Consumer products industry and the research credit

Jun 23, 2021
Credits & incentives Business tax Consumer goods


A recent U.S. Tax Court case, Leon Max v. Commissioner,1 has concerned practitioners and taxpayers claiming research and development (R&D) credits under section 41, as the Tax Court's opinion addressed more than was required to reject this renowned clothing designer's claim for research credits.

Case Highlights

The Tax Court disallowed California-based fashion designer Leon Max Inc. (LMI)'s claim of approximately $750,000 in research tax credits for 2011 and 2012. The Tax Court held that the amount spent on the multistep process of designing and producing the garments at issue here may not be claimed as qualified research expenses, as the design activities constituted normal business practices typical of the fashion industry, not qualified research activities.

  • Section 174 test: The court dismissed LMI's argument that it faced uncertainties throughout the development process, such as how to cut and drape printed fabrics, fabric choices, thread sizes, details such as twists, pintucks and pleating in the fabric, etc., as these activities were not investigative in nature but rather normal business activities for clothing designers.
  • Technological information test: The court disagreed with LMI's claim that it fundamentally relied on science and engineering in its production process: "Receiving feedback from the fit model and then enlarging too-tight armholes or creating more room in a pant leg is not applying ‘the properties of matter and the sources of energy in nature."
  • Process of experimentation: The court held that LMI did not meet this test either. In part, this was because it failed the section 174 test. Additionally, since most clothing design is inherently style driven, LMI ran afoul of the section 41(d)(3)(B) prohibition regarding research relating to "style, taste, cosmetic or seasonal design factors." Furthermore, LMI also failed the process of experimentation test because it did not prove that substantially all the research activities relating to the garments constituted elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.
  • Business component test: Since the taxpayer had already failed three tests under section 41(d) (although merely failing one test would disallow the research credit claim), the Court did not feel the need to address this test.

Considerations for Consumer Products clients

Section 41(d)(3)(B)'s exclusion of research relating to "style, taste, cosmetic, or seasonal design factors" from qualifying research activities is an obstacle consumer products taxpayers may experience while considering claiming the research credit. Taxpayers should carefully consider how this exclusion affects their specific industry activities. Similar to the Leon Max case, a recent opinion by the California Office of Tax Appeals ruled against an apparel industry client claiming a state research credit: Swat-Fame, Inc. shows that design activities generally do not constitute qualified research because the activities of a clothing designer relate to style, taste, cosmetic, or seasonal design factors.2 The taxpayers in both cases did not demonstrate that "substantially all" of their research activities constituted a process of experimentation for a qualified purpose.

While it was determined in these cases that fashion design does not usually constitute qualified research under section 41, there are instances in which taxpayers in the apparel industry may qualify for the credit. Below is a chart summarizing potential qualifying activities and non-qualifying activities for the research credit in the apparel industry. to claim the R&D credit. Companies have had to pivot their operations and reinvent products and services to be able to comply with COVID restrictions, which has involved improving their online platforms and developing functionalities and improvements to their existing businesses. Such activities should be examined to determine eligibility for the research credit.


Potentially Qualifying

Research to identify and market test colors that will be on trend for the next season

Development of colorants and dyes using new or eco-friendly materials; process development to auto-match desired colors

Basic fit testing of models to evaluate and correct too tight arm-holes

Development of software to auto fit/measure/develop design customized to individual; fit and use testing in extreme conditions for specialized gear

Consumer research regarding fabric preferences

Development and utilization of new materials providing enhanced performance properties (quick drying, cooling, machine washable)

Redesign of logo and graphics on packaging to be more appealing to customers

Development of new packaging materials that offer functional advantages over existing materials (protection during transport, waterproof, anti-wrinkle)

The R&D credit has incentivized US-based research in many industries with the consumer products industry representing a significant share as these industries continually develop new and improved products and processes to meet constantly evolving consumer demands. Qualified research activities for consumer products can include development of new or improved products, design improvements that increase functionality, reliability, performance, or overall quality, etc.

To be sure, Leon Max, Swat-Fame, and section 41(b)(3)(D) all suggest that the consumer-products sector should exercise caution in making research credit claims. That said, there is certainly ample authority for those in the consumer-products sector for claiming some of their activities as being research and development within the meaning of the Internal Revenue Code – for example:

  • Athletic footwear: Expenditures relating to the design of athletic footwear has qualified for the section 174 deduction for research and experimental expenditures.3
  • Sensory taste: The development of new food products and manufacturing techniques, as well as the improvement of existing food products and manufacturing techniques, have been explicitly held not to run afoul of the section 41(b)(3)(B) exclusion of research relating to taste.4
  • Wine: Research and development relating to a new wine production process using a different method of crushing grapes can satisfy the section 174 criteria.5
  • Food-Shredding Blade: The developing and designing of a new food shredding blade for use by such designer in its food manufacturing can qualify for the research credit.6

Additionally, the changes to the consumer products industry due to coronavirus also may provide taxpayers additional opportunity to be eligible to claim the R&D credit. Companies have had to pivot their operations and reinvent products and services to be able to comply with COVID restrictions, which has involved improving their online platforms and developing functionalities and improvements to their existing businesses. Such activities should be examined to determine eligibility for the research credit.


The Leon Max case, in addition to several other high profile taxpayer losses in recent years, such as Little Sandy Coal Co. (2021), Audio Technica (2020), Siemer Milling Company(2019), and Quebe (2019),indicate that there are significant potential pitfalls around research credit claims. Not only that, but the IRS announced in 2020 that the Large & Mid-Sized Business division would conduct a research credit focused compliance campaign. Thus, taxpayers should anticipate potential significant scrutiny of their research credit claims.

In light of this potential scrutiny, it is crucial for taxpayers to understand the areas of most risk in their tax position, have a prudent methodology, and robust documentation to substantiate their research credit claims. Professional standards require tax professionals to conduct a certain amount of due diligence in tax matters, which requires determining the underlying facts and relevant law that are applicable. Signing tax preparers also need to do the necessary work to determine an appropriate position on a tax return, regardless if another organization prepares tax return information. Our trusted tax professionals, focused on research credit claims, can help you gather preliminary information to determine if your company has potential qualified research activities, assess the amount of the estimated credit your company could receive, as well as identify other R&D tax planning opportunities. You cant hen make an educated decision on whether a more in-depth R&D credit analysis would be beneficial for your company.

1 T.C. Memo. 2021-37.
2 2020-OTA-046P.
3 FSA 200125019.
4 TAM 9522001.
5 Treas. Reg. § 1.174-2(a)(11) example 10.
6 Treas. Reg. § 1.41-4(a)(8) example 3.

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