Are You Using a Methodical Plan in Your Experimentation?
Most have heard of the “Four-Part Test" used to qualify R&D activities for tax purposes. Here is a quick recap:
- Did you have a new or improved business component for a permitted purpose?
- Was it technological in nature?
- Was there technical uncertainty?
- Was there a process of experimentation?
Let's take a closer look at the process of experimentation, since this has become an area of greater concentration during IRS exams.
During the process of experimentation, the activity must include an evaluative process and generally should be capable of identifying and evaluating one or more alternatives to achieve a result. Through legislation, statutes, and court cases, the definition of experimentation has been changing since 1986.
History of the Process of Experimentation
1986: The IRS created the four-part test, including the process of experimentation requirement. The legislative history provided additional guidance on the meaning of “process of experimentation” by using the phrases “the evaluation of more than one alternative” and “developing one or more hypotheses, testing and analyzing those hypotheses.”
1998: Treasury proposed a more scientific four-step process be used as the definition of experimentation.
2001: Treasury removed the specified four-step process and retained the earlier language.
2004: Treasury expanded the guidance of experimentation and included a step-by-step process with the core elements: "Identify uncertainty, identify a process, conduct an evaluative process."
Case law from two specific court cases has helped define today's explanation of experimentation. The Union Carbide (UCC) case set the standard that a: "methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis" is required. The Siemer Milling case generally followed the standard UCC decision but included additional commentary: “narrating the steps of its process does not establish that it engaged in experimentation in the scientific sense."
A key takeaway from the continually changing definition and the various cases is to understand that qualification criteria are continually evolving, and keeping up with the most current definition and expectations is critical. Therefore, be sure you are employing a 'Methodical Plan' in your process of experimentation.
Please reach out to one of our RCIS team members if you would like more information on the standards or to discuss your process of experimentation in detail. You may also watch our Webinar on this topic.
