, depreciation, and amortization) over a
four-year period. Mr. Robert could strive to increase the value of Nevco
in any way; thus, he was not limited to achieving that goal by performing
research or developing new products. In 2014 and 2015 he was the only
Nevco employee to receive an additional bonus tied to growth in the
value of Nevco.

       The management of Nevco operated informally in many ways.
The high level of trust and informality that existed among Nevco’s top
management is illustrated by the fact that the formula for Mr. Robert’s
additional bonus was never written even though it potentially involved
substantial amounts of money. Neither Mr. Robert nor anyone at Nevco
kept records of his activity or the amount of time he spent on any
particular project. Mr. Robert did not report his activity or time
allocation to any other Nevco employee. No one at Nevco maintained
documents during 2014 and 2015 detailing any of the officers’ or
employees’ responsibilities and duties.

       As president, Mr. Robert was responsible for the entire company.
Mrs. Moore managed many of the company’s financial initiatives, and
Mr. Moore supervised most of the marketing and sales initiatives. Their
assistance enabled Mr. Robert to focus his attention on overseeing
Nevco’s operations and new product development during 2014 and 2015.

       Mr. Robert’s office was in the building across the street from the
factory where the engineering department was located during 2014 and
2015. Dave Paslay was the director of engineering at Nevco, and he
reported to Mr. Robert. During those years Mr. Paslay and Mr. Robert
had weekly project update meetings that lasted from one to three hours.
At those meetings Mr. Paslay updated Mr. Robert on the engineers’
progress on various projects at Nevco. The discussions were extremely
detailed. The front-line engineers did not attend those meetings. Mr.

      3   As discussed below, the parties dispute this percentage.
                                                  4

[*4] Paslay and Mr. Robert also met in each other’s office daily or almost
daily, sometimes more than once daily, during 2014 and 2015.

          2.        Other Senior Staff

      The members of senior management during 2014 were Messrs.
Robert, Paslay, Phalan, Schulte, and Winkler. Mr. Robert chaired and
set the agenda for the weekly meetings of that group. No one kept
written minutes for any of the meetings conducted at Nevco during 2014
and 2015. The chief financial officer (CFO) of Nevco was Dan Phalen in
2014 and Chad Schnarre in 2015. 4 Jeffrey Schulte was the purchasing
manager, and Ed Caperton was the quality and service manager. In
2015 Mike Lane was vice president of sales, Mike West was plant
manager, Cheryl Corte was supervisor of shipping and receiving, and
Mr. Winkler was large project supervisor. 5 Mr. Robert directly
supervised those individuals.

          3.        Engineering Department

       Mr. Paslay was the direct supervisor of the six to ten engineers in
Nevco’s engineering department during 2014 and 2015. Mr. Paslay
supervised the engineers’ work on new product design, the development
and improvement of existing products and the manufacturing processes
for those products. During 2014 and 2015 Mr. Robert was the direct
supervisor of Mr. Paslay and the second-level supervisor of the other
engineers in the engineering department. Mr. Robert was not a member
of the engineering department.

      The engineers engaged in qualified research during 2014 and
2015. 6 Some of Nevco’s engineers did not have a college degree in
engineering. Engineering department employees did not record how
they spent their time during 2014 and 2015.

      4 The organizational chart names Mr. Phalen as CFO during May 2015;

however, the parties stipulated and we find that Mr. Schnarre was CFO throughout
2015.
          5 The organizational chart says Mr. Winkler was director of new product
development, but the parties stipulated and we find that he was large project
supervisor. Exhibit 6–J spells his name “Winkeler,” but Exhibit 7–J spells it (and we
find it is) “Winkler.”
          6   The parties stipulated this fact.
                                    5

[*5] C.     New Products Under Development in 2014 and 2015

       Mr. Robert contributed to Nevco’s new product development
during 2014 and 2015 through his numerous meetings with Mr. Paslay
and his visits to the engineering department and manufacturing area.
Five of those products are discussed next.

      1.     Scoreboard Truss

       A scoreboard truss is a structure or extension above the
scoreboard with visible girders to which personalizing items may be
added, such as school or team logos, names, and mascots. Nevco
historically purchased pre-engineered trusses from third parties. This
practice resulted in lost sales due to lead times and the costs of the pre-
engineered trusses.        Mr. Robert concluded that Nevco could
manufacture scoreboard trusses in house. As a result Nevco developed
this capability and subsequently introduced larger trusses into its truss
product line. He developed processes to design the trusses, and to build
them using aluminum and Nevco’s existing equipment. Mr. Robert
worked with members of the engineering department to help ensure
that Nevco’s trusses were durable and feasible for Nevco to
manufacture. Through an experimental process, Mr. Robert, Mr.
Paslay, and the engineering staff developed technology for these new
scoreboard trusses which enabled them to withstand winds up to 180
miles per hour.

      2.     Scorbitz

      Scorbitz is a Nevco product that transmits scoreboard
information, such as the score and time remaining, to interested users’
personal devices. Mr. Robert was extensively involved with the
development of Scorbitz. Mr. Robert was project leader for Scorbitz until
2014 or 2015. The engineers, including Mr. Paslay, focused on the
technical aspect of what could be done. Mr. Robert directed the
engineering staff toward a design that Nevco could build which provided
value to potential customers and would be marketable. In addition, he
defined expectations for how the product would function.

       Mr. Robert used his programming background to assist with
development of the database, which was an important part of the
project. He worked with the engineers to develop database technology
that could transfer scoreboard information to the cloud and back to user
devices. Mr. Robert, Mr. Paslay, Mr. Moore, and one other individual
were named on the Scorbitz patent issued March 15, 2016. In 2014 or
                                   6

[*6] 2015 Mr. Moore supplanted Mr. Robert as project leader for
Scorbitz. Mr. Moore’s role was primarily customer-facing and Mr.
Robert remained focused on product development.

      3.     New Caney Ribbon Board

       The New Caney Ribbon Board is an LED display that extends 276
feet along both sides of the New Caney, Texas, high school stadium. It
can be programmed to show various images, such as the current score
and advertisements. Nevco’s New Caney ribbon board was a prototype.
At the outset of the project, Mr. Robert defined the requirements of the
product.    As the project progressed, he participated in product
development by sharing his ideas and suggesting modifications to how
the user would operate the ribbon. It was essential that the ribbon board
be affordable for small colleges and high schools and that one person be
able to operate it. Mr. Robert’s ideas and technical suggestions were
important in achieving these design objectives.

      4.     MPCX–2

       The MPCX was a hand-held device used to operate Nevco’s
scoreboards.    The product was popular among customers, but
interference problems arose when several MPCX devices were operated
near one another. At some time during 2014 and 2015 Mr. Robert
decided that the MPCX had to be redesigned in order to eliminate the
interference. The second version of the MPCX, the MPCX–2, was
designed by a team coordinated by Mr. Robert to eliminate this problem.

       Mr. Robert was the leader of the MPCX–2 project. He made all
the decisions but delegated certain tasks including supplier selection
and circuit board design to the procurement and engineering
departments. Nevco employees administered a barrage of tests to
identify components to be obtained from third parties for installation by
Nevco on the circuit board. Both Mr. Robert and Mr. Paslay participated
in testing the components under consideration. The test results were
used by the engineering department in designing a circuit board that
could use the chosen component.

      5.     Slim Shot Clock

      When Mr. Robert became president of Nevco, the company had
produced the same bulky shot clock for several years. That shot clock
had protruding LEDs which could be damaged by errant basketballs.
                                         7

[*7] Mr. Robert proposed a new design, the Slim Shot Clock, and
instructed his subordinates to begin building prototypes in house.

       The prototypes employed different configurations for LED
viewing angles, impact resistance, plexiglass type, and structural
materials. Mr. Robert instructed the manufacturing and procurement
departments to build approximately 20 prototypes before ultimately
selecting a design that he believed was satisfactory. Designing the Slim
Shot Clock was an iterative process with many designs, experiments,
and failures. Each decision to reject a prototype was made by Mr.
Robert.

D.     Tax Returns

       Petitioners filed their 2014 and 2015 joint income tax returns on
Forms 1040, U.S. Individual Income Tax Return. Nevco filed its 2014
and 2015 income tax returns on Forms 1120S. Nevco claimed research
credits on those returns, which flowed through to petitioners’ individual
income tax returns for 2014 and 2015. Nevco used the base period 1984
to 1988 to calculate the fixed-base percentage for its 2014 regular
research credit. Nevco used the alternative simplified credit method to
calculate its 2015 research credit. An accounting firm prepared
petitioners’ Forms 1040 and Nevco’s Forms 1120S for both 2014 and
2015.

                                    OPINION

A.     Introduction

       After concessions, 7 we must decide whether (and if so to what
extent) Nevco may take into account compensation paid to Mr. Robert,
Nevco’s president and COO during 2014 and 2015, in computing Nevco’s
research credit for those years. That in turn requires that we decide
whether Mr. Robert was engaged (1) in performing “qualified services,”
see § 41(b)(2)(B)(i), or (2) in direct supervision or direct support of
persons who performed qualified services during 2014 and 2015, see
§ 41(b)(2)(B)(ii).

        7 Respondent concedes that Nevco is entitled to the research credit for wages

paid to personnel in Nevco’s engineering department, including Mr. Paslay.
                                    8

[*8]   1.    Section 41

       Section 41(a) establishes the method for computing the research
credit. § 38(b)(4). A taxpayer’s qualified research expenses include “in-
house research expenses” “which are paid or incurred by the taxpayer
during the taxable year in carrying on any trade or business of the
taxpayer.” § 41(b)(1)(A). A taxpayer’s “in-house research expenses”
include “any wages paid or incurred to an employee for qualified services
performed by such employee.” § 41(b)(2)(A)(i). Section 41(b)(2)(A)
includes as wages “all remuneration . . . for services performed by an
employee for his employer, including the cash value of all remuneration
(including benefits) paid in any medium other than cash.” See
§§ 41(b)(2)(D)(i), 3401(a). An employee performs “qualified services” by
either “(i) engaging in qualified research, or (ii) engaging in the direct
supervision or direct support of research activities which constitute
qualified research.” § 41(b)(2)(B).

       2.    Time Spent by Mr. Robert on New Product Development

      Petitioners contend that Nevco properly counted 65% of Mr.
Robert’s compensation in computing the research credits for 2014 and
2015. Respondent contends petitioners have not adequately proven that
percentage.

       Mr. Robert testified that he spent two thirds or more of his time
working on new product development in 2014 and 2015. He also said he
spent “well north of 50%” on new product development. His testimony
was substantially corroborated by the credible testimony of Mr. Moore
and Mr. Paslay. In challenging that claim respondent properly relies on
the total lack of written records showing how Mr. Robert used his time.
Respondent also points out that, as president, Mr. Robert had many
other duties. But we are satisfied that with the assistance of petitioners,
who handled substantial duties that would otherwise have been
performed by Mr. Robert, Mr. Robert spent from 50% to 65% of his time
on new product development during 2014 and 2015. However, as
discussed below, the precise percentage does not affect the result
because not all of Mr. Robert’s work on new product development was
qualified services.

B.     Whether (and if so to What Extent) Mr. Robert Engaged in
       Qualified Research

      Under section 41(d), four requirements must be met in order for
an activity to be “qualified research.” First, the research expenditures
                                     9

[*9] must be eligible to be treated as expenses under section 174.
§ 41(d)(1)(A). Under section 174(a)(1), “[a] taxpayer may treat research
or experimental expenditures which are paid or incurred by him during
the taxable year in connection with his trade or business as expenses
which are not chargeable to capital account.” Those “expenditures so
treated shall be allowed as a deduction.” § 174(a)(1). Treasury
Regulation § 1.174-2(a)(1) defines “research or experimental
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.”

       Second, the research must be undertaken to discover information
which is “technological in nature.” § 41(d)(1)(B)(i). Third, the
application of that research must be “intended to be useful in the
development of a new or improved business component of the taxpayer.”
§ 41(d)(1)(B)(ii). Fourth, “substantially all of the activities of” the
research must “constitute elements of a process of experimentation for
a purpose” related to “a new or improved function,” “performance,” or
“reliability or quality.” § 41(d)(1)(C), (3)(A). Section 41(d)(4) provides a
list of activities that are specifically excluded from the definition of
qualified research.

      Treasury Regulation § 1.41-4(a)(5)(i) defines “process of
experimentation” as “a process designed to evaluate one or more
alternatives to achieve a result where the capability or the method of
achieving that result, or the appropriate design of that result, is
uncertain as of the beginning of the taxpayer’s research activities.”
Treasury Regulation § 1.41-4(a)(5)(i) also provides that a process of
experimentation

      involves the identification of uncertainty concerning the
      development or improvement of a business component, the
      identification of one or more alternatives intended to
      eliminate that uncertainty, and the identification and the
      conduct of a process of evaluating the alternatives
      (through, for example, modeling, simulation, or a
      systematic trial and error methodology).

      Treasury Regulation § 1.41-4(a)(4) provides as follows regarding
the use of technology in the process of experimentation:

      For purposes of section 41(d) and this section, information
      is technological in nature if the process of experimentation
                                   10

[*10] used to discover such information fundamentally relies on
      principles of the physical or biological sciences,
      engineering, or computer science. A taxpayer may employ
      existing technologies and may rely on existing principles of
      the physical or biological sciences, engineering, or
      computer science to satisfy this requirement.

       The parties dispute whether (and if so, to what extent) Mr. Robert
performed qualified services in 2014 and 2015 by engaging in qualified
research; that is, whether or to what extent his work met these four
requirements, and he thus performed qualified research during those
years. As stated above, not all of Mr. Robert’s work on new product
development is qualified research, and thus, all of that work cannot be
considered in computing the credit. Petitioners seem to acknowledge
this point. They state in their opening brief that “at least some” of Mr.
Robert’s work on new product development was qualified research.
More specifically, in their opening brief petitioners state that “[t]he
testimony presented at trial supports the proposition that at least some
of the activities in which Mr. Robert engaged in during 2014 and 2015
as part of Nevco’s new product development were ‘qualified research’ as
defined under section 41(d)(1).”

       Unfortunately from petitioners’ standpoint, the record provides at
best little on which to base a finding regarding the portion (i.e., the
number of hours) of his work on new product development which was
qualified research. The record provides no estimates of the amount of
time Mr. Robert spent on qualified research as distinguished from the
broader category of new product development.

       On the truss project, he received (primarily from Mr. Paslay)
descriptions of the engineers’ progress and he specified the
requirements for the product. Those activities were not qualified
research (i.e., were not research applying technology in an experimental
process). His work with the engineers to identify a design that would
perform well in high winds may have involved qualified research, but
our record does not show how much time he spent on that activity.

       For the Scorbitz project, Mr. Paslay testified that the engineers
knew “the technical aspect of everything that could be done.” Mr. Robert
urged finding the value for the customer, and he guided the concept into
something that would be marketable. He was also instrumental in
developing the requirements for the product. That activity was not
qualified research (i.e., was not research applying technology in an
                                   11

[*11] experimental process). On the other hand, he was involved in the
technical details of programming how the scoreboard data would get to
the cloud and back to users’ phones. That work may have constituted
qualified research, but our record does not show how much time Mr.
Robert spent doing these things.

       His work on Scorbitz led to his name with three others from Nevco
being included on a patent. This fact supports petitioners’ position here.
See Fudim v. Commissioner, T.C. Memo. 1994-235, 1994 WL 223280,
at *12 (finding that the contemporaneous award of two patents
supported the taxpayer’s claim to a research tax credit under section 41).
However, we may not overlook evidence suggesting that some of his
work on Scorbitz was not qualified research or estimate with no basis in
the record the amount of time he spent on activity which may have been
qualified research.

       For the New Caney Ribbon Board, he defined product
requirements (e.g., that it be affordable by likely customers and operable
by one person) and made technical suggestions important to achieving
these goals. He led the MPCX–2 project and participated in testing
components to be used on the MPCX–2 circuit board. He proposed the
design for the new Slim Shot Clock and directed subordinates to build
prototypes, approximately 20 of which he rejected before accepting the
final version. Even if some of his activity on these three products was
qualified research, we have no basis for estimating how much of his time
was so spent. Thus, petitioners may not take any of the compensation
paid to Mr. Robert into account under section 41(b)(2)(B)(i) for directly
engaging in qualified research.

C.    Direct Supervision and Direct Support

       We next consider whether petitioners may take any of the
compensation paid to Mr. Robert into account under section
41(b)(2)(B)(ii) (“engaging in the direct supervision or direct support of
research activities which constitute qualified research”).

      1.     Direct Supervision

       Petitioners contend that Mr. Robert directly supervised qualified
research conducted by Mr. Paslay and Nevco’s other engineers by
chairing weekly senior management meetings and by working daily on
new product development with Mr. Paslay. We agree that Mr. Robert
presided over those meetings and met with Mr. Paslay. However, those
activities do not constitute “engaging in the direct supervision . . . of
                                          12

[*12] research activities” under Treasury Regulation § 1.41-2(c)(2),
which provides:

        The term “direct supervision” as used in section 41(b)(2)(B)
        means the immediate supervision (first-line management)
        of qualified research (as in the case of a research scientist
        who directly supervises laboratory experiments, but who
        may not actually perform experiments).               “Direct
        supervision” does not include supervision by a higher-level
        manager to whom first-line managers report, even if that
        manager is a qualified research scientist.

       Mr. Paslay, not Mr. Robert, was the first-line manager of
personnel in the engineering department. Under that regulation, Mr.
Robert does not qualify as the direct supervisor of staff subordinate to
Mr. Paslay in the engineering department. Mr. Robert directly
supervised Mr. Paslay during the relevant period; that is, he was the
“higher-level manager” to whom Mr. Paslay reported. As quoted above,
Treasury Regulation § 1.41-2(c)(2) specifically excludes from the
definition of direct supervision “supervision by a higher-level manager
to whom first-line managers report.” Thus, Mr. Robert did not perform
qualified services through his direct supervision of Mr. Paslay.

        2.      Direct Support

       Petitioners argue that Mr. Robert performed qualified services by
providing “direct support” of persons performing qualified research. The
regulations under section 41(b)(2)(B)(ii) provide that the term “direct
support” includes services in the direct support of either “[p]ersons
engaging in actual conduct of qualified research” or “[p]ersons who are
directly supervising persons engaging in the actual conduct of qualified
research.” Treas. Reg. § 1.41-2(c)(3). Treasury Regulation § 1.41-
2(c)(3)(ii) provides as examples of direct support a secretary “typing
reports describing laboratory results derived from qualified research,” a
laboratory worker “cleaning equipment used in qualified research,” and
a machinist “machining a part of an experimental model used in
qualified research.” Mr. Robert did not provide direct support as that
term is used in the regulations. 8 Thus, wages paid to Mr. Robert may

       8 The examples in the regulations are very similar to those in legislative history

accompanying the enactment of a predecessor of section 41(b)(2)(B)(ii) in the Economic
Recovery Tax Act of 1981. S. Rep. No. 97-144, at 80 (1981), as reprinted in 1981
U.S.C.C.A.N. 105, 185; H.R. Rep. No. 97-201, at 117 (1981), as reprinted in 1981-2 C.B.
352, 361.
                                  13

[*13] not be taken into account in computing the credit under section
41(b)(2)(B)(ii).

D.    Conclusion

      Upon due consideration of the foregoing, petitioners may not
consider any wages paid to Mr. Robert in computing Nevco’s section 41
research credit for 2014 or 2015.

      To reflect the foregoing,

      Decision will be entered under Rule 155.