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.
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.