in-20250430-IR-045250183NRA: DEPARTMENT OF STATE REVENUE

DEPARTMENT OF STATE REVENUE LETTERS OF FINDINGS: 01-20242001; 01-20242041; 02-202421918 Indiana Income Tax For the 2016–2019 Tax Years HOLDING Corporation and shareholders 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); United States v. Grigsby, 86 F.4th 602 (5th Cir. 2023); Stinson Estate v. United States, 214 F.3d 846 (7th Cir. 2000); 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 S corporation (“Corporation”) and its shareholders. Corporation does not pay income tax but instead passes its profits and losses through to its shareholders. Corporation files regular returns with the Indiana Department of Revenue (“Department”). Two of Corporation’s shareholders are Indiana residents who also regularly file returns with the Department. The Department audited Corporation’s returns for the tax years 2016 through 2021. The Department determined that Corporation was ineligible to claim any RECs between 2016 and 2019. Because the RECs were denied, Corporation had more taxable income to pass through to its shareholders. Because Corporation is a pass-through entity with both resident and nonresident shareholders, the Department issued assessments to both Corporation and its resident shareholders. 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 Corporation had qualifying research expenses (“QREs”) that entitle it to claim RECs in the years at issue. 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: The term “qualified research” means research— 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). 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. Corporation is a tool-and-die machinist that creates made-to-order parts for its clients. During its audit, the Department found that Taxpayers had not substantiated their claim that Corporation was uncertain about how to create its various products. Taxpayers respond by arguing that uncertainty is a low bar, and that federal regulations specifically state that a company that makes custom machines has uncertainty when it receives an order for a product that it has never made before. Treas. Reg. § 1.174-2(a)(11) Example 3. Taxpayers also point to the fact that Corporation only claimed that half of its roughly 18,000 projects contained QREs. Taxpayers claim that this shows that Corporation was not simply claiming that every project it undertook involved QREs, but rather that Corporation selected only those that truly qualified. Taxpayers misunderstand the Department’s concern. The Department does not argue that Corporation’s expenses categorically fail to qualify as Section 174 expenses. The Department’s audit notes that Corporation 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. Corporation provided only an unsupported narrative summary of the uncertainty present in each project. However, 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). Taxpayers have submitted no documentation to the Department that shows that Corporation had uncertainty regarding any of the projects at issue, nor that Corporation incurred the expenses at issue to resolve any uncertainty. The Department is therefore unable to agree that Corporation 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). The Department’s audit agrees that “[t]here is no doubt the taxpayer relies on principles of engineering, physics, etc. for the work that it engages in[.]” The Department will therefore not revisit this factor at this time. 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)). Prior to the audit, Corporation’s representatives described the research at issue as intended “to design and develop manufacturing processes and prototypes for new and unique manufacturing components for clients.” Corporation’s representatives described the improvements made by the research as “new component and manufacturing process[es] to impart new functionality, enhanced quality, and improved performance to meet or exceed both customer specifications and industry standards.” (Emphasis added). In its audit report, the Department found that the so-called processes that Corporation alleged that it was researching were nothing more than the usual process by which Corporation created its made-to-order parts. In other words, Corporation was not designing a new process nor improving an existing one — it was using the same process as always to design and test products based on customer specifications to fulfill customer orders. Taxpayers argue that the Department misunderstood what Corporation claimed it was designing. Taxpayers argue that what Corporation really designed was a process for creating products of a certain type. At the hearing, Taxpayers agreed that in most cases, Corporation only undertook this research as necessary to fulfill a customer's order. However, Taxpayers claim that this is irrelevant, because research does not need to be completely divorced from a specific demand from a client. Taxpayers suggest that the Department’s auditor “feigned confusion” and ignored Corporation’s consistent use of the word “process” to describe what it was researching and its persistent avoidance of the term “product.” However, Corporation’s description of its own research activities show that it was not improving its processes — it was designing its made-to-order products according to its existing process, as the audit report stated. Corporation’s representatives created a report intended to show that Corporation was engaged in qualifying research activities. This report provided an “Example [of] Qualified Services.” Corporation’s representatives described the following work performed by Corporation’s machinists as qualifying research: To summarize, Corporation’s machinists did four things, which Taxpayers argue all constitute the development of a business component when taken together: they designed parts, they developed the computer code needed to make the parts, they made the parts, and they “ensured quality by detecting malfunctions and measurements.” Unfortunately for Taxpayers, none of these things suggest the design of a new process, whether on their own or taken as a whole. On the first point, Taxpayers stated at the hearing that the customers provided general designs for the parts they ordered, and Corporation would add details to them. This shows that the designs that Corporation developed were intended to create specific parts, not a process for creating parts generally. On the second point, “developing the programming code” in this context means nothing more than transferring a blueprint design into a computer for purposes of communicating the design to the cutting implements. This is not related to developing a process because this is a routine part of every project that Corporation does. On the third point, the physical manufacture of designed products is not related to the development of a new process or improving Corporation’s existing process. On the fourth point, the activities as described constitute “quality control testing,” which is categorically excluded from Section 174’s definition of research. Treas. Reg. § 1.174-2(a)(6)(i); see also Little Sandy Coal, 62 F.4th at 298. Furthermore, Taxpayers also have provided no documentation showing what Corporation’s process looked like before the research at issue, what it looked like after the research, how the research improved the process, or even how the research was related to the development of a new process. The fact that Corporation described its research as related to a “process” and not a “product” is irrelevant. To prevail, Taxpayers must show that Corporation’s research was meant to improve its business and not merely to design products according to customer specifications, and Taxpayers have failed to do so. The Department cannot agree that Corporation’s activities satisfy the business component test. 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. The Department’s audit found that Corporation had not provided documentation sufficient to show that it had engaged in a process of experimentation. Specifically, the Department found that Corporation had not shown what, if any, alternatives were evaluated in the course of Corporation’s research activities. At the protest stage, Taxpayers provided further documentation, such as computer-aided designs. However, Taxpayers were not able to show that Corporation had any uncertainty about the development of a business component, nor were Taxpayers able to show that Corporation eliminated any alternatives. The Department therefore cannot agree that Corporation’s activities meet this requirement. Even if an activity would otherwise qualify as research, it cannot be qualified research “to the extent funded by any grant, contract, or otherwise by another person[.]” I.R.C. § 41(d)(2)(H). The Department must consider all agreements between a taxpayer and “other persons” in determining whether the taxpayer’s research is funded. Treas. Reg. § 1.41-4A(d). “Amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research... are not treated as funding.” Id. Research is also considered funded if “the researcher retains no substantial rights in its research[.]” United States v. Grigsby, 86 F.4th 602, 616–17 (5th Cir. 2023) (citing Treas. Reg. § 1.41-4A(d)). In other words, Taxpayers must show either that Corporation retained substantial rights in its research or that Corporation’s right to payment was “contingent on [the] success of the research.” Id. Taxpayers argue both points. The Department’s audit found that the following clause in one of Corporation’s purchase orders showed that Corporation did not retain any rights to its research: Taxpayers respond that Corporation’s research was intended to design a process, and that this clause mentions nothing about assigning rights to Corporation’s business processes. However, this argument does not agree with the plain meaning of the text of the clause. The Department cannot agree that Corporation’s business processes are not included in “inventions... designs... business information, and other information conceived, developed, or otherwise generated” during the contract. Taxpayers have therefore failed to show that Corporation retained any rights in its research. Taxpayers also argue that Corporation’s right to payment was contingent upon the success of the research because it was a fixed-price contract. That is, Corporation would receive the negotiated payment regardless of how difficult or expensive its production process was. Taxpayers argue that “the courts have consistently held that fixed-price contracts inherently place the largest amount of risk on the [t]axpayer.” Taxpayers also argue that the contracts are not funded because Corporation’s purchase orders are subject to an inspection clause, which allows buyers to reject the products if they do not approve of the product that is delivered. However, Taxpayers misstate the law. First, although courts have “consistently held” that fixed-price contracts are riskier for sellers than buyers, they have not consistently held that fixed-price contracts cannot be the source of research funding. As the Fifth Circuit has stated, one of the authorities on which Taxpayers rely “found that the fixed price contract at issue was funded.” Grigsby, 86 F.4th at 619 (citing Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330, 1339 (11th Cir. 2015)) (emphasis in original). Second, Corporation’s right to payment was not contingent upon the success of its research. The inspection clauses in Corporation’s contracts allow its customers to reject delivery if the products delivered “are found to be defective in material or workmanship” or that “do not meet [the customer’s] requirements.” However, these contracts were for the provision of custom-made parts, not the delivery of a “process.” Corporation’s customers do not care whether Corporation successfully designs a process, they only care about receiving parts that fulfill their needs. Indeed, the purchase orders do not allow Corporation’s customers to reject delivery if Corporation failed to develop a new process. This analysis shows why Taxpayers’ repeated attempts to establish that Corporation intended to design a process and not a product are ultimately irrelevant. Taxpayers are correct that, if Corporation’s activities were meant to design a new product, that the activities would not be fully funded. However, as discussed above, if Corporation intended to design a product, its activities would not qualify for RECs under the four-part Section 41 test. But as this section shows, if Corporation intended to design a process, then any research would be fully funded regardless of the Section 41 analysis. Taxpayers have not established that Corporation conducted any qualifying research for purposes of Indiana law. Taxpayers have not shown that Corporation’s activities met all four factors required under Indiana law to be qualifying research. Further, Taxpayers were unable to show that Corporation’s research was not ineligible due to being fully funded. Finally, Taxpayers were not able to present contemporaneous records to substantiate their claims. Because Corporation did not conduct qualifying research, the Department correctly determined that Corporation 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. FINDING Taxpayers’ protest is denied. February 24, 2024 Replaces Finding Document at: New