A successful fashion designer and businessman setup an S Corporation that produces and sells millions of garments each year. The company designers begin with hand-drawn sketches and the patternmakers and sample makers follow a structured process for designing and developing the garments.
For these activities, the S Corp. claimed credits under IRC Sec. 41 for increasing research activities for 2011-2012, which flowed through to the business owner. Under IRC Sec. 41 guidelines, qualified research and related expenses must relate to a new or improved function, performance, reliability, or quality of the product or process. Four tests must be met: (1) the Section 174 test, (2) the technological information test, (3) the business component test, and (4) the process of experimentation test.
The company’s activities did not satisfy any of the four tests. Therefore, the expenses it incurred in the design process were not eligible for the research credit.