in-20250827-IR-045250412NRA: DEPARTMENT OF STATE REVENUE

DEPARTMENT OF STATE REVENUE LETTERS OF FINDINGS: 04-20242334; 01-20242335; 01-20242336; 01-20242337; 01-20242338; 01-20242339 Indiana Income Tax For the 2021 and 2022 Tax Years HOLDING LLC and members did not establish that they were entitled to claim research expense credits (“RECs”). ISSUE

I. Indiana Income Tax – Research Expense Credits.

Authority: I.R.C. § 41 ; I.R.C. § 174 ; IC 6-3-1-3.5 ; IC 6-3-2-1 ; IC 6-3.1 et seq. ; IC 6-3.1-4-2 ; IC 6-3.1-4-4 ; IC 6-8.1-5-1 ; IC 6-8.1-5-4 ; Little Sandy Coal Co., Inc. v. Commissioner of Internal Revenue, 62 F.4th 287 (7th Cir. 2023); Stinson Estate v. United States, 214 F.3d 846 (7th Cir. 2000); Betz v. Commissioner, T.C. Memo 2023-84; Harper v. Comm’r of Internal Revenue, T.C. Memo. 2023-57; Dep’t of State Revenue v. Caterpillar, Inc., 15 N.E.3d 579 (Ind. 2014); Indiana Dep’t of State Revenue v. Rent-A-Center East, Inc., 963 N.E.2d 463 (Ind. 2012); Tell City Boatworks, Inc. v. Indiana Dep’t of State Revenue, 162 N.E.3d 603 (Ind. Tax Ct. 2020); Wendt LLP v. Indiana Dep't of State Revenue, 977 N.E.2d 480 (Ind. Tax Ct. 2012); Scopelite v. Indiana Dep't of Local Gov't Fin., 939 N.E.2d 1138 (Ind. Tax Ct. 2010); Lafayette Square Amoco, Inc. v. Indiana Dep’t of State Revenue, 867 N.E.2d 289 (Ind. Tax Ct. 2007); Treas. Reg. § 1.41-4; Treas. Reg. § 1.41-4A; Treas. Reg. § 1.174-2. Taxpayers protest the denial of claimed research expense credits. STATEMENT OF FACTS Taxpayers are an Indiana limited liability company (“LLC”) and its members. LLC elects to be taxed as an S corporation, and its profits and losses pass through to its shareholders. LLC files regular returns with the Indiana Department of Revenue (“Department”). All of LLC’s members except one are Indiana residents who also regularly file returns with the Department. Starting in 2022, LLC elected to pay Pass-Through Entity Tax (“PTET”), meaning that LLC paid taxes on its own income for 2022, and credits for the taxes that LLC paid flowed through to its members. The Department audited LLC’s returns for the tax years 2019 through 2022. The Department determined that LLC was ineligible to claim any RECs in 2021 and 2022. Because the RECs were denied, LLC had more taxable income to pass through to its shareholders. The Department issued assessments to both LLC and its resident shareholders. The Department also denied carry-forward credits from 2019 attributable to RECs claimed in that year. Taxpayers protested timely, and the Department held an administrative hearing. This Letter of Findings results. Additional facts will be provided below as necessary.

I. Indiana Income Tax – Research Expense Credits.

DISCUSSION Taxpayers argue that LLC had qualifying research expenses (“QREs”) that entitle it to claim RECs in the years at issue. The Department based its assessments on the grounds that LLC had claimed RECs for which it did not qualify. The resulting adjustment resulted in a decrease in the credit passed through to the shareholders. As a threshold issue, it is Taxpayer’s responsibility to establish that the existing tax assessment is incorrect. A proposed assessment is prima facie evidence that the Department’s claim for the unpaid tax is valid. IC 6-8.1-5-1(c). The burden of proving that the proposed assessment is wrong rests with the person against whom the proposed assessment is made. Id.; See e.g., Indiana Dep’t of State Revenue v. Rent-A-Center East, Inc., 963 N.E.2d 463, 466 (Ind. 2012) and Lafayette Square Amoco, Inc. v. Indiana Dep’t of State Revenue, 867 N.E.2d 289, 292 (Ind. Tax Ct. 2007). Where a taxpayer is challenging the Department’s final determination, the taxpayer is required to provide documentation explaining and supporting its challenge. Poorly developed and non-cogent arguments are subject to waiver. Scopelite v. Indiana Dep't of Local Gov't Fin., 939 N.E.2d 1138, 1145 (Ind. Tax Ct. 2010); Wendt LLP v. Indiana Dep't of State Revenue, 977 N.E.2d 480, 486 n.9 (Ind. Tax Ct. 2012). Additionally, “when [courts] examine a statute that an agency is ‘charged with enforcing . . . [courts] defer to the agency’s reasonable interpretation of [the] statute even over an equally reasonable interpretation by another party.’” Indiana Dep’t of State Revenue v. Caterpillar, Inc., 15 N.E.3d 579, 583 (Ind. 2014). Thus, all interpretations of Indiana tax law contained within this decision are entitled to deference. Indiana assesses a tax on the “adjusted gross income of every resident person[.]” IC 6-3-2-1(a). Indiana’s definition of adjusted gross income begins with the federal definition and makes state-specific modifications. IC 6-3-1-3.5(b). Once a taxpayer’s adjusted gross income is determined, it may claim tax credits to reduce its taxable income. See IC 6-3.1 et seq. Like deductions, exemptions, and exclusions, tax credits are matters of legislative grace. Stinson Estate v. United States, 214 F.3d 846, 848 (7th Cir. 2000). They should be narrowly construed and the burden rests with the taxpayer to demonstrate that it qualifies for any given credits. Id.; Tell City Boatworks, Inc. v. Indiana Dep’t of State Revenue, 162 N.E.3d 603, 626 (Ind. Tax Ct. 2020). Indiana allows taxpayers to claim RECs if they have “qualified research expense[s] [(“QREs”)] in a particular taxable year.” IC 6-3.1-4-2(a). Indiana uses the federal definition of qualified research for purposes of RECs. IC 6-3.1-4-4; I.R.C. § 41. The Internal Revenue Code defines “qualified research” as follows: I.R.C. § 41(d)(1). This definition sets out a four-part test to determine whether an activity is qualified research. First, the research must qualify for a business deduction under I.R.C. § 174. I.R.C. § 41(d)(1)(A). Second, the research must be for the purpose of “discovering information [] which is technological in nature[.]” I.R.C. § 41(d)(1)(B)(i). Third, the taxpayer must intend to use the research to develop a new business component or improve an existing one. I.R.C. § 41(d)(1)(B)(ii). Last, the taxpayer must use a “process of experimentation” during “substantially all” the research. I.R.C. § 41(d)(1)(C). An activity must satisfy all four parts to qualify for the credit. However, regardless of whether all four parts are satisfied, an activity cannot be qualified research “to the extent funded by any grant, contract, or otherwise by another person[.]” I.R.C. § 41(d)(2)(H). I.R.C. § 174 allows a taxpayer to deduct “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” Treas. Reg. § 1.174-2(a)(1). Expenses qualify under this rule if “they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.” Id. However, expenses do not qualify if they occur “after the elimination of uncertainty[.]” Treas. Reg. § 1.174-2(a)(2). Under this section, “product” means “any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease, or license.” Treas. Reg. § 1.174-2(a)(3). A taxpayer must establish that it was uncertain about “the concept of a model or product,[] as opposed to the construction or manufacture of the product itself.” Little Sandy Coal Co., Inc. v. Commissioner of Internal Revenue, 62 F.4th 287, 298 (7th Cir. 2023) (quoting Union Carbide Corp. v. Commissioner of Internal Revenue, T.C. Memo. 2009-50 at *79) (internal quotations omitted) (emphasis in original). If a taxpayer is uncertain only about “whether a product is built to satisfy a client's desired specifications” and not about “the concept of the product,” it cannot take a deduction under I.R.C. § 174. Id.; see also I.R.C. § 41(d)(4)(B) (“The term ‘qualified research’ shall not include . . . [a]ny research related to the adaptation of an existing business component to a particular customer’s requirement or need.”). LLC operates two factories in Indiana. LLC’s only business is finishing pre-molded parts from another manufacturer (“Manufacturer”). Relevant to this protest, Manufacturer molds its own parts and sends them to LLC, who trims unwanted pieces from the molded parts and returns the finished parts. Taxpayers claimed that several jobs that Manufacturer hired LLC to do required LLC to conduct research. Specifically, Taxpayers claim that LLC had to improve its process for removing the unwanted pieces. Taxpayers stated at the hearing that sometimes, LLC’s original processes would not remove the unwanted pieces to Manufacturer’s satisfaction. If that happened, Taxpayers state, LLC would research ways to improve their processes. Taxpayers also state that sometimes, complaints from Manufacturer would motivate these process improvements. After review, many of the activities for which LLC claimed QREs are categorically excluded by I.R.C. § 41(d)(4)(B). LLC has only a single customer — Manufacturer. Any process improvement that is meant to ensure that the molded parts are trimmed “correctly” is clearly “the adaptation of an existing business component to a particular customer’s requirement or need.” I.R.C. § 41(d)(4)(B) specifically excludes this kind of adaptation from the definition of qualified research. The Department therefore cannot agree that any of LLC’s activities which are intended to prevent damage to the parts or otherwise ensure that the parts are finished “correctly” constitute qualified research for which RECs can be claimed. Further, Taxpayer was not “uncertain” about one additional project for the purposes of the Section 174 test. In Project 22-19, Taxpayer claimed that it had to research where to place a certain sensor so that it would be in the right place for various parts as they were processed. The Department cannot agree that Taxpayer was “uncertain about the concept” of the sensor, as Little Sandy Coal requires. Rather, Taxpayer was uncertain about the placement or “construction” of the sensor mechanism, which Little Sandy Coal held does not constitute the proper type of uncertainty. The Department cannot agree that this project constitutes qualified research. Taxpayers also were unable to demonstrate via documentation that they had uncertainty for any of the projects. The Department’s audit notes that LLC did not provide any documentation substantiating its claims that (1) it had uncertainty about the specific projects at issue, and (2) that its activities were intended to eliminate that uncertainty. Taxpayers provided emails describing the changes made, “process change request” forms explaining what changes were ultimately made, and descriptions of the changes made. But none of these are able to show either of the two factors noted by the Department’s audit to be necessary. The QRE test “requires us to walk by sight, not by faith.”  Little Sandy Coal, 62 F.4th at 308. Federal regulations require that taxpayers that want to claim research credits must “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” Treas. Reg. § 1.41-4(d). Indiana law requires taxpayers to keep “books and records” such that the Department can determine their tax liabilities. IC 6-8.1-5-4(a). The documentation that Taxpayers submitted is not enough for Taxpayers to carry their burden to show that LLC had uncertainty about its projects. The Department is therefore unable to agree that LLC has carried its burden to establish eligibility under I.R.C. § 174. Research must be for the purpose of “discovering information [] which is technological in nature” to qualify for the Indiana REC. I.R.C. § 41(d)(1)(B)(i). Information is technological in nature “if the process of experimentation used to discover [it] fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.” Treas. Reg. § 1.41-4(a)(4). This requirement does not require a taxpayer “to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research.” Treas. Reg. § 1.41-4(a)(3)(ii). The Department’s audit found that Taxpayers had not provided documentation showing that the information LLC sought was technological in nature. However, Taxpayers provided documentation during the hearing process, including images and videos, as well as descriptions of the processes in question, which demonstrated that the information sought was generally technological in nature (excepting Project 22-19, in which Taxpayers needed only to determine where to place a sensor). The Department thus finds that Taxpayers have carried their burden to show that all projects except Project 22-19 meet the requirements of the “technological in nature” test. Qualifying research must also be for a purpose “intended to be useful in the development of a new or improved business component of the taxpayer[.]” I.R.C. § 41(d)(1)(B)(ii). A business component is “any product, process, computer software, technique, formula, or invention which is to be [] (i) held for sale, lease, or license, or (ii) used by the taxpayer in a trade or business of the taxpayer.” I.R.C. § 41(d)(2)(B). In other words, to satisfy this component, research must be (1) useful (2) in creating or improving (3) a business component. A taxpayer must show that the research “provide[d] some level of functional improvement” to satisfy this test. Harper v. Comm’r of Internal Revenue, T.C. Memo. 2023-57 at *5. However, the mere creation of a “design or modification to meet customer specifications” does not qualify as a business component for taxpayer. Little Sandy Coal, 62 F.4th at 298. Moreover, a “design or modification to meet customer specifications” cannot qualify unless it “remove[s] the correct type of uncertainty: that related to the ‘development or improvement’ of the product.” Id. Similarly, testing to determine “whether particular units of materials or products conform to specified parameters” does not constitute qualified research either. Id. (quoting Treas. Reg. § 1.174-2(a)(6)(i)). The Department noted at audit that “some of the projects could be identified as process improvements,” but it further noted that Taxpayers had not provided enough information to be certain. During the protest process, Taxpayers provided further information, including descriptions of LLC’s manufacturing process and images and videos depicting the manufacturing process. Further, Taxpayers described the different steps of LLC’s manufacturing process so that the Department could identify discrete business components. The Department finds that this additional information is sufficient for Taxpayers to carry their burden to show that their projects were “intended to be useful in the development of a new or improved business component[.]” Qualifying research must be conducted using a process of experimentation. I.R.C. § 41(d)(1)(c). A process of experimentation is “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.” Treas. Reg. § 1.41-4(a)(5). Further, it must “fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science,” and it must “identif[y] . . . 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[.]” Id. “Merely identifying a project difficulty and the eventual design solution, without bridging the gap with evidence as to what investigative activities were performed” is not enough to establish the existence of a process of experimentation. Betz v. Commissioner, T.C. Memo 2023-84 at *41. The Department’s audit found the following in denying that LLC proved that it engaged in a process of experimentation: Taxpayers have not presented documentation sufficient to overcome the Department’s position at audit. Indeed, Taxpayers’ documentation does not show that any alternatives were tested, what those alternatives might have been, or even that LLC ever needed to consider alternatives, as opposed to simply making the necessary changes. The Department is thus unable to agree that Taxpayers have carried their burden to show that they engaged in a process of experimentation. Taxpayers have not established that LLC conducted any qualifying research for purposes of IC 6-3.1-4-4 and I.R.C. § 41. Taxpayers have not shown that LLC’s activities met all four factors required under IC 6-3.1-4-4 and I.R.C. § 41 to be qualifying research. Finally, Taxpayers were not able to present contemporaneous records sufficient to carry their burden under IC 6-8.1-5-1(c) to show that the Department’s assessment was incorrect. Because LLC did not conduct qualifying research, the Department correctly determined that LLC had no QREs during any of the years under audit, and therefore also was ineligible to claim any RECs. The Department is therefore unable to agree that Taxpayers are eligible to claim any RECs on their Indiana tax returns. Therefore, the Department’s adjustments removing the RECs were correct. FINDING Taxpayers’ protest is denied. June 10, 2025 Replaces Finding Document: New