United States Tax Court

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T.C. Memo. 2024-113

PHOENIX DESIGN GROUP, INC.,

Petitioner

COMMISSIONER OF INTERNAL REVENUE,

Respondent

__________

Docket No. 4759-22.

Filed December 23, 2024.

__________

Matthew S. Reddington, Russell G. Garza, Janine M. Campanaro, and

Jefferson H. Read, for petitioner.

Jonathan E. Behrens, Hannah Kate Comfort, and Randall B. Childs, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GREAVES, Judge: This case involves the section 41 “Credit for

Increasing Research Activities” (research credit) claimed by Phoenix

Design Group (PDG or petitioner), a multidisciplinary engineering

consulting firm. 1 The Internal Revenue Service (IRS or respondent)

disallowed research credits claimed for 2013 through 2016 (research

years) and imposed accuracy-related penalties.

The disallowed research credits relate to over 200 projects;

however, the parties agreed to try a nonbinding three-project sample.

The issues for decision are (1) whether any of the three trial projects

entailed qualified research and (2) whether petitioner is liable for

1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C., in effect at all relevant times, regulation references are to the

Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and

Rule references are to the Tax Court Rules of Practice and Procedure.

Served 12/23/24

[*2] accuracy-related penalties under the parties’ stipulations. We hold

that none of the three projects entailed qualified research and that

petitioner is liable for accuracy-related penalties as stipulated by the

parties.

FINDINGS OF FACT

Some of the facts are stipulated and are so found. The parties’

stipulations of facts and the attached exhibits are incorporated herein

by this reference. Between 2015 and 2019 (credit years), PDG was

treated as a C corporation for federal tax purposes and had a principal

place of business in Tennessee.

PDG History

To understand PDG and the projects at issue, one must first

appreciate the journey the company’s principals took to become

professional engineers. The path to becoming a professional engineer is

a long and rigorous one. It begins with a four-year course of study

through an accredited engineering program, focusing on principles of

science and math. During this time, the student chooses a specific

discipline such as civil, mechanical, electrical, or biomedical

engineering. Following completion of his undergraduate studies, the

student must take a two-day fundamentals of engineering exam within

the chosen discipline. After passing this exam, the graduate is an

“engineer” but not a “professional.” Training continues with the

aspiring professional engineer serving in an apprentice-like role for four

years under a professional engineer. Thereafter, he may sit for the

professional engineering exam over the course of two days, which again

focuses on his discipline of choice. If successful, he can finally add the

word “professional” to his resume.

So why does someone put in all the work to become a professional

engineer? A professional engineer leads teams that design and maintain

infrastructure that is vital for life and commerce. A professional

engineer is the ultimate authority on building projects with the power

to stamp and approve design documents. This approval signifies that

all requested revisions have been made and the final design satisfies all

requirements of applicable law.

At the beginning of his career, the professional engineer is greatly

involved in the day-to-day activities of design work, using his years of

training. However, as he climbs the corporate ladder, the professional

engineer, who has spent countless years steeped in the intricacies of

[*3] engineering, assumes an unfamiliar business and marketing role.

He will go from designing complex fire suppression systems that are

vital for the safety of high-rise building occupants to putting out

mundane human resources fires between employees. He will go from

calculating the appropriate pitch of sewer pipelines to proofreading

marketing pitches. This career path results in the most experienced

professional engineers’ having little to no involvement in the design

process.

Discouraged by this rat race, professional engineer Ross T.

Malloy, along with professional engineers Thomas Fisher and Clyde

Searcy, sought to create an alternative engineering firm, focused on

keeping those with the most experience involved in the design process.

In 1997 they formed PDG, a professional engineering firm that focuses

on designing mechanical, electrical, plumbing, and fire protection

(MEPF) systems in laboratories and hospitals. These MEPF systems

are often not visible to an occupant and are forgotten during the day-today use of a building. However, if one stops working, such as the boiler

system heating the courtroom during the trial for this case, their

importance is clear.

During the research years, PDG’s principals were Ross T. Malloy,

Thomas Fisher, John Wade, Jerry Young, and Brian Moore. They never

sought to be the largest engineering firm; instead, they strived to

distinguish PDG from the field by using senior employees’ experience.

This business strategy succeeded, with PDG developing a reputation

that attracts clients around the country. As a result, PDG does not

dedicate a lot of time to marketing. Instead, it relies on word-of-mouth

endorsements from satisfied customers and architecture firms. PDG is

recognized in the industry as a firm on the forefront of technology with

its engineers frequently speaking at industry-wide conferences to

discuss the revolutionary MEPF systems PDG engineers design.

II.

PDG Disciplines and Organization Structure

It is said that engineers solve problems you did not know you had

in ways you cannot understand. This saying is readily apparent in the

highly complex and technical projects undertaken by PDG. PDG

engineers work within three disciplines: mechanical, electrical, and

plumbing. 2

2 Plumbing engineers are typically engineers with formal training in

mechanical engineering that subsequently specialize in plumbing systems.

[*4] We start with a basic discussion of the systems designed by PDG

mechanical engineers that we were able to stitch together from the

discrete presentation of the various components. The mechanical

discipline focuses on customizing heating, ventilation, and air

conditioning (HVAC) systems to meet a client’s specific needs. There

are various customizable components that PDG mechanical engineers

consider in designing an HVAC system, including the air volume, the

components of the air handler, and the distribution of the air around the

building.

One of the first decisions PDG mechanical engineers must make

is whether the HVAC system will be a constant air volume system or a

variable air volume system. In a constant air volume system, a constant

stream of air flows through the system. The airflow in each room cannot

be changed. Instead, to adjust the temperature in each room, a

mechanism located near the room heats the air to raise the temperature

to desired levels. In contrast, a variable air volume system adjusts the

amount of airflow entering each space to control temperature. This

means when an occupant wants a warmer temperature, the HVAC

system will reduce the airflow to that zone.

After determining the type of system, PDG mechanical engineers

begin designing the air handling unit. The air handling unit is the

component of the HVAC system that heats or cools the air by blowing

air across a hot or cold coil with a fan. The air handling unit also

contains filters to purify the air and a mechanism to control the

humidity of the air. There are multiple options for each of these

components. First, PDG mechanical engineers must determine the

source of energy for the coils. For cooling, the coils may be cooled with

chilled water or refrigerant. As air blows over the coil, the liquid inside

the coil heats up and that heat must be removed from the system. This

may be done with a chiller, a cooling tower, or a condensing unit. For

heating, the coils may be heated with steam, hot water, or electricity.

Fan size varies with the pressure required to distribute air

around the building. To determine the appropriate fan size, PDG

mechanical engineers calculate the resistance in the duct system, which

is the measure of the decrease in pressure between the air handling unit

and the room. This calculation is based on the characteristics of the

ducts, including the size and the fittings. The result of this calculation

is the required pressure to move air through the system and determines

the appropriate fan size.

[*5] Depending on the needs of the client, PDG mechanical engineers

may add components to the HVAC system. For example, the system

may use a dedicated outside air system to circulate additional fresh air

in the building. There are also various energy-saving components that

may be added to the system.

After the air passes through the air handling unit, the ductwork

building. PDG mechanical engineers focus on the ventilation in the

room and any pressure differential created by the HVAC system. Air is

fed into a room via ducts and discharged from the room via return ducts

or other exhaust points such as fume hoods.

PDG mechanical engineers also design fire prevention systems

that are integrated into the HVAC system. Buildings with high

occupancy are generally required to have fire rated walls that will

prevent fire and smoke from spreading across the building. When

running duct work for an HVAC system, a hole is created in the wall to

allow the ductwork to pass, which compromises the fire rated wall. To

prevent fire and smoke from spreading through the duct work, fire and

smoke dampers are installed, which seals the duct in the event of a fire.

These dampers are required by building code.

We move now to the systems designed by PDG electrical

engineers. The electrical discipline focuses on lighting and electricity,

emergency electricity, and communication systems. PDG electrical

engineers design all electrical systems for the projects from the point at

which the electricity is fed into the building to the outlet used to power

lifesaving or research equipment. PDG electrical engineers work with

utility companies to bring electricity to a project, if required. Once the

electricity is connected to the building, PDG electrical engineers design

switchboards that distribute the electricity to smaller electrical panels

around the building. From the smaller electrical panels, PDG electrical

engineers route wires of varying sizes to access points.

Finally, we conclude with the systems designed by PDG plumbing

engineers. The plumbing discipline focuses on waste piping, fluid

piping, reverse osmosis and distilled water systems, and effluent

disinfecting systems for laboratories. PDG plumbing engineers also

design water-based fire protection systems such as sprinklers.

Each discipline works on the building systems within its

expertise. PDG engineers and support staff are assigned to a specific

[*6] discipline and for the most part work exclusively in that discipline.

Within each discipline, there are four types of employees: 3 principals,

senior engineers, engineers, and computer aided design (CAD)

designers. A principal is a professional engineer with a minimum of five

years of experience that is responsible for project management and has

stock ownership. A senior engineer is a professional engineer that does

not have stock ownership. Principals and senior engineers have

supervisory authority and are ultimately responsible for final review

and approval of projects. An engineer is an employee that has an

engineering degree but is ineligible to sit for the professional

engineering exam. Finally, a CAD designer is an employee that has

some technical education but did not complete an accredited engineering

program. The CAD designers create construction drawings and

sketches on computer design software. CAD designers do not design

projects independently but rather do “some legwork” for engineers by

entering marked-up drawings into the computer design software. In

addition to the employees within each discipline, PDG has limited

administrative staff. Ross T. Malloy’s wife, Melanie Malloy, acts as the

bookkeeper, janitor, and receptionist, among other roles within PDG.

Throughout trial, petitioner did not clearly distinguish the work

performed by the various types of engineers. Therefore, we use the term

“engineers” in this Opinion to refer collectively to professional engineers,

senior engineers, and engineers. Petitioner likewise failed to clearly set

forth the work done by the CAD designers. We use the term “PDG

employees” to refer collectively to the engineers and the CAD designers.

III.

PDG Design Process

Generally, an architect engages PDG to design MEPF systems for

a hospital or a laboratory. PDG engineers design these systems against

the backdrop of local building codes. Building codes set forth specific

minimum requirements for how structures and building systems are

constructed to provide a minimum standard to ensure public health,

safety, and welfare. 13 Am. Jur. 2d Buildings § 2 (2024). Building codes

provide standards for structural materials, design and construction

materials, fire protection, health, sanitation, and safety that may vary

with the use of a building. Id. For example, building codes may require

6 air changes per hour in a laboratory and 20 air changes per hour in an

3 This Opinion will use the term “employee” in the colloquial sense and not as

defined in section 3401(c).

[*7] operating room. PDG engineers must adhere to the relevant

building codes from initial planning through final inspection.

Petitioner describes PDG engineers’ approach to designing MEPF

systems as a six-stage design process: basis of design, schematic design,

design development, construction documents, bidding, and construction

administration. Petitioner indicated that the design process is not

linear but instead PDG engineers may loop back to previous stages if an

issue is encountered in a later stage.

The first stage is the basis of design. The basis of design phase is

an information gathering stage where the engineers attempt to

determine the design requirements of each project, including the scope

and unique characteristics of the project. The goal of this stage is to

define the client’s objectives and any restrictions that may affect the

design.

The second stage is the schematic design phase. The architect

begins determining the footprint of the building and creates gross block

diagrams. PDG engineers analyze this initial information to estimate

the appropriate MEPF systems and establish contact with utilities to

determine how to connect the building to existing infrastructure. PDG

engineers also provide the architect preliminary locations for the MEPF

systems.

The third stage of the design process is the design development

stage. The design development stage begins with the architect’s

providing PDG with plans that incorporate PDG’s preliminary locations

for the MEPF systems. PDG engineers use this information to

determine the best route for the HVAC system and adjust the MEPF

systems to accommodate any changes to the size of the building. PDG

engineers also work with local zoning authorities to ensure compliance

with any legal requirements. PDG engineers develop alternative

systems and run calculations to ensure feasibility. PDG engineers

convey the alternative systems and suggestions to the architect to

incorporate in the design. The architect or owner determines which

system to incorporate.

The fourth stage is the construction document phase. The owner

determines final equipment selection, such as imaging systems, and

PDG engineers ensure that the MEPF systems can support the

equipment. To make these determinations, PDG engineers rely on cut

sheets provided by the manufacturers, which explain the requirements

[*8] of the new equipment. PDG mechanical engineers run final load

calculations to ensure the HVAC system can properly serve the building.

PDG electrical engineers design the lighting systems in the building. At

the conclusion of this phase, PDG produces the construction documents

that contractors will use in construction and code officials will review for

compliance. PDG professional engineers stamp these documents as a

final product.

Next is the bidding stage. The owner or architect solicits bids

from construction contractors to complete the work. The building owner

may request that PDG revise the design plan to minimize costs.

The final stage is construction administration, in which the actual

construction of the building begins. At the beginning of this stage, PDG

engineers review shop drawings from contractors, which set forth the

equipment they plan to use. PDG engineers review the shop drawings

to ensure that the contractor complied with the construction documents

and that PDG engineers made no mistakes in the construction

documents. PDG engineers sometimes recorded this work as a separate

stage from construction administration.

PDG engineers also make site visits to determine compliance with

the construction documents. PDG engineers prepare a report on any

errors they encounter. Throughout this process, contractors will send

PDG requests for information. These requests for information flag

conflicts in the construction documents and request PDG engineers’

input on alternatives. The owner may also request changes to the design

based on shifting business needs.

During the research years, PDG employees generally recorded

their time by discipline and stage of the design process. PDG employees

recorded their time spent in hourly increments on projects through

Azero (hour sheets). The hour sheets were not used to bill clients but

were instead an internal metric to measure employee performance.

Each project had a unique project number assigned, and employees

recorded time to the specific project number. Each time that the scope

of the project expanded, PDG created a derivative project number from

the main project. Employees were instructed to record time separately

to the main project number and the derivative numbers. 4 Once a

particular design phase was completed, an employee could not go back

4 It appears that employees generally followed this instruction. However, the

hour sheets that petitioner provided for the main project numbers contain some entries

associated with the derivative project numbers.

[*9] and add time to that phase. For each increment of time, an

employee included a short narrative description of his work.

IV.

alliantgroup Study

On February 1, 2017, Melanie Malloy executed an engagement

letter on petitioner’s behalf with alliantgroup, a tax consulting and

lobbying firm, to conduct a section 41 research credit study. Petitioner

provided documentation on all projects undertaken between 2012 and

2016, and alliantgroup identified 419 possible projects that qualified for

research credits. From this group, alliantgroup removed all projects

known not to contain qualifying activities and de minimis projects,

which reduced the total possible projects to 238. alliantgroup conducted

an analysis of a sample of these projects and issued a report to

petitioner.

Amended Returns and Audit

On the basis of the alliantgroup reports, petitioner amended its

2014 through 2016 tax returns to claim the research credits. Petitioner

did not amend its 2013 tax return. Rather on its amended 2014 tax

return, petitioner included the credits allocable to 2013 on line 4 of Form

3800, General Business Credit, as a carryforward of a general business

credit to 2014. 5 Petitioner claimed the following research credits per

year: 6

5 It appears petitioner did not properly claim the credit for the 2013 tax year

on its 2014 tax return. However, petitioner raised this issue in its petition, and we

have jurisdiction over this claimed credit because it relates to the determination of the

correct tax liability for the credit years. See § 6214(b) (allowing us to “consider such

facts with relation to the taxes for other years or calendar quarters as may be necessary

correctly to redetermine the amount of such deficiency”); Brock v. Commissioner, T.C.

Memo. 1982-335, 1982 WL 10645 (holding that the Court had jurisdiction to consider

facts related to prior years to determine the proper amount of credit carryforward); see

also Noell v. Commissioner, 66 T.C. 718, 727 (1976) (considering a tax credit raised for

the first time at trial); Norwest Corp. & Affiliated Cos. v. Commissioner, T.C. Memo.

1992-282 (considering a tax credit first raised in a petition), aff’d, 69 F.3d 1404 (8th

Cir. 1995).

6 All numbers are rounded to the nearest whole number.

[*10]

Tax Year

Research Credit Claimed

2013

$138,205

2014

158,031

2015

138,334

2016

128,228

The research credits are attributable solely to wages paid to

PDG’s employees. Petitioner used the research credits during the credit

years as follows:

Tax Year

Research Credit Claimed

2015

$110,576

2016

74,488

2017

211,142

2018

68,147

2019

71,102

Respondent selected petitioner’s tax returns for 2015 through

2019 for examination. On December 14, 2021, respondent issued a

notice of deficiency to petitioner, disallowing the research credits and

determining the following deficiencies and accuracy-related penalties:

Tax Year

Deficiency

Accuracy-Related

Penalty

2015

$55,504

$11,101

2016

47,811

9,021

2017

219,177

43,835

2018

68,147

13,629

2019

71,102

14,220

Petitioner timely petitioned this Court for redetermination of the

deficiencies and penalties.

VI.

Research Projects

Given the number of projects for which petitioner claimed

research credits, the parties agreed to try a sample of three research

projects (trial projects). Our conclusions with respect to these trial

projects are not binding as to the remaining research projects. Rather,

[*11] it is the Court’s expectation that this decision will enable the

parties to mutually resolve the credits for the remaining research

projects. See Little Sandy Coal Co. v. Commissioner, T.C. Memo. 202115, at *20, aff’d, 62 F.4th 287 (7th Cir. 2023). The parties selected the

following three projects for trial: (1) Gerald Champion Military

Psychiatric Unit (Gerald Champion), project No. 13008.00; (2) Baptist

Memorial Health North Mississippi Oxford (BHNM Oxford), project No.

13003.00; and (3) Vanderbilt University Engineering and Science

Building (VU ESB), project No. 12010.01. 7

The parties further narrowed the scope of trial to the

determination of whether these projects entailed qualified research and

not the amounts of qualified research expenses. Additionally, the

parties stipulated that if we determine that none of the trial projects

involved qualified research, petitioner will be liable for an accuracyrelated penalty for each of the credit years in which there is a deficiency

determined by the Court or by agreement of the parties. However, if we

determine that one or more of the trial projects involved qualified

research, respondent concedes that petitioner is not liable for accuracyrelated penalties for any of the credit years.

Gerald Champion, Project No. 13008.00

Gerald Champion Regional Medical Center contracted

architecture firm Ascension Group Architects, LLP, for two projects:

(1) a geropsychiatric and military psychiatric renovation and new

construction and (2) a catheterization laboratory infill. 8 As to the first

7 Petitioner contends in its posttrial brief that the Court should expand the

scope of the stipulation to all projects at a given location. For example, Gerald

Champion is project No. 13008.00. The related catheterization laboratory is assigned

project No. 13008.01. Petitioner contends both of those projects should be considered

part of the trial; whereas respondent argues the parties tried only project No. 13008.00.

Because the parties agreed to the specific project numbers in both stipulations related

to the scope of trial, we will limit our review to the project numbers specified in the

stipulations as listed above. Petitioner’s argument to expand the scope of trial directly

conflicts with the representation that employees billed times to the appropriate project

number. Petitioner did not provide hour sheets related to the derivative project

numbers.

Petitioner did not provide a project description for each project number and

derivative project number. Therefore, we have used the titles of the projects and the

hour sheets related to the primary project number to discern the scope of the projects

at issue.

8 The catheterization laboratory is beyond the scope of this trial.

[*12] project, the renovations occurred in two existing wings in the

hospital and included a small addition.

On July 23, 2013, PDG and Ascension Group Architects, LLP,

entered a service contract related to these projects. Specifically, PDG

was engaged to design and update the MEPF systems within the

renovation and addition area. Gerald Champion Regional Medical

Center sought to retain as much of the existing systems as possible to

reduce costs. PDG agreed to a fixed compensation of $90,000, which

would be paid at the completion of specified milestones in the design and

construction process.

Gerald Champion initially provided PDG

engineers with existing schematic design documents from previous

engineering firms, a gross block diagram, and historic data that would

allow sizing of equipment.

Petitioner did not identify the final construction documents it

provided to Ascension Group Architects, LLP. The record contains a

series of design drawings dated September 26, 2013, that appear to set

forth a nearly complete plan for the MEPF systems. On the same day,

PDG engineers also delivered a project manual for the renovation. PDG

engineers periodically revised the designs and issued new design

drawings. However, petitioner did not explain why or how the revisions

were made.

PDG’s employees recorded time to the Gerald Champion project

under at least three distinct project numbers, including separate project

numbers for the catheterization laboratory and military behavioral

health wing. 9 As established above, the scope of the trial is confined to

project No. 13008.00, which is described as “Gerald Champion Military

Psychiatry Unit.” To act as engineers of record on the final project, PDG

engineers had to ensure that any retained MEPF systems complied with

relevant building codes.

Mechanical Systems

Gerald Champion Regional Medical Center wanted to use its

existing HVAC system to support the renovations and the addition. To

determine the feasibility of this request, PDG mechanical engineers

reviewed the existing drawings and systems during the design

9 The projects include Gerald Champion Military Psychiatry Unit, project No.

13008.00; Gerald Champion Cath Lab, project No. 13008.01; and Gerald Champion

Cath Lab Revisions, project No. 13008.02. We have disregarded all evidence to the

extent it does not relate to Gerald Champion Military Psychiatry Unit.

[*13] development phase. PDG mechanical engineers determined that

the existing HVAC system was installed in accordance with the original

plan documents but found major flaws in the design. The original

engineers failed to account for the elevation of the hospital in designing

the existing HVAC system, which affects the required airflow to reach a

desired temperature. After calculating the heating and cooling loads of

the spaces, PDG mechanical engineers “analyzed” the existing HVAC

system and determined that it could support the renovation but not the

small addition. Therefore, PDG mechanical engineers designed a new

air handling system to serve the addition.

PDG mechanical engineers considered whether the system should

be a constant air volume system or a variable air volume system. PDG

mechanical engineers selected the variable air volume system because

of the need for individual temperature control in the rooms.

As for the energy source to cool the coils, PDG mechanical

engineers considered whether to use chilled water supplied from the

hospital’s central plant or to design a standalone refrigeration system

for the unit. PDG mechanical engineers performed some calculations

that determined that the existing plumbing was insufficient to serve the

new air handling system, and thus they selected a local system.

Relatedly, PDG mechanical engineers designed a method to reject the

excess heat from the cooling system. PDG mechanical engineers

determined that it was not cost efficient to connect to the hospital-wide

refrigerant system that was located on the opposite side of the building.

Therefore, PDG mechanical engineers selected a local condensing unit

that would sit outside and reject the excess heat into the environment.

As for the energy source to heat the coils, PDG mechanical engineers

determined that the existing piping distribution was sufficient to serve

the new air handling unit. To make this determination, PDG

mechanical engineers calculated the amount by which the water

pressure dropped between the central plant and the addition. PDG

mechanical engineers performed static pressure calculations during the

construction document phase to determine the appropriate fan size for

the HVAC system.

After making these determinations, PDG mechanical engineers

identified the addition’s heating and cooling requirements, the range of

possible temperatures, and the filtration requirements of the new

system. Using this information, PDG mechanical engineers selected an

appropriate air handling unit from a commercial producer. At this

point, PDG mechanical engineers provided the architect with an

[*14] estimated size of the HVAC system. It was uncertain to this point

whether the equipment would be housed in a mechanical room or on the

roof. PDG mechanical engineers indicated their preference for a rooftop

system, but the architect rejected this option because of aesthetic

concerns. The architect approved placing the unit indoors but requested

that the mechanical room be as small as possible. PDG mechanical

engineers collaborated with the manufacturer to reduce the footprint of

the unit by splitting the equipment over two levels.

In addition to the technical HVAC design, PDG mechanical

engineers also had to ensure that the HVAC system complied with

precautions taken for psychiatric patients.

Specifically for the

mechanical engineers, this included using tamper resistant fasteners

that could not be unscrewed with a coin and restricting access to

thermostats. These precautions also limited the choice of equipment for

the system. For example, PDG considered adding a dedicated outside

air system to circulate fresh air into the building that would require a

portion of the system to be housed in patient rooms. This posed an

additional risk to the patients, and consequently, PDG mechanical

engineers rejected this idea.

During the construction administration phase, PDG mechanical

engineers also discovered new information. For example, during a site

visit, PDG mechanical engineers determined that the windows became

incredibly warm during the day. PDG mechanical engineers reran

heating and cooling load calculations to ensure the HVAC system could

compensate for this new variable and found that it could.

Electrical Systems

As with the mechanical engineers, PDG electrical engineers

began work on the project by evaluating the systems currently in place.

PDG electrical engineers determined that the electrical panels were full

and could not support the renovation. They designed new electrical

panels that allowed the project to be completed in phases while patients

were on site. They also had to add another electrical panel to supply a

new information technology room.

Plumbing Systems

Petitioner presented little evidence to show the work PDG

plumbing engineers performed for Gerald Champion. The sole issue

mentioned at trial was the need to design the patient-facing systems in

a way that was safe for psychiatric patients, such as slanting piping. In

[*15] other parts of the record, we see design drawings that appear to

show revisions to the plumbing systems, equipment selection

information and emails, and requests for information. Petitioner did not

provide any further information regarding the design decisions or the

revisions.

Employee Time

PDG employees recorded a total time of 487 hours on the Gerald

Champion project. The mechanical discipline recorded 170 hours, the

electrical discipline recorded 180 hours, and the plumbing discipline

recorded 137 hours. CAD designers recorded 143 hours, broken down

by discipline as follows: 60 hours for mechanical, 52 hours for electrical,

and 31 hours for plumbing.

BHNM Oxford, Project No. 13003.00

Baptist Memorial Health Care Corp. (Baptist Memorial)

contracted architecture firm Earl Swensson Associates, Inc. (Earl

Swensson), to design a new hospital to replace its current hospital. On

June 2, 2011, PDG and Earl Swensson entered into a service contract

related to this project. Specifically, Earl Swensson engaged PDG to

design the MEPF systems.

PDG agreed to a fee of 1.3% of the building’s construction cost.

This fee was payable at the completion of specific milestones in the

design and construction process. PDG’s employees recorded time to this

project solely under project No. 13003.00. Having operated several

hospitals, Baptist Memorial was familiar with the MEPF systems

required for hospitals and had strong equipment preferences.

At the start of the project, Earl Swensson provided petitioner with

floor diagrams and a preliminary master plan. Petitioner did not

identify the final construction documents it provided to Earl Swensson.

The record contains a series of design drawings dated December 15,

2014, that appear to set forth a nearly completed plan for the MEPF

systems. PDG engineers periodically revised the designs and issued

new design drawings. However, petitioner did not explain why or how

the revisions were made.

Mechanical Systems

The BHNM Oxford project called for the design of a large hospital

with varying climate needs for each department. For example, the

[*16] surgical unit had to be cooled to 62 degrees. Because of the

varying needs of the hospital, the mechanical engineers determined that

the HVAC system should have multiple air handling units. PDG

mechanical engineers collaborated with a manufacturer that Baptist

Memorial designated to design custom air handling units for critical

areas: surgery, emergency, intensive care, imaging, and roof. For the

remaining air handling units, PDG mechanical engineers selected

conventional units designed by the manufacturer. The air handling unit

for the surgical area contained a secondary coil to ensure temperature

requirements could be met.

With several air handling units set to service the hospital, PDG

mechanical engineers had to determine the appropriate location of each

unit. PDG mechanical engineers first considered placing a mechanical

room at the end of each wing to house the air handling units. However,

Baptist Memorial rejected this option because it would take revenuegenerating space from the hospital. PDG mechanical engineers

redesigned the system to place the air handling units on the end of the

roof of each wing.

As for the source to cool the coils, Baptist Memorial indicated that

it wanted to use chilled water. To chill the water, Baptist Memorial

selected a centrifugal chiller compressor to provide refrigerant to the air

conditioning system. Baptist Memorial also set forth their preference

for a specific manufacturer, required levels of redundancies, and how

the chillers should be piped. PDG mechanical engineers designed the

piping configuration between the centrifugal chiller compressor and the

air handling units.

As for the source to heat the coils, PDG mechanical engineers

selected steam because it could serve multiple purposes. In addition to

heating the coils, the selected steam system could be used to sterilize

surgical instruments. Next, PDG mechanical engineers considered

whether the steam should be provided by local generators or at a central

steam plant. They selected a central steam plant that could service both

the heating and sterilization systems. They used heat exchangers on

the steam plant to heat water that would be used to heat the building.

They designed a complex three-boiler system to distribute heat

throughout the building and provide steam for sterilization.

Baptist Memorial indicated that it wanted a backup fuel system

to provide emergency power to the boiler system. PDG mechanical

engineers designed tanks to hold the backup fuel after Baptist Memorial

[*17] specified that the tanks should be above ground. PDG mechanical

engineers had to ensure the tanks could withstand earthquakes and

that the fuel stored inside would not become contaminated over time.

PDG mechanical engineers also had to comply with the local

building code regarding airflow requirements. Airflow was particularly

relevant for the hybrid operating room, which would include both

imaging equipment and operating room capabilities within a sterile

environment. Operating rooms, whether traditional or hybrid, require

very slow air to flow that does not spiral where the table is positioned.

Typically, an operating room table is in a fixed location in the room. In

contrast, the hybrid operating room was designed to allow the operating

staff to move the bed to several configurations, which affected the design

of the diffusers needed to create the required airflow. PDG mechanical

engineers designed the layout with various diffusers positioned

throughout the room to create a sterile field regardless of the orientation

of the bed.

Electrical Systems

PDG electrical engineers began work on the BHNM Oxford

project by estimating the electrical needs for the various zones of the

hospital. The PDG electrical engineers then met with the utility

company, North East Mississippi Electric Power Co. (North Power), to

determine how to supply electricity to the new building. Baptist

Memorial requested that the hospital be connected to two substations in

case one substation was taken offline.

PDG electrical engineers worked with North Power to run

electricity from two substations to the hospital in a configuration that

allowed for subsequent development.

North Power provided

recommendations and alternatives on how to run the electricity lines to

the campus and the switch that would allow the hospital to be fed by the

two substations.

PDG electrical engineers communicated this

information to Baptist Memorial, and Baptist Memorial made the

ultimate decision.

Once North Power determined the route for the electric, PDG

electrical engineers had to determine how to distribute it across the

building. PDG electrical engineers estimated a large electric load would

be required for the building. To accommodate this load, PDG electrical

engineers informed the architect that they would require multiple

switchboards to distribute the electricity and the estimated size of the

[*18] electrical rooms needed to store this equipment. PDG electrical

engineers initially designed multiple electrical rooms to serve the

building but reduced the number at the request of Baptist Memorial.

PDG calculated the number of electrical panels required for distribution

on the basis of estimated demands of the system. As the project

progressed, the electrical demands often changed. For example, the

hospital purchased a different piece of imaging equipment and PDG

electrical engineers had to review the information provided by the

manufacturer to determine whether the current design could support

the new equipment.

The operating rooms provided an additional challenge in that the

building code required isolated power. This required an isolated power

pad, which alerts medical staff if there is a surplus of voltage that could

harm the patient. PDG electrical engineers included this in the design.

Baptist Memorial also requested that PDG electrical engineers

use a Powerwave Bus System to power the information technology

center. PDG electrical engineers met with the vender to understand

how this system worked. PDG electrical engineers then consulted with

Baptist Memorial to determine the equipment that would be housed in

the information technology room. Along with the mechanical engineers

that were responsible for cooling the room, the electrical engineers

determined the configuration of the equipment. The manufacturer then

built systems to meet the expected demand.

Plumbing Systems

Petitioner presented little evidence to show the work PDG

plumbing engineers performed for BHNM Oxford. In the record we see

design drawings that appear to show revisions in the plumbing systems

and equipment selection information. Petitioner did not provide any

further information regarding the design decisions or the revisions.

Employee Time

PDG employees recorded a total time of 16,650 hours on the

BHNM Oxford project. The mechanical discipline recorded 5,941 hours,

the electrical discipline recorded 5,876 hours, and the plumbing

discipline recorded 4,333 hours. The remaining 501 hours were recorded

to specific phases of the project without a specified discipline. CAD

designers recorded 2,118 hours, broken down by discipline as follows:

261 hours for mechanical, 947 hours for electrical, 909 hours for

[*19] plumbing, and 1 hour to construction administration without a

specified discipline.

VU ESB, Project No. 12010.01

Vanderbilt University contracted architecture firm Wilson

Architects, Inc. (Wilson Architects), to design an engineering and

science building (TEAM building). Vanderbilt University intended the

new building to be an interdisciplinary research building for the school

of engineering and medical center that would house research

laboratories, faculty offices, conference facilities, a cleanroom, imaging

facilities, and a vivarium. On July 17, 2013, PDG and Wilson Architects

entered a service contract for PDG to design the MEPF systems and

telecommunication systems for the TEAM building. Specifically, PDG’s

services included (1) designing MEPF systems that meet the

requirements for LEED Silver certification and (2) consulting with the

cleanroom contractor to determine which utilities are needed for the

cleanroom.

PDG engineers completed their work through the design

development phase when the medical center pulled out of the joint

venture. Vanderbilt University stopped all work on the project until it

could determine how the project would continue. The university decided

to continue the design and construction of the building but modified the

plans to fit only its needs. Vanderbilt University decided to remove the

biomedical portions of the design plan, including reducing the number

of laboratories and deleting the vivarium. It also reduced the size of the

building. Vanderbilt University retained the cleanroom and imaging

facility.

On January 1, 2014, Vanderbilt University and Wilson Architects

entered into a new contract related to the shifting scope. Under this

new contract, Wilson Architects was to design and construct an

engineering and science building. The new building would have five

above-ground floors that would house research labs and community

spaces. The building would also house a 10,000-square-foot clean room

on the ground floor. Two floors below the ground level would house

classrooms and imaging areas containing nanoscale and atomic-level

microscopes.

PDG executed a new contract with Wilson Architects on

September 29, 2015, to design the MEPF and telecommunication

systems for the new project. Specifically, PDG’s services included

[*20] (1) revising the systems for the reconfigured building and

(2) reselecting the required equipment. In addition to PDG, Wilson

Architects contracted a specific engineering firm that specialized in

cleanroom mechanical, electrical, and plumbing systems. Because

previous work had been done for the combined engineering and medical

building, PDG was contracted to start at the design development phase

of the project. PDG agreed to a fixed fee of $1,758,500 for this project to

be paid at specific milestones in the project.

PDG engineers submitted the stamped final construction

documents to Wilson Architects. These construction documents set forth

the MEPF systems designs by floor, including the exhaust systems,

electricity distribution, and mechanical equipment. These documents

were subsequently revised, but petitioner did not explain the revisions

and we are unable to derive meaning from the design drawings.

PDG’s employees recorded time to this project under at least 18

distinct project numbers, including separate project numbers for

laboratory revisions, the chilled water tie-in, and the steam line

relocation. 10 As established above, the scope of the trial is confined to

project No. 12010.01, which is described as “VU ESB (Olin Hall).” PDG’s

employees recorded time to this project in years 2013 through 2017.

PDG represents that the work completed on the TEAM building with

the medical center was not recorded to project No. 12010.01.

Mechanical Systems

PDG mechanical engineers were tasked with designing an HVAC

system that could accommodate the varying uses of the building and

achieve at least an LEED Silver certification. PDG mechanical

10 The projects include: VU ESB (Olin Hall), project No. 12010.01; VU ESB –

Central Plant Chilled Water, project No. 12010.02; VU ESB 3rd & 4th Floor Redesign,

project No. 12010.03; VU ESB – Olin Steam Line – Relocation, project No. 12010.04;

VU ESB – LEED Forms Additional Service, project No. 12010.05; VU – ESB – RFP

#25 Innov Ct Changes, project No. 12010.06; VU ESB – Add Third Chiller & Olin Hall,

project No. 12010.07; VU ESB – AV Revisions, project No. 12010.09; VU ESB – Roof

Terrace Revision, project No. 12010.10; VU ESB Campus Chilled Water Tie-ins, project

No. 12010.11; VU ESB 2nd Fl Server Room/IT RFP 53, project No. 12010.12; VU ESB

– CNC Laser Cutter Fitout, project No. 12010.13; VU ESB – Animal Holding, project

No. 12010.14; VU ESB – 4th Floor Revisions 2016, project No. 12010.15; VU ESB Bus

Stop Duct Bank/Light Pole, project No. 12010.16; VU ESB Bardham Lab Olin Hall,

project No. 12010.17; VU ESB – Lab 343 Buildout for Pint, project No. 12010.18; and

VU ESB – Art Work Additional Lighting, project No. 12010.19. We have disregarded

all evidence to the extent it does not relate to project No. 12010.01.

[*21] engineers ran heating and cooling loads throughout the design

process to account for changes in the design plans, such as changing

window sizes. In addition to calculating the heating and cooling loads,

PDG mechanical engineers made recommendations to limit the demand

on the heating and cooling systems, such as glazing the windows to

prevent heat transfer.

In considering how to achieve the LEED Silver certification, PDG

mechanical engineers contemplated whether to use water or air systems

to cool and heat the building. PDG mechanical engineers selected a

hybrid system, which would increase efficiency to help meet LEED

Silver certification. As for the source of cooling for the coils and water

system, PDG mechanical engineers selected a building chiller. 11 The

building chiller system is a large draw on electricity that could affect the

building’s qualification for LEED certification. To determine the design

of the building chiller system, PDG mechanical engineers modeled units

from three different manufacturers to determine which unit had the

lowest operating cost in peak and part load performance. PDG

mechanical engineers determined that it would use two chillers with one

on standby to service the building. 12 PDG mechanical engineers created

a control system to ensure the chillers functioned as one unit. PDG

mechanical engineers worked on the chiller system from the design

development phase to the construction document phase.

As for the source of heating for the coils and water system,

Vanderbilt University has a campus-wide steam distribution system.

The distribution system is contained in a “mole hole” 100 feet below

ground. Inside the mole hole is a pipe that carries high pressure steam

around campus. PDG mechanical engineers designed a piping system

to connect the science building to the steam distribution system. 13 In

making this design, PDG mechanical engineers had to account for the

11 In its posttrial brief petitioner categorizes this design as falling under the

plumbing discipline. However, the referenced exhibit is a mechanical engineering

diagram, and time spent on this project was billed to the mechanical discipline.

Therefore, we will treat this design challenge as falling under the mechanical

discipline.

12 PDG engineers also designed a backup system using the campus chilled

water system, but that is beyond the scope of the current trial.

13 In its posttrial brief petitioner categorizes this design as falling under the

plumbing discipline. However, the referenced exhibit is a mechanical engineering

diagram, and time spent on this project was billed to the mechanical discipline.

Therefore, we will treat this design challenge as falling under the mechanical

discipline.

[*22] effect of the steam on the piping. The steam from the steam

distribution system is over 400 degrees. In contrast, the ground

temperature in the area that would house the pipes connecting the

steam distribution system to the VU ESB project would be

approximately 50 degrees. When the hot steam entered the pipe, it

would cause the pipes to expand and contract because of the change in

temperature. If PDG mechanical engineers did not account for this

expansion, the pipe would rupture.

To determine the rate of expansion or stress on the system, PDG

mechanical engineers initially hand drafted a design for the pipe and

created computer models. They then calculated the force that would be

on the pipe between the point of connection to the steam distribution

system and the VU ESB project. After coming up with an initial design,

PDG mechanical engineers entered the information into pipe stress

analysis software. This analysis flagged the points on the pipe where

the stress had to be mitigated to prevent rupture. PDG mechanical

engineers then introduced elbows, expansion bellows, and different

configurations to reduce stress on certain points of the pipe. After

making these edits, PDG mechanical engineers ran the program again

and continued this process until there were no ruptures. PDG

mechanical engineers reran the program during the construction

administration phase because the contractor could not build the pipe in

the exact location specified in the construction documents. 14

PDG mechanical engineers designed a two-story penthouse to

house the air handlers, chillers, pumps, and exhaust ducts. They

determined the layout of the penthouse but did not specify how the

components would be hung in the penthouse. The contractor came up

with a solution to provide intermediate supports rather than hanging

the piping from the ceiling.

As discussed above, once the air is chilled or heated, it is

distributed around the building via duct work and return air is

circulated out of the space. Because of the research performed in the

laboratories, the VU ESB project had additional exhaust sources from

each room. The third and fourth floors of the science building were

designed as research laboratories. Laboratories are either dry or wet.

A wet laboratory is one that contains biological or hazardous materials

14 PDG mechanical engineers also designed a mechanism to connect the old

engineering building to the VU ESB with a valve that allowed steam to travel in two

directions. This project is beyond the scope of this trial.

[*23] that require a fume hood. At the start of the design, Vanderbilt

University was not certain as to which researchers would be assigned to

each laboratory.

Because of this uncertainty, PDG mechanical

engineers designed each laboratory with one fume hood that would allow

each room to operate as either a wet or a dry laboratory. This was an

additional exhaust point that had to be accounted for in the design of

the HVAC system and would make the system less energy efficient. 15

PDG mechanical engineers designed a system that captured energy

from exhaust air when most of the fume hoods were not in use.

PDG mechanical engineers routed the exhausts from the

laboratories to the roof of the science building. The VU ESB project was

located among other university buildings, so there was concern about

the fallout of particles discharged from the fume hoods on adjacent

buildings. PDG mechanical engineers had to determine the proper

height of the plume exhaust system that was located on the roof and the

required fan strength to minimize fallout on adjacent buildings. They

considered two options for the plume system: one with two stacked fans

and one with a single stronger fan. They determined that the single-fan

option would not propel the air high enough to get the required

distribution, so the engineers selected the two-fan system.

PDG mechanical engineers were also particularly concerned with

airflow and pressure relationships. The work occurring in several of the

rooms was particularly sensitive to slight air disturbances. For

example, the imaging facility contained a Krios microscope that could be

used to examine atoms. This process was extremely sensitive to slight

disturbances, which would distort the images. PDG mechanical

engineers considered this sensitivity in designing the HVAC system for

this area because any airflow in the room could result in distortion.

They determined that the vent locations for the HVAC system should be

placed at the periphery of the space and the researchers would need the

ability to turn off the system during research.

In addition to airflow concerns, the pressure relationship between

the various rooms affected the design of the HVAC system. Both the

imaging room and the cleanroom required particular attention to

pressure differentials. To prevent disruption of the work in the imaging

facility, PDG mechanical engineers designed the HVAC system such

that the pressure in the imaging facility was greater than in the

15 The laboratories were then further customized as the university assigned

researchers to each space, but the redesign exceeds the scope of the trial project.

[*24] surrounding areas. This would ensure that when the doors were

open, air would blow out of the imaging facility and prevent dust from

entering the room. Likewise, the HVAC system for the cleanroom had

to be designed to achieve a particular pressure relationship on the

account of the biohazardous materials and hazardous chemicals studied

there.

In addition to designing the HVAC system, PDG mechanical

engineers designed smoke and fire dampers to work with the HVAC

system. One area that presented a particular challenge was the clean

room. PDG determined that traditional smoke and fire dampers would

be dangerous because the exhausts expelled air at a high rate to counter

the harsh chemicals used in the room and could not be turned off. If a

fire or smoke damper was triggered, it would cut off the makeup air

supply that compensates for the high exhaust rate, which would suck

the oxygen from the room. The imbalance in pressure would also result

in occupants’ being unable to open any outward opening doors. After

determining that their initial design led to these safety concerns, PDG

mechanical engineers considered alternative designs but did not find a

solution. PDG mechanical engineers obtained an exception from the

local authorities to not install the smoke and fire dampers in the

cleanroom.

In relation to fire prevention for the HVAC system, Vanderbilt

University requested that PDG design the system so that it could be

tested without disturbing research.

PDG mechanical engineers

discovered a vendor they had not used before that offered dampers that

could be tested from a centralized control panel without visual

inspection. They integrated this damper system into the existing design

for the fire alarm system.

Electrical Systems

As with the other projects, PDG electrical engineers began the

project by determining the building’s estimated load using software that

based energy demand on square footage. Instead of using generic

laboratory estimates, Vanderbilt University and PDG electrical

engineers determined the average energy consumption of other

laboratory buildings on campus. PDG electrical engineers then worked

with Vanderbilt University to determine how to convey the electricity

from the campus distribution system to the VU ESB project. PDG

electrical engineers routed the electricity around the building, ensuring

that the requirements of each laboratory were met. This included

[*25] ensuring that the system could satisfy the high electrical demand

of the cleanroom.

Vanderbilt University also requested emergency electricity in the

building. Because of the large electrical demands of the building and

limited space, PDG electrical engineers determined that the backup

generators should be located on the VU ESB’s roof. Additionally, PDG

electrical engineers accounted for electromagnetic interference from all

of the electrical wires providing electricity to the cleanroom that would

disrupt the sensitive research equipment. To prevent this interference,

PDG electrical engineers insulated the wires.

Plumbing Systems

Petitioner presented little evidence to show the work PDG

plumbing engineers performed for the VU ESB project. In the record we

see design drawings that appear to show revisions to the plumbing

systems and unexplained calculations. Petitioner did not provide any

further information regarding the design decisions or the revisions.

Employee Time

PDG employees recorded a total time of 12,671 hours on the VU

ESB project between 2013 and 2017. 16 The mechanical discipline

recorded 3,862 hours, the electrical discipline recorded 4,086 hours, and

the plumbing discipline recorded 1,801 hours. The remaining 2,924

hours were recorded to specific phases of the project without a specified

discipline. CAD designers recorded 3,515 hours, broken down by

discipline as follows: 1,574 hours for mechanical, 1,466 hours for

electrical, 473 hours for plumbing, and 2 hours to project management

without a specified discipline.

OPINION

Burden of Proof

The Commissioner’s determinations set forth in a notice of

deficiency are generally presumed correct, and the taxpayer bears the

burden of proving the determinations are in error. See Rule 142(a)(1);

Welch v. Helvering, 290 U.S. 111, 115 (1933). Credits are a matter of

legislative grace, and taxpayers must demonstrate their entitlement to

16 The hour sheets contained entries from 2017; however, petitioner claimed

research credits only between 2013 and 2016.

[*26] credits claimed. See Feigh v. Commissioner, 152 T.C. 267, 270

(2019) (citing INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992)).

Petitioner does not contend, and the evidence does not establish, that

the burden of proof shifts to respondent under section 7491(a) as to any

issue of fact.

II.

Section 41 Research Credit

Basic Structure

Section 38(a) permits a taxpayer to claim on its return a credit

against tax equal to the sum of (1) business credits carried forward to

the tax year, (2) current year business credits, and (3) business credits

carried back to the tax year. Current year business credits include the

credit under section 41 for increasing research activities. § 38(b)(4).

Section 41(a)(1) provides that the research credit is equal to 20%

of the excess of the taxpayer’s qualified research expenses (QREs) over

the base amount. 17 QREs are limited to the amounts “paid or incurred

by the taxpayer during the taxable year in carrying on any trade or

business.” 18 §§ 41(b)(1), 7701(a)(25). QREs comprise in-house research

expenses and contract research expenses. § 41(b)(1). In-house research

expenses are (1) “any wages paid or incurred to an employee for qualified

services performed by such employee” and (2) “any amount paid or

incurred for supplies used in the conduct of qualified research.”

§ 41(b)(2)(A)(i) and (ii). Qualified services are defined as either

(1) engaging in qualified research or (2) engaging in the direct

supervision or direct support of qualified research. § 41(b)(2)(B). Direct

support of qualified research includes direct support of either the person

engaging in qualified research or the person directly supervising the

qualified research. Treas. Reg. § 1.41-2(c)(3). Generally, wages are

considered in-house research expenses to the extent that the wages were

paid for qualified services. § 41(b)(2)(A)(i). If at least 80% of the services

an employee performs are qualified services, a taxpayer may include

100% of the wages paid to the employee as in-house research expenses.

Treas. Reg. § 1.41-2(d)(2).

17 Respondent conceded the issue of petitioner’s base amount; therefore, we

need not address it further.

18 Petitioner is a cash method taxpayer. A cash method taxpayer takes liability

into account when the expenditure is actually paid. § 446; Treas. Reg. § 1.446-1(c)(1)(i).

[*27] B.

Qualified Research

To constitute qualified research, the research must satisfy a fourpart statutory test:

Sec. 41(d). Qualified research defined. . . .

(1) In general.—The term “qualified research”

means research—

(A) with respect to which expenditures

may be treated as expenses under section 174,

(B) which is undertaken for the

purpose of discovering information—

(i) which is technological in

nature, and

(ii) the application of which is

intended to be useful in the

development of a new or improved

business component of the taxpayer,

and

which constitute elements of a process of

experimentation for a purpose described in

paragraph (3).

The four-part statutory test is applied separately to each business

component. § 41(d)(2)(A). A business component is defined in relevant

part as a product that the taxpayer either (1) holds for sale, lease, or

license or (2) uses in its trade or business. § 41(d)(2)(B). For each trial

project, petitioner claims that the mechanical, electrical, and plumbing

systems together—the MEPF systems as a whole—represent the

business component.

Respondent concedes the technological

information test and the business component test. We now examine the

remaining portions of the four-part statutory test: the section 174 test

and the process of experimentation test. 19

The Section 174 Test

The first requirement is that the research must be research “with

respect to which expenditures may be treated as expenses under

19 In addition to the four-part statutory test, section 41(d)(4) excludes certain

activities from the definition of qualified research. We need not consider these

excluded activities for purposes of deciding this case.

[*28] section 174.” § 41(d)(1)(A). 20 We refer to this as the “section 174

test,” whereby the taxpayer must show (1) that the claimed research

expenditures would be eligible for a deduction under section 174 and

(2) that the claimed research activities constituted research and

development within the meaning of section 174. See Norwest Corp. &

Subs., 110 T.C. at 491. For tax years ending after July 21, 2014, if we

conclude that the taxpayer fails the section 174 test at “the level of a

product” as a whole, the taxpayer may still satisfy the test “at the level

of the component or subcomponent.” Treas. Reg. § 1.174-2(a)(5). 21

For background, section 174 operates as a narrow, elective

exception to the general capitalization rules. §§ 174(a), 263(a)(1),

263A(c)(2). Section 174(a) allows a taxpayer to elect a current deduction

for research and expenditures which are paid by the taxpayer during the

taxable year in connection with the taxpayer’s trade or business. 22 See

also Treas. Reg. § 1.174-1. Research and experimental expenditures are

research and development costs in the experimental or laboratory sense

and generally include all costs incident to the development or

improvement of a product. Treas. Reg. § 1.174-2(a)(1).

We apply a two-step test to determine whether a taxpayer’s

activities constituted research and development within the meaning of

section 174. In the first step the taxpayer must show that the

information objectively available to it did not establish the appropriate

design of the product. See Treas. Reg. § 1.174-2(a)(1); see also Max v.

Commissioner, T.C. Memo. 2021-37, at *29. If such information was not

available to the taxpayer with respect to establishing either the

capability, method, or appropriate design, then uncertainty existed. See

Union Carbide Corp. & Subs., T.C. Memo. 2009-50, slip op. at 195;

20 We have previously interpreted this requirement as incorporating section

174 requirements on both the nature of the activities and the nature of the

expenditures. See Norwest Corp. & Subs. v. Commissioner, 110 T.C. 454, 491 (1998)

(requiring “the taxpayer to satisfy all the elements for a deduction under section 174”);

Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo. 2009-50, slip op. at 197

(analyzing whether a taxpayer’s activities constituted research and development

within the meaning of section 174 and whether the costs associated with these

activities may be treated as expenses under section 174), aff’d, 697 F.3d 104 (2d Cir.

2012).

21 For tax year 2013, Treasury Regulation § 1.41-4(b)(2) provided an identical

shrinking-back rule.

22 Section 174 was later amended to eliminate the current deduction and

instead requires amortization of research and development expenditures for tax years

starting after December 31, 2021. See Tax Cuts and Jobs Act of 2017, Pub. L. No. 11597, § 13206, 131 Stat. 2054, 2111–13.

[*29] Treas. Reg. § 1.174-2(a)(1). In determining whether uncertainty

existed, we examine the information objectively available to the

taxpayer, rather than the taxpayer’s subjective understanding of that

information. Union Carbide Corp. & Subs., T.C. Memo. 2009-50, slip op.

at 195–96 (“Whether an uncertainty exists is an objective test that

depends on the information available to the taxpayer.” (citing Mayrath

v. Commissioner, 41 T.C. 582, 590–91 (1964), aff’d, 357 F.2d 209 (5th

Cir. 1966))); see also Max, T.C. Memo. 2021-37, at *30 (finding no

uncertainty where appropriate design may have been subjectively

unknown to the taxpayer but the taxpayer “already ha[d] the

information necessary to address that unknown”). Expenditures that

are paid after the elimination of uncertainty are not research and

development expenditures. Treas. Reg. § 1.174-2(a)(2). Furthermore, it

bears emphasis that uncertainty related to a subcomponent does not

necessarily render the appropriate design of the product as a whole

uncertain.

Betz v. Commissioner, T.C. Memo. 2023-84, at *76

(determining that a taxpayer failed to show objective uncertainty as to

the design of the product as a whole because the taxpayer would not

have to scrap the entire product if it did not work); Little Sandy Coal

Co., T.C. Memo. 2021-15, at *53.

In the second step, if uncertainty existed, the taxpayer must show

that it undertook investigative activities that were “intended to discover

information that would eliminate uncertainty.” Treas. Reg. § 1.1742(a)(1); see Max, T.C. Memo. 2021-37, at *30–31 (citing Mayrath, 41 T.C.

at 590) (requiring the taxpayer to show it undertook investigative

activities because the purpose of section 174 was to limit deductions to

expenditures of an investigative nature). The resolution of this

uncertainty does not necessarily require experimentation. See Little

Sandy Coal Co., T.C. Memo. 2021-15, at *36. We have previously held

that a meeting or email soliciting further information and specifications

is an investigative activity within the meaning of section 174. See Betz,

T.C. Memo. 2023-84, at *80, *89.

However, performing basic

calculations on available data is not an investigative activity because

the taxpayer already has all the information necessary to address that

unknown. Id. at *84, *87 (finding that performing calculations to

determine duct size based on airflow was not an investigative activity);

Max, T.C. Memo. 2021-37, at *30 (finding that while information was

subjectively unknown to the taxpayer with respect to the appropriate

design of a component, the taxpayer “already ha[d] the information

necessary to address that unknown”). A taxpayer may not carry its

burden to show it engaged in investigative activities merely by

presenting an issue and eventual solution. See Betz, T.C. Memo.

[*30] 2023-84, at *86. Instead, the taxpayer must show it actually

conducted investigatory activities. See id.

Petitioner argues that the second step of the section 174

analysis—whether PDG engineers undertook investigative activities—

is not before the Court. Petitioner argues that respondent’s stipulation

that he would not contest the technological information prong of the

four-part statutory test binds respondent as a concession that PDG

engineers undertook investigative activities.

Petitioner cites no

authority for extending this concession, and we will not do so in this

case. See Betz, T.C. Memo. 2023-84, at *68, *86 (considering whether a

taxpayer satisfied the investigative activities portion of the section 174

test even when the IRS conceded the technological information test).

The Process of Experimentation Test

Finally, section 41 requires that (1) substantially all the research

activities (2) constitute elements of a process of experimentation (3) for

a qualified purpose. § 41(d)(1)(C). We refer to this as the process of

experimentation test. A process of experimentation is a “process

designed to evaluate one or more alternatives to achieve a result where

. . . 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)(i). The

requisite uncertainty under this test is essentially identical to the

uncertainty required by the section 174 test. Union Carbide Corp. &

Subs., T.C. Memo. 2009-50, slip op. at 199. Unlike the section 174 test,

however, this evaluative process must follow the scientific method. Id.

at 201.

The substantially all requirement is satisfied if “80 percent or

more of a taxpayer’s research activities, measured on a cost or other

consistently applied reasonable basis . . . , constitute elements of a

process of experimentation for a [qualified purpose].” Treas. Reg. § 1.414(a)(6). The substantially all requirement is satisfied even “if the

remaining 20 percent (or less) of a taxpayer’s research activities with

respect to the business component do not constitute elements of a

process of experimentation for a [qualified purpose], so long as these

remaining research activities satisfy the [section 174 test] and are not

otherwise excluded under section 41(d)(4).” Id. Therefore, the

numerator of the relevant fraction is all research activities that

constitute an element of a process of experimentation for a qualified

purpose. Little Sandy Coal Co., T.C. Memo. 2021-15, at *40; Treas. Reg.

§ 1.41-4(a)(6). The denominator is all research activities that meet the

[*31] section 174 test that are not covered by one of the statutory

exclusions. Little Sandy Coal Co., T.C. Memo. 2021-15, at *40; Treas.

Reg. § 1.41-4(a)(6). Petitioner bears the burden of providing sufficient

information to demonstrate that the substantially all fraction equals or

exceeds 80%. Little Sandy Coal Co., T.C. Memo. 2021-15, at *43–44.

Petitioner indicated only the number of hours worked by each employee

on each project; therefore, we will apply the substantially all test on this

basis.

The final part of the process of experimentation test requires that

the activities be for a qualified purpose as defined in section 41(d)(3).

Qualified research includes research that is related to (1) a new or

improved function, (2) performance, or (3) reliability or quality.

§ 41(d)(3). Research related to style, taste, cosmetic, or seasonal factors

is not for a qualified purpose. Id.

Shrinking-Back Rule

If a business component fails any part of the four-part statutory

test, we may apply the test to a subset of the product (shrinking-back

rule). Treas. Reg. § 1.41-4(b)(2). The shrinking-back rule instructs us

to reapply the four-part statutory test to the business component at its

most significant subset of elements. Id. If that subset of elements again

fails, we generally drill down to a more granular subset of the business

component until either (1) a subcomponent satisfies the test or (2) the

most basic level of the component fails to satisfy the test. Id. When a

component fails, we have previously applied this rule to an issue that a

taxpayer encounters in the design process when the issue relates to an

identifiable subcomponent. See, e.g., Betz, T.C. Memo. 2023-84, at *81.

As noted above, an identical test applies if a business component fails

the section 174 test. See Treas. Reg. § 1.174-2(a)(5).

If we determine that the MEPF systems for any trial project fails,

petitioner contends that we can apply the shrinking-back rule by relying

on the hour tracking information. Petitioner presents several options to

shrink back including by (1) discipline, (2) particular design phase, or

(3) individual employee. Petitioner’s first suggestion to apply the

shrinking-back rule by discipline aligns with the regulatory text. That

is, if the MEPF systems as a whole fail to qualify, we will narrow the

scope of our review separately to the mechanical systems, electrical

systems, and plumbing systems. If this secondary level fails, the

shrinking-back rule directs us to determine the next most significant

subset of the business component.

[*32] We reject petitioner’s other shrinking-back methods. We must

apply the shrinking-back rule to the next most significant subset of

elements of the business component. Looking at the design stages, we

cannot identify subsets of the MEPF systems. Instead, PDG engineers

worked on various subsets of the MEPF systems in each design stage

and subsets of the systems were not neatly resolved in one design stage.

For example, during the project design stage of the BHNM Oxford

project, PDG engineers worked on the roof units and the fire alarm

system. Additionally, work on the lighting systems extended over

several design stages.

As for applying the shrinking-back rule to focus on the activities

of one employee, we likewise run into the issue of ignoring the most

significant subset rule. No one employee exclusively focused on one

subset, nor was any one subset worked on by only one employee. For

example, in the VU ESB project mechanical engineer Thomas Fisher

worked on the chiller issue and the steam distribution issue.

Mechanical engineer Ross T. Malloy also worked on the steam

distribution issue. Therefore, applying the shrinking-back rule by

employee would not identify the most significant subset of the MEPF

systems. Thus, we will apply the shrinking-back rule, if required, to

examine the mechanical system, electrical system, and plumbing

system. If these systems also fail, we then will have to determine

whether there is sufficient information to apply the shrinking-back rule

to a further subset of the systems.

III.

The Qualification of the Trial Projects as Qualified Research

Now we turn to the issue of whether any trial project entailed

qualified research within the meaning of section 41. Petitioner contends

that it faced uncertainty as to the appropriate design of each of the

MEPF systems even beyond the delivery of stamped construction

documents because the appropriate design of the MEPF systems could

not be established until construction was complete. Petitioner claims

this uncertainty continued because PDG engineers would have to revise

and alter the design through construction. For how PDG engineers

resolved this uncertainty, petitioner directs the Court to its six-stage

design process. Petitioner alleges that when faced with an issue in a

later design stage, its engineers would revert to earlier stages to resolve

the issue, creating an iterative process that mirrors the scientific

method.

[*33] At the outset, we reject petitioner’s theory that uncertainty

existed because of the possibility of revising the design of the MEPF

systems before construction was complete. The regulations and our

caselaw recognize a distinction between objective uncertainty as to the

design of the whole system (its basic design specifications) and objective

uncertainty as to the design of a particular component. Treas. Reg.

§ 1.174-2(a)(5); see also Betz, T.C. Memo. 2023-84, at *76. The mere

possibility of altering the design in later stages does not itself establish

that the appropriate design remained uncertain. See Betz, T.C. Memo.

2023-84, at *76; Little Sandy Coal Co., T.C. Memo. 2021-15, at *53.

These subsequent revisions may introduce some uncertainty, but the

scope of the uncertainty is a question based on the particular facts and

does not necessarily translate to the entire system. See Betz, T.C. Memo.

2023-84, at *76; Little Sandy Coal Co., T.C. Memo. 2021-15, at *53.

We similarly reject petitioner’s argument that it satisfied the

process of experimentation test simply by directing the Court to the sixstage design process. Merely connecting an activity to a larger plan that

may resemble the scientific method does not satisfy the process of

experimentation test. While the design process as framed by petitioner

may appear similar to the scientific method, the assertion alone is not

sufficient for us to find that PDG employees engaged in the process of

experimentation. Instead, we focus on the activities of PDG employees.

See Union Carbide Corp. & Subs., T.C. Memo. 2009-50, slip op.

at 200–01.

We are also skeptical of whether PDG employees followed

petitioner’s description of the six-stage design process because of the

way the hour sheets are filled out. PDG employees did not categorize

any of their hours on the basis of design phase. Additionally, the

descriptions do not appear to line up with the work completed in each

stage. For example, petitioner described the construction document

stage as ending with the delivery of stamped construction documents.

However, for the VU ESB project, mechanical engineer Ross T. Malloy

labeled time in the design development stage as “finishing up

construction documents.” Related to the BHNM Oxford project,

mechanical engineer John Wade labeled time in the design development

stage “schematic design,” which according to petitioner’s description of

the six-stage design process is an independent stage. Given these

inconsistencies between the description of the six-stage design process

and the narrative descriptions on the hour sheets, we cannot determine

that petitioner followed a process of experimentation by merely relying

on the description. Instead, we must apply a more granular approach

[*34] to determine whether the activities of these employees were part

of a process of experimentation for the trial projects. We must focus on

the uncertainty and the steps taken to resolve that uncertainty. See id.

Below, we will address only the relevant portions of the four-step

statutory test.

Gerald Champion

MEPF Systems as a Whole

The MEPF systems designed for Gerald Champion fail the section

174 test. Petitioner alleges uncertainty as to the appropriate design of

the MEPF systems because PDG engineers had to integrate new MEPF

systems within the existing systems. Petitioner argues that the

uncertainty continued until all mechanical and appliance components of

the systems were selected.

Petitioner failed to identify the specific information that was not

available to PDG engineers at the start of the project. Instead,

petitioner points to the limited information provided to it at the start of

the project, including a simple gross-block diagram that only generally

showed the location of the buildings. PDG engineers also received

historic data from the hospital that could be used to determine the

necessary size of the equipment. Testimony at trial also revealed that

PDG engineers were provided existing schematic design diagrams

although petitioner did not identify these documents to the Court. 23

Therefore, we do not know what information was shown on this diagram

or whether it provided sufficient evidence to determine the appropriate

design. Petitioner failed to show that the information set forth on the

gross-block diagram and the schematic design diagram did not establish

the appropriate basic design of the systems. Therefore, petitioner has

failed to establish that there was objective uncertainty as to the

appropriate design of the MEPF systems.

Petitioner further failed to demonstrate how uncertainty in one

element of the MEPF systems created uncertainty throughout the entire

MEPF systems. As we reiterated recently in Betz, T.C. Memo. 2023-84,

at *76, uncertainty regarding a subset of the business component does

not make the design of the entire business component uncertain. PDG

engineers provided sparse, conclusory testimony that a change in one

subcomponent affected the basic design of the entire MEPF systems.

23 Instead, petitioner identified internal communications that discuss the

existing schematic design drawing.

[*35] However, petitioner failed to develop this interconnection to any

meaningful extent. Instead, petitioner presented evidence at trial and

on brief focused around discrete issues. 24 Petitioner fails to satisfy the

section 174 test as to the entirety of the MEPF systems designed for

Gerald Champion.

Shrinking-Back Rule

We look next to the shrinking-back rule to determine whether any

of the activities related to a component or a subcomponent were

qualified research. The next most significant components of the MEPF

systems are the mechanical, electrical, and plumbing systems. This

level of review likewise does not involve qualified research. Petitioner

makes the same general argument about uncertainty as discussed above

and highlights a few additional uncertainties for specific systems. We

reject the general argument for the same reasons as above.

As it relates to the mechanical system, petitioner’s claimed

uncertainty relates to where the HVAC system would be located in the

hospital. Petitioner argues that this uncertainty was not resolved until

its engineers determine the required size for the system. Regardless of

whether this uncertainty existed, petitioner failed the process of

experimentation test related to the design of the mechanical systems.

PDG mechanical engineers calculated the approximate size of the

systems by referencing the historic data they were provided by Gerald

Champion at the start of the project and reported the required size of

the system to the architect. The architect ultimately decided that the

system would be placed in a mechanical room. Performing calculations

and communicating the results to the architect is not an evaluative

process that mirrors the scientific method. Instead, PDG mechanical

engineers provided the architect with the information that the architect

used to base the decision on aesthetics.

PDG mechanical engineers’ other decisions regarding the

mechanical systems likewise fail the process of experimentation test.

PDG mechanical engineers encountered several decision points in the

design, and rather than engage in experimentation, they selected an

option. This decision-making process was presented as decisions PDG

24 Even if petitioner satisfied the section 174 test, petitioner failed to provide

sufficient information to allow us to determine whether substantially all activities of

the PDG employees were part of a process of experimentation. See Little Sandy Coal

Co., T.C. Memo. 2021-15, at *40.

[*36] mechanical engineers made using their expertise rather than a

course of study as demanded by the scientific method.

As for the electrical systems and plumbing systems, petitioner did

not allege any additional uncertainty other than that it was “uncertain

as to the appropriate design” of each system. We reject this argument

for the same reason we rejected it with regard to the MEPF systems:

petitioner failed to set forth (1) what information was unavailable to

PDG electrical and plumbing engineers and (2) what investigative

activities PDG electrical and plumbing engineers undertook with

respect to the uncertainty. See Betz, T.C. Memo. 2023-84, at *76.

Having determined that the activities related to the mechanical,

electrical, and plumbing systems individually are not qualified research,

we shrink back to the next most significant subset of each of the systems.

While we have information to identify discrete issues faced by PDG

engineers, it would be futile. To demonstrate that its engineers

conducted qualified research, petitioner relies heavily on the hour

sheets. While these hour sheets are broken down by discipline, they are

not consistently broken down by subset or issue confronted by PDG

engineers. For example, mechanical engineer John Wade recorded time

to “HVAC,” electrical engineer Joseph Barnes recorded time to “ltg, pwr,

sys design,” and plumbing engineer Richard Miller recorded time to

“work on plumbing fixtures.” We cannot connect these time entries to

the discrete issues identified in testimony. Therefore, we are unable to

verify whether these activities were (1) investigative activities, (2) part

of a process of experimentation, or (3) for a permitted purpose.

Finally, to the extent we have the capability to apply the

shrinking-back rule, petitioner fails to carry its burden. Petitioner

failed to present any evidence that its engineers engaged in a process of

experimentation with respect to any subcomponent. Instead, petitioner

presented issues its engineers encountered and the decisions they made.

On occasion, petitioner indicated that its engineers did some

preliminary calculations or considered some factors. However, these

activities fall short of the process of experimentation test that must

mirror the scientific method.

Instead, PDG engineers made

determinations as to the design using their expertise. Likewise the

numerous design drawings in evidence do not demonstrate the activities

performed to get the solutions. As aptly summarized by petitioner’s

counsel, the unexplained design drawings “tell[] me nothing.”

[*37] B.

BHNM Oxford

MEPF Systems as a Whole

The MEPF systems designed for BHNM Oxford fail the section

174 test. Petitioner alleges that it was uncertain as to the design for the

MEPF systems because it was new construction and the PDG engineers

did not know the footprint of the hospital. Petitioner also argues that

the hybrid operating room, the lack of knowledge regarding the final

equipment, and the building code created uncertainty regarding the

entire system.

At the start of the project, the architect provided PDG engineers

a schematic block diagram and a preliminary master plan. The

schematic block diagram showed a preliminary layout of each floor of

the hospital and identified the location of each department. The

preliminary master plan appears to lay out the configuration of the

hospital and outbuildings, which would indicate where the MEPF

systems would be needed. PDG engineers were experts in their field

that had years of experience designing MEPF systems for hospitals.

Because petitioner claimed the general uncertainty was the lack of

information regarding the construction, these documents appear to

resolve such uncertainty and serve as a basis for the basic design of the

MEPF systems. Therefore, petitioner failed to establish that there was

objective uncertainty as to the appropriate design of the MEPF systems.

Even if there was uncertainty stemming from the hybrid

operating room, equipment selection, and building codes, petitioner

failed to show how this uncertainty would lead to uncertainty regarding

the whole MEPF systems. Uncertainty as to a component of the system

does not mean there is uncertainty related to the entire business

component. See Betz, T.C. Memo. 2023-84, at *76. Other than some

conclusory statements at trial about the interconnected nature of the

various pieces of the MEPF systems, petitioner failed to explain why the

inclusion of the hybrid operating room would render the entirety of the

MEPF systems uncertain. Drilling down further, the bulk of the

uncertainty regarding the hybrid operating room appears to stem from

the placement of the vents in the room to ensure a sterile field regardless

of the position of the table. Petitioner failed to introduce evidence that

this uncertainty would affect the basic design of the MEPF systems. For

example, how the ventilation would affect the electrical switch directing

electricity into the hospital is not clear. See Betz, T.C. Memo. 2023-84,

at *76; Treas. Reg. § 1.174-2(a)(5) (distinguishing between objective

[*38] uncertainty as to the design of a product as a whole (i.e., its basic

design specification) and objective uncertainty as to the design of a

particular subcomponent).

As for the equipment selection uncertainty, there may have been

objective uncertainty as even Baptist Memorial did not know the

ultimate selection of equipment. However, PDG engineers did not

engage in the process of experimentation to resolve this uncertainty.

Instead, they waited for the final selection to come from Baptist

Memorial. After receiving this information PDG electrical engineers

verified that their design could support the equipment. There is no

evidence these engineers relied on the scientific method to make this

determination. Instead, they reran load calculations, which gave them

an answer one way or another. This is not a process of experimentation.

As for the building code, petitioner did not develop this argument

to any significant extent. We note, however, that all systems designed

by PDG engineers are subject to a building code, with the majority being

the stricter hospital building codes encountered here.

To the extent any uncertainty existed before the architect

provided PDG engineers with the schematic block diagram and the

preliminary master plan, petitioner failed to show that PDG engineers

engaged in investigative activities to resolve the uncertainty. Petitioner

did not provide any information as to the activities that its engineers

conducted to determine the scope of the project before receipt of the

documents. The hour sheets do not disclose the precise activities PDG

engineers undertook to resolve the uncertainty. Instead, it appears as

though the uncertainty was resolved by the actions of Baptist Memorial

and the other contractors on the project. Again, the unexplained design

drawings tell us nothing. Petitioner failed to carry its burden that the

design of the entirety of the BHNM Oxford MEPF systems constituted

qualified research.

Shrinking-Back Rule

We look next to the shrinking-back rule to determine whether any

of the activities related to a component or a subcomponent were

qualified research. The next most significant components of the MEPF

systems are the mechanical, electrical, and plumbing systems. The

activities related to these systems likewise were not qualified research.

Petitioner makes the same general argument about uncertainty as

explored above and points to additional elements that introduced

[*39] uncertainty as to the design of each system. We reject the general

arguments for the same reasons as above.

As it relates to the mechanical systems, petitioner claimed

uncertainty stemming from the chiller plant, the unknown size of the

hospital, the boiler plant, and the air handling systems. Petitioner

failed to demonstrate how uncertainty related to one of these

subcomponents would cause uncertainty as to the entire design of the

systems.

Rather, petitioner presented these issues as discrete

challenges its engineers encountered and did not connect the issues. See

Betz, T.C. Memo. 2023-84, at *76; Treas. Reg. § 1.174-2(a)(5).

Petitioner failed to show that its engineers conducted

investigative activities to resolve the uncertainties. Instead, the record

shows that the bulk of the claimed uncertainties, such as the chiller

system, were resolved by Baptist Memorial. As for decisions left to PDG

mechanical engineers, petitioner failed to show any investigative

activities. See Betz, T.C. Memo. 2023-84, at *86 (“Merely identifying a

project difficulty and the eventual design solution, without bridging the

gap with evidence as to what investigative activities were performed,

does not satisfy petitioners’ burden.”).

As for the electrical system, petitioner claimed an additional

uncertainty related to how to route the electricity from the substations

to the vacant lot. At a minimum, the record establishes that PDG

electrical engineers did not engage in a process of experimentation to

resolve this uncertainty. Instead, they met with the electricity company

and Baptist Memorial to resolve the uncertainties. While this could be

an investigative activity, there is no evidence that PDG electrical

engineers used a process of experimentation to determine how to route

the electric. See id. at *80, *89. PDG electrical engineers merely passed

the recommendation and options from North Power to Baptist

Memorial. Baptist Memorial then selected its preferred option. Meeting

with North Power and presenting the options to Baptist Memorial is a

far cry from the evaluative process mirroring the scientific method

demanded by the process of experimentation test. As for the other

decisions encountered by PDG electrical engineers, petitioner failed to

show any investigative activities. See id. at *86.

As for the plumbing system, petitioner spent no time at trial

explaining the uncertainties encountered by PDG plumbing engineers.

The hour sheets likewise do not disclose this information in any

meaningful manner. Petitioner failed to set forth (1) what information

[*40] was unavailable to PDG plumbing engineers and (2) what

investigative activities they undertook with respect to the uncertainty.

See id. at *76.

Having determined that the mechanical, electrical, and plumbing

systems individually did not involve qualified research, we shrink back

to the next most significant subset of each system. Again, petitioner

identified issues its engineers confronted in the design of the systems

and offered testimony at trial regarding the solutions to the issues and

appears to rely on the hour sheets to fill in the gaps.

However, like the hour sheets from the Gerald Champion project,

the hour sheets for the BHNM Oxford project lack sufficient detail to

allow us to make the necessary determinations.

For example,

mechanical engineers John Wade and John Beard recorded significant

time to “design,” electrical engineer Brian Moore recorded time to

“mark-ups,” and plumbing engineer James Hobbs recorded significant

time to “SD.” Petitioner provided us with no metric to allocate this

generic time to each issue encountered by its engineers. We cannot

determine, nor did petitioner explain, what subset of the systems these

engineers worked on. Therefore, we are unable to determine whether

these activities were (1) investigative activities, (2) part of a process of

experimentation, or (3) for a permitted purpose. Therefore, shrinking

back would be futile.

Even if we could apply the shrinking-back rule to the issues

petitioner confronted using solely the general descriptions provided, the

activities were not qualified research. Petitioner often identified an

issue and the solution without bridging the evidentiary gap as to the

activities its engineers conducted. Therefore, petitioner failed to carry

its burden to show its engineers conducted investigative activities. See

id. at *86. Additionally, for the vast majority of the uncertainties

petitioner claims with respect to the issues, PDG engineers did not

perform activities related to a process of experimentation. For example,

Baptist Memorial, not PDG engineers, selected the chiller that would be

used for the building. The activities and ultimate solutions were

attributable primarily to third parties.

VU ESB

MEPF Systems as a Whole

The MEPF systems for the VU ESB project fail the section 174

test. Petitioner alleges general uncertainty as to the appropriate design

[*41] of the MEPF systems because the building was new construction

and the specific use of each portion of the building was not determined.

Petitioner also alleges uncertainty related to the strict requirements of

each room.

Petitioner failed to identify specific information that was not

available to the PDG engineers at the start of the project that caused

the uncertainty. We are unable to determine this information from the

record because petitioner failed to identify the initial information

provided by the architect, the design documents completed for the

TEAM building project before the hospital pulled out of the project, and

the date it ended work on the TEAM building project. While the building

size was reduced and some portions of the building were designated for

different purposes, other portions of the building were retained, such as

the cleanroom and imaging suite. Additionally, PDG engineers recorded

considerable time before PDG was formally engaged on the VU ESB

project. While petitioner alleges none of the hours overlapped, we

hesitate to accept this as fact when there are other errors on the hour

sheets 25 and petitioner failed to provide even the most basic timeline of

the projects. Without presenting the information objectively available

to them at the start of the project, petitioner failed to show objective

uncertainty as to the design of the entire MEPF systems.

Petitioner further failed to set forth the interrelated nature of the

various components of the MEPF systems such that uncertainty as to

one portion renders the entire design of the MEPF systems uncertain.

Uncertainty as to one subcomponent does not necessarily render the

entire business component uncertain. See id. at *76. Petitioner argues

that the strict requirements of each room caused uncertainty as to the

appropriate design of the whole MEPF systems. Other than conclusory

statements that all the systems affected LEED Silver certification,

petitioner provided no evidence of the interdependence of the systems.

For example, petitioner did not explain how strict airflow requirements

in the imaging suite affected the electrical design of the building.

Therefore, even if there was uncertainty as to specific subcomponents,

petitioner failed to carry its burden to show that there was uncertainty

as to the whole design. See id.; Treas. Reg. § 1.174-2(a)(5).

25 For example, time that petitioner admits should have been recorded to the

VU ESB – Olin Steam Line – Relocation, project No. 12010.04, was recorded to the

project number at issue.

[*42] To the extent there was uncertainty because the specific use of

each portion of the building was not known, PDG engineers did not

engage in investigatory activities to resolve this uncertainty. There is

no evidence PDG engineers had any involvement in this decision

making. Instead, the evidence shows Vanderbilt University resolved

this uncertainty by indicating to PDG engineers the specific use of each

portion of the building. There is no evidence that PDG engineers were

involved in this decision-making process. Instead, PDG engineers began

designing the MEPF systems with the knowledge that the information

would come from Vanderbilt University. Again, the numerous versions

of the design drawings in evidence tell us nothing. 26 Petitioner has

failed to carry its burden to show that the design of the entirety of the

MEPF systems meets the section 174 test.

Shrinking-Back Rule

We look next to the shrinking-back rule to determine whether the

activities related to any particular component or subcomponent were

qualified research. The next most significant component of the MEPF

systems are the mechanical, electrical, and plumbing systems. The

activities related to these systems likewise were not qualified research.

Petitioner makes the same general argument about uncertainty as

advanced for the whole MEPF systems. Again, petitioner failed to

identify the specific information unavailable to the PDG engineers at

the start of the project that resulted in the design uncertainty.

Therefore, we reject this argument.

As for the mechanical system, petitioner alleges that the

appropriate design of the entire system was uncertain because

Vanderbilt University had not assigned researchers to each laboratory

and thus PDG mechanical engineers did not know the ventilation

requirements of each laboratory. Because the ventilation in each

laboratory would require adjustments to the airflow to compensate for

the extracted air, petitioner contends that this caused system-wide

uncertainty as to the basic design of the mechanical system. This is the

first time in this case that petitioner coherently tied uncertainty in one

subcomponent to another. However, there are several other components

of the mechanical system that do not appear dependent on the

ventilation. Petitioner did not provide information on how the

26 Even if petitioner satisfied the section 174 test, it again failed to provide

sufficient information to allow us to determine whether substantially all activities of

the PDG employees were part of a process of experimentation. See Little Sandy Coal

Co., T.C. Memo. 2021-15, at *40.

[*43] ventilation would, for example, affect the steam pipe connection.

Therefore, petitioner failed to demonstrate that even if there was

uncertainty regarding ventilation, the basic design specifications were

uncertain. See Betz, T.C. Memo. 2023-84, at *76; Treas. Reg. § 1.1742(a)(5).

Additionally, petitioner failed to show its employees engaged in

investigative activities related to this uncertainty. Instead, Vanderbilt

University resolved the uncertainty by selecting researchers as

discussed above, which would dictate the proper configuration for the

laboratory. As for the other decisions PDG electrical engineers

encountered, petitioner failed to show any investigative activities. See

Betz, T.C. Memo. 2023-84, at *86.

As for the electrical systems, petitioner alleges there was

uncertainty regarding the appropriate design of the electrical systems

due to the unknown demand from each laboratory. Even if the activities

of PDG electrical engineers met the section 174 test, petitioner failed to

show PDG electrical engineers undertook a process of experimentation.

Electric engineer Brian Moore testified at trial that PDG electrical

engineers entered the estimated square footage of the building into

software that estimated the load of the building. PDG electrical

engineers then increased this figure to account for the higher demands

of the laboratories in the building. This increase was based on a “study

with Vanderbilt University” of the other laboratories on campus.

Petitioner provided no additional information on the study or the

division of work between PDG engineers and Vanderbilt University.

Entering previously available information into software does not

show that PDG electrical engineers engaged in a process of

experimentation. Although the study with Vanderbilt University may

have mirrored the scientific method, petitioner did not provide sufficient

information for us to make this determination. Instead, petitioner

asserts simply that a “study” was conducted. Without knowing the

activities involved in the study and PDG electrical engineers’

involvement, we cannot find that petitioner engaged in a process of

experimentation.

As for the plumbing system, petitioner did not mention any

additional uncertainty.

Petitioner failed to set forth (1) what

information was unavailable to PDG plumbing engineers and (2) what

investigative activities were undertaken by PDG plumbing engineers

with respect to the uncertainty. See Betz, T.C. Memo. 2023-84, at *76.

[*44] Having determined that the mechanical, electrical, and plumbing

systems individually are not qualified research, we apply the shrinkingback rule to the next most significant subset of each system. We

confront the exact difficulties in shrinking back as discussed above. As

an initial note, we are particularly skeptical of the hour sheets related

to the VU ESB project. To start, PDG engineers recorded significant

time before the execution of the new contract with the architect in 2013

and 2014. Petitioner did not provide the exact date that the TEAM

building was put on hold. Petitioner represents that all the time

recorded to this project was for the VU ESB project and not the TEAM

building project, but we are unable to verify this. Additionally,

petitioner’s other representations regarding the hour sheets, namely

that no subproject was recorded to the project number at issue, are

directly contradicted by entries on the hour sheets. Finally, the hour

sheets contain entries for 2017, which is beyond the scope of the credits

claimed in this case.

The hour sheets also fail to provide sufficient information to

conduct the qualified research analysis. As with the other projects, the

narrative descriptions do not consistently relate to the issues petitioner

identifies. Mechanical engineer John Beard recorded significant time to

“design,” electrical engineer Brian Moore recorded time to “project

coordination,” and plumbing engineer Raymond Parham recorded time

to “ABP.” Petitioner provided us with no metric to allocate this generic

time to each issue discussed in testimony. We cannot determine, nor did

petitioner explain, what subset of the systems these engineers worked

on. Therefore, we are unable to determine whether these activities were

(1) investigative activities, (2) part of a process of experimentation, or

(3) for a permitted purpose. Therefore, shrinking back would be futile.

One particular issue petitioner encountered deserves a closer

look: connecting to the steam distribution system. At trial, Ross T.

Malloy testified that he, Thomas Fisher, and Ryan Malloy were the only

employees involved in this process. The three men indicated when they

worked on the steam line project in their time sheets, but the hours

sheets tell a different story. The hour sheets show CAD designer Barry

Septer recorded time with a description referencing the steam line. This

directly refutes the testimony, and we cannot accurately determine

whether other employees worked on the steam line and recorded time

under the generic terms noted above.

Even if we could apply the shrinking-back rule to the issues

petitioner confronted solely on the basis of the general descriptions

[*45] provided, they would not qualify as qualified research. Petitioner

often identified an issue and the solution without bridging the

evidentiary gap as to the activities conducted by its engineers. Again,

the unexplained design drawings tell us nothing. Therefore, petitioner

failed to carry its burden to show its engineers conducted investigative

activities. See id. at *86.

IV.

Accuracy-Related Penalties

The parties stipulated that if we determine that none of the trial

projects entails qualified research, petitioner is liable for the accuracyrelated penalties for the credit years in which there are deficiencies, as

determined by the Court or agreement of the parties. Because we

determined that none of the trial projects involved qualified research,

petitioner is liable for accuracy-related penalties as specified by the

parties. 27

CONCLUSION

As said before, engineers solve problems you did not know you

had in ways you cannot understand. Without an explanation of the work

or process of the engineers, we cannot understand how PDG engineers

came to the ultimate solutions and determine whether the activities

qualify as research within the meaning of section 41. None of the trial

projects as a whole or at the shrinking-back level involved qualified

research. Petitioner is liable for the accuracy-related penalties as

stipulated by the parties.

To reflect the foregoing,

An appropriate order will be issued.

27 Nothing in this Opinion should be construed as determining the amounts of

the deficiencies in petitioner’s federal income tax for the credit years. Instead, this

Opinion solely determined that the three trial projects do not constitute qualified

research.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.