United States Tax Court

Agency decision

Ask Donna

What actually matters in this document.

Text

T.C. Memo. 2023-84

MARK BETZ AND CHRISTINE BETZ,

Petitioners

COMMISSIONER OF INTERNAL REVENUE,

Respondent

DENNIS LINCOLN AND JULIA LINCOLN,

Petitioners

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket Nos. 21587-18, 21588-18.

Filed July 6, 2023.

—————

Ps in these consolidated cases are shareholders in C,

an S corporation that designs and supplies air pollution

control systems. As of 2014, C had extensive institutional

knowledge and experience in supplying systems that met

the specifications of customers in manufacturing

industries. On its 2014 information return, C claimed a

research credit under I.R.C. § 41 in connection with 19

projects. C claimed the research credit in connection with

both the costs of producing the systems it supplied and the

wages it paid to certain of its employees for activities

performed in connection with the projects. C did not use a

time-tracking system for its employees’ activities and thus

estimated the amounts of employee time spent performing

qualified services. On their personal federal income tax

returns for 2014, Ps claimed a flowthrough of the credit and

later carried forward the remaining portion of the credit to

their 2015 and 2016 returns.

Served 07/06/23

[*2]

Held: For all 19 projects, Ps failed to carry their

burden of establishing that the products were pilot models.

Accordingly, C’s purported qualified research expenditures

(QREs) for costs of production failed to satisfy I.R.C.

§ 41(d)(1)(A) and were not creditable.

Held, further, for all 19 projects, Ps failed to carry

their burden of establishing that the wages of certain of C’s

employees were incurred in connection with the

performance of qualified services.

Accordingly, C’s

purported QREs for wages were not creditable.

Held, further, for five of the projects, C did not retain

substantial rights in the results of its research under its

applicable contracts with its customers. Accordingly, C’s

purported QREs for those five projects were incurred in

connection with funded research within the meaning of

I.R.C. § 41(d)(4)(H) and were not creditable.

Held, further, Ps are liable for accuracy-related

penalties under I.R.C. § 6662(a) for tax years 2014, 2015,

and 2016.

—————

John H. Dies, Jeffrey E. Falvey, Jeremy M. Fingeret, Jefferson H. Read,

and Matthew S. Reddington, for petitioners.

Jonathan E. Behrens, Frederic J. Fernandez, Eugene A. Kornel, and

Richard L. Wooldridge, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

NEGA, Judge: These cases involve a section 41 1 research credit

claimed by an S corporation engaged in the business of designing and

supplying air pollution control systems that eliminate harmful airborne

manufacturing byproducts. The issues for decision are (1) whether

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.

[*3] petitioners, the groups of which include the sole shareholders of the

S corporation, are entitled to a research credit of $501,531 for tax year

2014 and (2) whether petitioners are liable for accuracy-related

penalties for tax years 2014, 2015, and 2016. We hold for respondent on

both issues.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The

Stipulations of Facts and the attached Exhibits are incorporated herein

by this reference. Petitioners resided in Illinois when they timely filed

their Petitions.

Catalytic Products International, Inc.

Catalytic Products International, Inc. (CPI), was founded in 1969

by Erwin Betz. In 2014 CPI was a subchapter S corporation, with the

shares owned equally (50%) by Erwin Betz’s children, petitioner Mark

Betz (Mr. Betz) and petitioner Julia Lincoln (Ms. Lincoln). As of

January 2, 2014, CPI’s board of directors comprised Mr. Betz, Ms.

Lincoln, petitioner Dennis Lincoln, and Matthew Lincoln. In 2014 CPI

used an accrual method of tax accounting.

Beginning in 1987, when Mr. Betz joined the company, CPI

transitioned its business away from manufacturing catalysts for

installation in air pollution control systems, instead becoming a

designer and supplier of custom-built air pollution control systems,

primarily catalytic and thermal oxidizers.

II.

Oxidizer Basics

In 2014 CPI supplied both catalytic and thermal oxidizers, which

each eliminate certain environmentally hazardous airborne

manufacturing byproducts. We will refer to these byproducts as volatile

organic compounds (VOCs) as a convenient shorthand. 2 Catalytic

oxidizers are designed to convert VOCs into carbon dioxide and water

vapor via a process of chemical reaction between the VOCs and a

2 Our use of the term may not necessarily reflect whether the byproducts

discussed herein are VOCs within the technical meaning of regulations issued by the

Environmental Protection Agency (EPA). See 40 C.F.R. § 51.100(s) (2023).

[*4] catalyst. 3 Thermal oxidizers are designed to achieve the same

result but do so by using a burner to generate extremely high heat to

incinerate VOCs, rather than using a catalytic conversion process.

There are three separate subtypes of thermal oxidizers:

(1) direct/straight, (2) recuperative, and (3) regenerative.

A direct/straight thermal oxidizer uses a simplistic burner to heat

a combustion chamber; process air containing VOCs passes through the

system and oxidizes when encountering the high temperatures. A

recuperative thermal oxidizer adds to the concept by using a stainlesssteel heat exchanger to preheat process air, which provides for increased

energy efficiency. 4 This heat exchanger usually consists of a shell and

tube structure that operates by intaking clean, postcombustion air into

an exterior shell that transfers heat to interior tubes carrying the

process air. A regenerative thermal oxidizer instead uses a heat

exchanger comprising ceramic media beds, which retain heat at an even

higher rate and thus allow for increased energy efficiency. Regenerative

thermal oxidizers operate by intaking process air through the media,

then reversing the postcombustion air back through the media, thus

retaining the heat. Because of their energy efficiency, the issue of

overtemperature, where the system’s temperature rises too high and

degrades the heat exchanger, is a particular problem for regenerative

thermal oxidizers. Designs of regenerative thermal oxidizers typically

use a hot gas bypass, which diverts high temperature air out of the

system in order to reduce temperature. As of 2014, regenerative

thermal oxidizers were the most common type of oxidizer used in

manufacturing industries.

A few general considerations go into the choice of a type of

oxidizer system and its basic design. One consideration is the

aforementioned energy efficiency: Oxidizers can use considerable

volumes of natural gas in operating the burners that heat the air. For

cost-conscious customers, an oxidizer with reduced volume or

performance but increased thermal efficiency (i.e., where high

3 A catalyst is a substance that triggers a chemical reaction but is not itself

consumed in that chemical reaction. A common example is the catalytic converter in

an automobile, which converts the VOCs present in the exhaust into carbon dioxide

and water.

4 To illustrate the concept, heat exchangers are typically used as part of the

heating process in residential gas furnaces. Furnaces use a burner to generate hot gas

within a heat exchanger chamber; cold air then encounters the now-heated outer walls

of the heat exchanger and becomes hotter before being distributed throughout the

residence.

[*5] temperature is maintained without significant use of fuelconsuming burners) might be optimal. Another basic consideration is

the concentration and type of VOCs generated by the customer’s

manufacturing process; for certain VOCs, a catalytic reaction is less

effective than a thermal one or would degrade the catalyst over time.

Certain types of VOCs may also require a higher operating temperature

or residence time to oxidize, which would affect the sizing of components

and increase upfront costs.

Another consideration is whether the customer’s manufacturing

process airflow contains other particulates or chemicals that could affect

the oxidizer’s performance. For instance, if the process airflow

contained silicone, oxidization would generate silicone dioxide (i.e.,

sand), which could accumulate and plug an oxidizer. Finally, the

location and layout of a customer’s manufacturing process plays a role.

Space constraints at the facility may dictate the choice and sizing of

various components, while extreme temperatures or heavy winds may

require additional insulation or structural support features for outdoor

components.

III.

CPI’s General Process

In 2014 CPI’s business model was as follows. First, CPI would

either solicit or be contacted by a prospective customer. If unfamiliar

with the customer, CPI personnel would sometimes visit the customer’s

facility to review their manufacturing process and measure what VOCs

were being generated. Customers would often provide CPI with the

necessary specifications about the process airflow at the customer’s

facility, such as the volume of process airflow, the type of VOCs

generated, and the airflow temperature. If the customer was unable to

provide specifications, CPI personnel or a third party would sometimes

test and measure the airflow at a jobsite.

CPI personnel considered an oxidizer’s design to be largely

dictated by three basic considerations: (1) the necessary level of

destruction efficiency; (2) the process air flow volume; and (3) the

particular VOCs generated. 5 Once this information was available, CPI

personnel would begin assembling a project proposal. CPI personnel

would input the particular VOCs and airflow volumes at issue into a

computer spreadsheet (known internally at CPI as Bessy), which would

5 Destruction efficiency is the percentage of the VOC concentration in the

process air that is destroyed by the oxidizer.

[*6] then output calculations breaking down how the VOCs would

oxidize, including the lower explosive limit (LEL) and heat value of the

airflow exhaust. 6 Based on the particular VOCs at issue and the airflow

volume, CPI personnel would then calculate the necessary sizes of the

various components, such as burners and fans, by using standardized

spreadsheets or performing simple hand calculations.

Next, the now-sized components would be incorporated into a

general arrangement design drawing and a process and instrument

diagram (P&ID). 7 On the basis of the prepared drawings, CPI personnel

would solicit bids from subcontractors about the potential cost of

assembly. With an estimated cost of assembly in hand and the size of

the components preliminarily calculated, CPI personnel would come up

with a quoted price for the customer and assemble a project proposal.

In the project proposal, CPI would recommend a particular type of

oxidizer based on the applicable characteristics of the process airflow

and describe its various components and features. Generally, the initial

project proposal provided by CPI to the customer was not the final

version. Customers often requested changes to the proposal, such as

increases in the guaranteed efficiency of the oxidizer, additional

guarantees or warranties, or revisions to terms and conditions.

Once a final proposal was accepted by a customer and purchase

and sale orders exchanged, additional design drawings would be

prepared, reviewed, and completed for various components of the

oxidizer. The project would then be passed on to a project manager, who

would begin issuing purchase orders to suppliers (for various

components of the oxidizer) and to subcontractors (for fabrication and

assembly). CPI maintained ongoing relationships with a number of

suppliers and subcontractors. CPI would engage a subcontractor,

typically PRE-Heat, Inc., to fabricate the physical structure of the

system, which was generally composed of heavy, welded steel, and to

assemble the components of the system.

CPI would purchase

components from suppliers, who would then directly provide those

LEL indicates the lowest concentration of an airborne compound that is

capable of exploding in the presence of an open ignition source. If an airflow is

measured at a high percentage of LEL, that airflow is at greater risk of igniting;

National Fire Prevention Association standards generally dictate that a number above

25% of LEL is an unsafe level.

7 A general arrangement drawing portrays the physical structure of the

assembled oxidizer, while a P&ID details how airflow, gas, and electrical signals

interact with components of the system.

[*7] components to the fabricating subcontractor to be assembled as

part of the oxidizer. For the exhaust stack, CPI would usually engage a

separate subcontractor, typically IVI North, Inc., to fabricate the stack.

On some projects, the subcontractor would take on greater design

responsibility. For instance, PRE-Heat would typically handle the

design for heat exchangers, inputting data from the particular facility

into a proprietary program in order to determine the appropriate sizing.

CPI personnel would also begin designing the electrical control

system of the oxidizer. Using the P&ID drawing, CPI engineers would

create an electrical schematic drawing for the control panel, showing the

placement of the various inputs and outputs into the system and the

requisite horsepower. Finally, CPI engineers would program a sequence

of operations into the control system to automate its various functions.

CPI would engage a subcontractor, typically Quantum Design, Inc., to

build the control system panel and enclosure for the oxidizer.

While fabrication was ongoing, CPI personnel would sometimes

conduct quality control inspections on the work of the fabricating and

electrical subcontractors, to ensure that the fabrication conformed to

CPI’s design drawings. Sometimes revisions would be made to an

oxidizer’s design over the course of a project in response to feedback from

either a subcontractor or the customer. Once an oxidizer was completed,

CPI personnel would typically oversee assembly of a system at the

fabrication subcontractor’s facility; the oxidizer would then be freight

shipped to the customer’s facility. At the customer’s facility, CPI would

either install the system itself or have personnel present to supervise

the installation. After physical installation, CPI startup personnel

would spend time at the facility, programming the control system and

conducting further quality testing to ensure that components conformed

to CPI’s design drawings and operated without issues. Finally, a third

party would generally conduct testing on the oxidizer for purposes of

compliance with environmental regulations. On some occasions, a

tested oxidizer would perform below the destruction efficiency

guarantee made by CPI, which would contractually require CPI to make

additional repairs or modifications to the oxidizer.

IV.

The Alliantgroup Study

Alliantgroup L.P. is a tax consultancy and lobbying firm which,

inter alia, maintains a research credit group that specializes in

promoting section 41 credits and assisting taxpayers with all stages of

claiming the credit. On February 20, 2015, Ms. Lincoln executed an

[*8] engagement letter for Alliantgroup to conduct an R&D tax credit

study for CPI and to provide audit defense. The engagement letter

stated that Alliantgroup would bill at a blended hourly rate of $375; the

billed fees were capped so as not to exceed 25% of the combined state

and net federal research credits identified by Alliantgroup. Initially,

Alliantgroup requested from CPI a list of employees with job details, job

costing reports, Forms W–2, Wage and Tax Statement, and payroll

records for 2010 through 2013, and CPI’s federal and state tax returns

for 2010 through 2013. On April 2, 2015, an Alliantgroup representative

emailed Ms. Lincoln a list of CPI projects that they wished to discuss

during an upcoming site visit to CPI; the list comprised 18 projects. 8

On April 8, 2015, Alliantgroup personnel visited CPI’s facility;

during the visit, Alliantgroup personnel interviewed Messrs. Betz and

Harmsen and Ms. Lincoln. On April 9, 2015, Alliantgroup personnel

emailed Mr. Harmsen and Ms. Lincoln a spreadsheet based on their

discussions, which purported to allocate certain percentages of the 2014

wages paid to CPI’s employees to 19 CPI projects. The interviews with

Messrs. Betz and Harmsen were the source of the underlying allocation

percentages in the spreadsheet. In 2014 CPI did not have a system that

tracked employee time. On April 10, 2015, an Alliantgroup employee

emailed to Ms. Lincoln a pro forma Form 6765, Credit for Increasing

Research Activities, with calculations for a potential research credit for

CPI. The pro forma Form 6765 listed $1,983,647 as the amount of wages

for qualified services and $5,732,211 for the cost of supplies, which

amounted to a gross credit of $771,586 and a net credit of $501,531.

On October 26, 2015, an Alliantgroup employee provided Ms.

Lincoln with a project summary report for the research credit study,

which concluded that CPI was qualified to claim a section 41 credit. 9 On

December 10, 2015, Mr. Betz and Ms. Lincoln signed a copy of the

completed study, under a field entitled “Employees Verifying

Information.” In the study, Alliantgroup identified 19 projects with

associated qualified research expenditures. The completed study again

stated that CPI had paid or incurred $1,983,647 in qualifying wage

expenditures and $5,732,211 in qualifying supply expenditures, for a

total of $7,715,858 of QREs. With respect to wage expenditures, the

completed study stated that Alliantgroup had allocated percentages of

8 The DuPont La

Porte project, for which qualifying research expenditures

(QREs) were eventually claimed, was not listed in this email.

9 As we discuss in further detail below, both CPI and petitioners had timely

filed their respective tax returns for tax year 2014 in April 2015.

[*9] CPI’s employees’ wages paid or incurred for qualified services as

follows: 10

Employee Name

2014 R&D %

Tax Year 2014

Salaries

Tax Year 2014

QREs

G.B.

80%

$55,424

Betz, Mark

80%

823,231

F.C.

80%

49,022

C.D.

83%

69,328

S.F.

82%

39,172

Harmsen, Scott

88%

179,302

C.H.

63%

104,297

65,707

R.J.

80%

80,863

C.J.

60%

15,209

9,125

E.M.

82%

48,050

B.O.

60%

58,000

34,800

J.O.

90%

21,038

Shaver, Robert

80%

341,534

L.S.

90%

20,706

T.S.

60%

40,186

24,112

R.T.

80%

40,992

B.W.

50%

39,038

19,519

J.Y.

90%

24,466

T.Z.

86%

37,255

Total

n/a

$2,087,113

$1,983,647 11

For 17 of the employees, Alliantgroup allocated percentages of wages to

particular projects; the wage QREs of those 17 employees totaled

$818,882 (i.e., roughly 41% of the claimed wage QRE total).

For brevity’s sake, we exclude from the table the CPI employees that

Alliantgroup determined performed no qualified services in 2014. Aside from petitioner

Mr. Betz and Messrs. Harmsen and Shaver, both of whom testified at trial, we will use

initials to refer to particular CPI employees.

11 The wage QREs identified by Alliantgroup in fact amount to a total of

$1,983,646; we can safely attribute the one-dollar discrepancy from the listed amount

to rounding error.

[*10] Alliantgroup purported to allocate the wages of two employees,

Messrs. Betz and Shaver, evenly across all 19 projects; the wage QREs

of Messrs. Betz and Shaver totaled $1,164,765 (i.e., roughly 59% of the

claimed wage QRE total).

With respect to supply QREs, Alliantgroup personnel reviewed

CPI’s internal accounting records for each project. With respect to the

base period, Alliantgroup personnel interviewed Mr. Betz and Ms.

Lincoln and reviewed accounting statements from 1984, 1985, 1986, and

1987 in order to determine whether CPI had gross receipts and QREs

for those tax years. Alliantgroup ultimately calculated a fixed base

percentage of 3.02% and average annual gross receipts of $23,782,532.

Using those calculations, Alliantgroup again concluded in the study that

CPI was entitled to a research credit of $771,586, calculated without an

election under section 280C.

CPI Employees

In the study, Alliantgroup determined that 19 CPI employees

performed qualified services. We provide brief job descriptions for each

of those employees.

Mr. Betz

In 2014 petitioner Mark Betz was the vice president of

engineering for CPI. Mr. Betz’s primary responsibilities were wide

ranging and included both working with customers on the sales side and

doing application engineering.

Mr. Shaver

In 2014 Robert (Scott) Shaver was the vice president of sales for

CPI. Mr. Shaver’s primary responsibilities included heading up the

sales team, soliciting customers, and being involved at the outset in

CPI’s chemical application engineering. Mr. Shaver left his employment

with CPI sometime in 2016.

Mr. Harmsen

In 2014 Scott Harmsen was the director of engineering for CPI.

Mr. Harmsen’s primary responsibility was supervising the engineering,

drafting, and processing personnel at CPI, as well as being lead chemical

application engineer. Sometime after 2014 Mr. Harmsen was promoted

[*11] to president of CPI and remained in that position as of the dates

of trial in these cases.

R.J.

In 2014 R.J. was a senior electrical engineer for CPI. R.J.’s

primary responsibility was designing the electrical systems and

programming the control systems for CPI’s oxidizer systems.

C.D.

In 2014 C.D. was an electrical designer for CPI. C.D.’s primary

responsibility was largely identical to R.J.’s and involved designing the

electrical controls and programming the control systems for CPI’s

oxidizer systems.

S.F.

In 2014 S.F. was a design detailer for CPI. S.F.’s responsibilities

included creating and modifying design drawings and making

guidelines for CPI’s systems.

T.Z.

In 2014 T.Z. was an engineering manager for CPI. T.Z.’s primary

responsibilities consisted of reviewing all the design drawings,

supervising the draftsmen, and managing the schedule and construction

by the fabrication subcontractors.

L.S.

In 2014 L.S. was a fabrication specialist for CPI. L.S.’s

responsibilities consisted of overseeing and coordinating with the thirdparty fabricators, which included soliciting bids, reviewing design

drawings, and conducting quality audits.

Messrs. G.B. & R.T.

In 2014 G.B. and R.T. were each draftsmen for CPI. G.B. was

generally responsible for installation design, including preparing

ductwork, steel, and location drawings. R.T. was generally responsible

for drawing designs, project management, and sourcing components

from suppliers.

[*12] J.

Messrs. F.C., E.M., J.O., & J.Y.

In 2014 F.C., E.M., J.O., and J.Y. were each project managers for

CPI. All four of these individuals’ primary responsibilities were

interacting with the customer, reviewing and approving drawings and

calculations, and ensuring delivery of an oxidizer to the customer’s

facility. J.O. left his employment with CPI during 2014.

Messrs. C.H., C.J., B.O., T.S., and B.W.

In 2014 C.H., C.J., B.O., T.S., and B.W. were each sales engineers

(i.e., salespeople) for CPI. Their responsibilities included putting

together initial calculations in proposals delivered to customers and

generally soliciting new customers.

VI.

The Projects at Issue

3M Hutchinson (#13-07520)

During the years at issue 3M Company (3M) and CPI had an

ongoing commercial relationship, which was reflected in a Master

Equipment Supply & Services Agreement (master agreement), effective

August 4, 2010. Clause 8.3 of the master agreement provided that

Seller may create drawings, illustrations, instructions,

maintenance information, and other materials that relate

to the Equipment, and if Seller retains ownership of any

such materials, then Seller grants 3M the perpetual,

unrestricted right to use, copy, and distribute those

materials for 3M’s internal use.

Clause 10.2 provided that CPI “maintains all of its proprietary rights

related to its products and manufacturing processes, including all

product components and pre-existing product designs.” Clause 10.2 next

stated that

3M owns all tangible and intellectual property rights in

any goods, equipment (including the Equipment),

apparatus, documents, drawings, computer software and

artwork which 3M provides to Seller, Seller creates at 3M’s

[*13] expense, or Seller creates

Information (“3M Rights”).[12]

using

Confidential

Clause 10.2 continued, stating in relevant part that with respect

“to any property subject to 3M Rights, Seller: (a) hereby assigns to 3M

or its designated affiliate all of Seller’s rights, including, without

limitation, all intellectual and tangible property rights and (b) will

deliver that property to 3M when Seller has finished using it to fulfill

Order(s) under the Agreement.” Finally, clause 12 provided that “[a]ny

claim or dispute arising from or relating to the Equipment or the

Agreement will be: (a) governed by the laws of the State of Minnesota . . .

without regard to its conflict of laws provisions.” The terms of the

master agreement governed all of CPI’s projects for 3M, including 3M

Hutchinson.

During the years at issue 3M manufactured sticky notes at a

facility in Hutchinson, Minnesota. Before engaging CPI, 3M had used

an aging regenerative thermal oxidizer at the Hutchinson facility, which

it had determined to replace. As part of the bidding process on the

project, on June 25, 2013, 3M provided CPI with an extensive and

detailed list of required specifications for a 30,000 standard cubic feet

per minute (SCFM) regenerative thermal oxidizer. The specifications

provided for a 99% destruction efficiency. The specifications provided

measurements for the minimum and maximum airflow volume and

solvent rate at the facility and identified the VOC emissions as “a

combination of methanol, ethyl acetate, IPA, toluene, and other common

solvents.”

The 3M Hutchinson project was the first regenerative thermal

oxidizer designed by CPI. 13 However, Mr. Harmsen was experienced in

working with regenerative thermal oxidizers from prior employment,

and he handled the applications engineering on the project. 3M

recommended particular suppliers to use for the various components of

the oxidizer; for a number of other components, 3M also provided specific

brands and sizes to be included. Mr. Harmsen generally considered the

specifications to be typical. Several of the specifications required by 3M

12 Clause 10.1 separately defined “3M Confidential Information” as including

“all Orders placed by 3M, 3M Materials, 3M Equipment, the terms of the Agreement,

the Parties’ relationship, and any other information about how 3M makes or sells

products or conducts its business.”

13 Before the 3M Hutchinson project, CPI supplied regenerative thermal

oxidizers to customers but engaged other engineers to design them.

[*14] were atypical for CPI, such as using two burners instead of one,

including manual lifts in the system, and providing for a control

enclosure that could contain a desk. The specifications also stated that

3M was “concerned with residue build-up on the forced draft fan wheel

or other internal parts” and provided two options—an induced draft

process fan with a mixing box or a forced draft process fan with a preheat

system—to address this concern in the design. 14

In July 2013 after questions by other parties bidding on the

project, 3M issued a revised set of specifications. CPI then provided 3M

with an initial proposal for an oxidizer system; after reviewing CPI’s

proposal, 3M requested that several more clarifications and revisions be

incorporated into the design. In August 2013 CPI submitted a revised

proposal for a regenerative thermal oxidizer, which 3M accepted. The

proposal included additional technical specifications for various

components of the oxidizer. The proposal also included a 99%

destruction efficiency performance guarantee. In September 2013 3M

and CPI exchanged purchase and sale orders. The final payment terms

were a total price of $1,135,840. CPI then engaged IVI North to

fabricate and supply an exhaust stack for the system and engaged PREHeat to fabricate and supply the oxidizer system.

In late October 2013 G.B. completed an initial general

arrangement drawing and an initial P&ID drawing for the oxidizer. In

December 2013 C.D. completed initial electrical schematic diagrams for

a control panel. CPI engaged Quantum Design to fabricate a main and

remote control panel and enclosure for the oxidizer and Lantec to supply

a ceramic heat exchanger. In December 2013 CPI issued a purchase

order to AirPro Fan & Blower Co. (AirPro) for a 300 horsepower booster

fan, described as arrangement 3B; AirPro then submitted design

drawings for a booster fan to CPI for approval, which were in turn

approved by 3M’s engineering department. In April 2014, after

reviewing CPI’s electrical schematic drawings, 3M’s electrical engineers

discovered some discrepancies from the voltage provided for in the

specifications. CPI then issued a change order to Quantum Design for

some revisions to the control panel.

In April 2014 S.F. completed a general arrangement drawing for

the oxidizer system, which was checked by J.Y. By the time S.F.

14 The difference between the two types of fans is a simple one: Induced draft

fans provide negative pressure (i.e., pull) while forced draft fans provide positive

pressure (i.e., push).

[*15] completed the general arrangement drawing, minor changes had

already been incorporated into the drawing in prior revisions made in

both 2013 and 2014. Those changes included (1) adding an additional

walkway to the front of the system for accessing the gas trains;

(2) adding davit cranes to the front of the system in order to lift

components; and (3) reworking the design of the gas trains.

Ultimately, CPI installed the system at the Hutchinson facility,

with Mr. Harmsen and F.C. on site to supervise the installation. In

January 2015 testing was performed on the system under actual process

conditions at the Hutchinson facility. The testing demonstrated that the

system was not satisfying the destruction efficiency performance

guarantee. Eventually, CPI discovered a gap under a poppet valve,

which it resolved by welding a ring into place to eliminate the gap. In

May 2015 3M informed Mr. Harmsen that the oxidizer had been

measured as satisfying 99%+ destruction efficiency.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*16]

Component

Cost

Barometric damper

$4,025

Booster fan (moved VFD sales est to electrical)

89,971

Burner

11,178

Ceramic media

43,862

Combustion air piping

9,451

Combustion blower

4,455

Component location

1,624

Control house

44,995

Ductwork

3,441

Electrical loose parts

5,767

Electrical panel (sales est includes VFD from BF)

91,955

Exhaust stack

50,370

Gas piping

24,461

Gas train

40,619

Hotside bypass damper

15,451

Internal assembly combustion chamber

13,995

Internally insulated ductwork

14,500

Mechanical loose parts

1,156

Total

$471,275

[*17] B.

Akzo Nobel (#13-07645)

During the years at issue Akzo Nobel Coatings, Inc. (Akzo Nobel),

manufactured industrial paint at a facility in Huron, Ohio. At the

facility, Akzo Nobel used reactors and tanks for mixing paint, which

emitted some limited VOC byproducts such as xylene, a paint dilutant.

For 30 years Akzo Nobel had used a direct thermal oxidizer to destroy

VOCs. In 2013 Akzo Nobel put out a request for bids on a new oxidizer,

to which CPI responded. CPI personnel visited the Huron facility, met

with Akzo Nobel personnel, and learned the specifications for the

project.

CPI personnel then entered the specifications into a

spreadsheet, which output a potential size of 8,000 SCFM; ultimately,

CPI determined that the size would be 6,000 SCFM. J.O. was the project

manager, while Mr. Harmsen was the applications engineer for the

project.

In December 2013 CPI provided a proposal to Akzo Nobel for a

regenerative thermal oxidizer, sized at 6,000 SCFM and with 95%

thermal efficiency. The proposal included a 98% destruction efficiency

performance guarantee. Akzo Nobel responded by sending to CPI a

confirmation of purchase order for the supply and installation of a

regenerative thermal oxidizer, for a total price of $271,000. CPI then

engaged Lantec to fabricate and supply multilayer ceramic media and

PRE-Heat to fabricate and supply the oxidizer system and various

components. Akzo Nobel and CPI personnel conducted a joint hazard

study of the oxidizer to assist Akzo Nobel personnel in learning the

equipment and understanding the safety protocols involved in operating

the oxidizer. As a result of the hazards study, CPI made some minimal

changes to the design of the electrical control system.

In January 2014 R.J. prepared electrical schematic drawings for

the oxidizer’s control panel. On February 7, 2014, Mr. Harmsen and

J.O. visited the Huron facility to meet with Akzo Nobel personnel. At

the meeting, Mr. Harmsen took notes on various potential issues and

sketched out a basic diagram of what the oxidizer would look like. In

his notes, Mr. Harmsen identified several potential issues, including

how fire suppression would be tied into the system and how to design

the ductwork and new dampers. CPI determined to include in the

design a flame arrestor, a component that would prevent flame

transmission. 15 CPI personnel later entered specifications into a

15 A flame arrestor is a failsafe component that impedes airflow and thus

essentially prevents a potential explosion from continuing past the arrestor’s location.

[*18] supplier’s sizing program, which output the potential model and

size for a flame arrestor component. Given the basic requirements of

the system, J.O. and other CPI personnel calculated the appropriate size

for various other components, including a media bed, burners, and a

fresh air damper.

CPI engaged MK Systems, Inc., to design and supply a booster

fan for the oxidizer. CPI engaged Quantum Design for the fabrication

of a control panel enclosure for the oxidizer, to be based on CPI’s drawing

set. On February 26, 2014, R.T. visited PRE-Heat’s facility to inspect

the fabrication of the oxidizer; in a checklist, R.T. signed off on a number

of different elements of the oxidizer and noted that other elements were

still work-in-progress.

On March 13, 2014, R.T. visited PRE-Heat’s facility to inspect the

fabrication. In March 2014 R.T. prepared a general arrangement

drawing for the oxidizer, which was checked by Mr. Harmsen. This

drawing incorporated revisions stemming from CPI’s having determined

what booster fan and combustion blower would be included in the

system. R.T. subsequently revised the general arrangement drawing of

the oxidizer in order to change the customer connection and to add a

handrail and access ladder, respectively, in response to a request from

Akzo Nobel.

Akzo Nobel performed the installation of the oxidizer at the

Huron facility, with CPI personnel supervising. In September 2014 a

third party performed emissions testing on the oxidizer and determined

that oxidizer’s destruction efficiency was on average 97.93%, just below

the 98% performance guarantee provided by CPI. As part of its

warranty, CPI sent service technicians to the facility to potentially make

adjustments. Ultimately, CPI resolved the issue by conducting its own

testing and measuring that the parts per million (PPM) of methane in

the exhaust was only 1.41—well below the alternate efficiency

guarantee of 25 ppm from CPI’s proposal. 16

As part of the research credit study, Alliantgroup also calculated

that the following supply costs were qualified research expenditures:

16 This was likely due to the low sample size of VOCs at issue, which made it

difficult to reach 98% at a given point because of the measuring issues.

[*19]

Component

Engineering add-ons

$2,086

Booster fan

8,564

Burner

1,822

Ceramic media

4,410

Combustion air piping

1,194

Combustion blower

3,681

Ductwork

Electrical boxes

1,296

Electrical loose parts

16,212

Electrical panel

39,906

Exhaust stack

14,634

External assembly combustion chamber

90,240

Fresh air damper

2,994

Gas train

7,502

Internal assembly combustion chamber

10,088

Mechanical loose parts

1,186

Total

Cost

$205,894

HA International (#13-07615)

During the years at issue HA International, LLC (HAI),

maintained a manufacturing plant in Oregon, Illinois. At the plant, HAI

produced frac sand, a chemically infused sand that is used by the

natural gas industry in the process of hydraulic fracturing (known more

familiarly as fracking). A number of hazardous chemicals, including

[*20] phenolic resins, furfuryl alcohol, hexamine, and ammonia, were

injected into the sand in order to make it useful for fracking purposes.

HAI contacted CPI about potentially designing two oxidizers, as

HAI’s scrubber equipment at the time was ineffective and had led to an

enforcement issue with the EPA. C.J. was staffed as the sales engineer

on the project. In early 2013 CPI employees did initial emissions testing

at HAI’s plant. CPI employees tested the air exhaust of the plant and

observed HAI’s manufacturing process. In an emissions study, dated

April 18, 2013, CPI concluded that HAI’s current scrubber equipment

was failing to achieve the required 98%+ efficiency and that the jobsite

had a number of issues, including a lack of proper ventilation and the

buildup on equipment surfaces of resin containing VOCs. The emissions

study also measured a number of different VOCs present in the process

airflow, including formaldehyde, phenol, and methanol.

CPI personnel determined that recuperative thermal oxidizers

would be more appropriate than catalytic ones because of the loose sand

generated by HAI’s manufacturing process, which could degrade a

catalyst, and HAI’s use of chemical compounds that were less

susceptible to catalytic conversion. CPI personnel determined that

recuperative thermal oxidizers would allow the loose sand to accumulate

in the bottom of the machine (where it could later be cleaned out)

without interfering with performance, whereas other oxidizers would be

negatively affected by the sand. Considering the VOCs present, CPI

personnel also determined that airflow’s percentage of LEL, as

measured, was sufficiently high that the airflow into the oxidizer should

be diluted. Accordingly, CPI included in the design a fresh air dilution

valve, a fresh air damper, and a safety system to guard against the risk

of explosion. In order to accommodate the existing water scrubber, CPI

included a duct heating system that would evaporate any water vapor

from the scrubber.

In November 2013 CPI delivered to HAI a revised proposal for the

design of two 13,700 SCFM recuperative thermal oxidizers with 99%

VOC destruction efficiency, with C.J. listed as the sales engineer. The

proposal included the assumed VOC characteristics and levels of the

process airflow. The proposal stated, inter alia, that the basis of CPI’s

recommendation was “its experience gained through +30 units in the

sand resin coating industry.” The referenced “+30 units” that CPI had

previously designed were oxidizers installed for customers using resincoated sand to coat automotive components. The proposal also discussed

several of the relevant design characteristics. In relevant part, the

[*21] proposal stated that CPI proposed “to preheat the exhaust gases

from the scrubber prior to entering the ductwork,” in order to “elevate

the saturated air stream well above the condensate threshold to help

reduce both water and resin buildup prior to the pollution control

equipment.” Accordingly, the proposal also stated that CPI would

supply a direct fired duct heater system designed to heat the water

vapor from the scrubber exhaust. Finally, the proposal included a 99%

VOC destruction efficiency performance guarantee.

Also in November 2013 HAI issued a purchase order to CPI for

the oxidizer, with attached terms and conditions and a total price of

$1,898,750. Clause 14 of the terms and conditions, entitled “Intellectual

Property Rights,” stated as follows:

HA is entitled to all documents, drawings, specifications,

calculations and other information carriers with respect to

the performance of the activities of Contractor under the

Order. HA will be solely entitled to all intellectual property

rights (including patents) created during the performance

of the obligations under the Order. In case the intellectual

property rights are with both Contractor and HA,

Contractor will assure and guarantee that HA has a full

license to use these without any conditions for an indefinite

period of time.

Clause 20 of the terms and conditions stated that the terms would “be

construed in accordance with the laws of the State of Ohio without

application of its conflict of laws provisions.” On November 18, 2013,

CPI issued to HAI a sales order for the oxidizer.

In early January 2014 G.B. completed an initial general

arrangement drawing for the oxidizer. R.J. completed a P&ID drawing

for the oxidizer as well as electrical schematic drawings for a control

panel. CPI engaged PRE-Heat to fabricate and assemble the thermal

oxidizer and other components and Quantum Design to fabricate two

control enclosures. On April 17, 2014, Quantum Design issued to CPI a

project scope change form, noting several changes, including an

increased enclosure size in order to accommodate an air conditioner.

After fabrication was completed, the oxidizer parts were shipped

to HAI’s facility for installation. In June and July 2014 R.J. and another

CPI employee conducted quality inspections on the oxidizer’s electrical

systems and oversaw startup.

[*22] After installation, testing of the oxidizer revealed another issue

in which several tubes in the heat exchanger overheated because of

inadequate airflow. CPI resolved the issue by replacing and rewelding

the tubes and then replacing the baffles installed with a different air

splitting component, in order to achieve better airflow uniformity.

Testing of the oxidizer also revealed that vibration within the oxidizer

had ruptured some pressure release valves. CPI resolved the issue by

cutting down the length of the damper blades, which were causing the

excess vibration.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*23]

Component

Booster fan

$45,330

Burner

10,378

Combustion air piping

11,883

Combustion blower

3,914

Duct heater

44,986

Electrical panel

39,960

Exhaust stack

18,690

Gas train

30,443

Heat exchanger

283,951

Internal assembly combustion chamber

44,952

Mechanical loose parts

Seal air blower

Seal air blower piping

Total

Cost

861

1,833

633

$537,813

3M Hartford (#13-07611)

During the years at issue, 3M manufactured different types of

tape at a facility in Hartford City, Indiana. 3M initially contacted CPI

to assist in replacing a failing heat exchanger in one of their existing

thermal recuperative oxidizers. The production process at the Hartford

facility emitted VOC byproducts such as heptanes and hexanes. These

VOCs were attached to silicone molecules, which presented an issue, as

oxidizing the VOCs would trigger the formation of silicone dioxide (i.e.,

sand) that needed to be cleaned out of the oxidizer. Upon examination

of the existing oxidizer, CPI personnel determined that the system was

beyond the point of failure and recommended that 3M replace it. C.H.

was the sales engineer on the project.

[*24] As with the Hutchinson project, 3M provided extensive

specifications and required criteria for a potential oxidizer, including the

maximum exhaust temperature, type of VOCs at issue, and required

destruction efficiency. CPI personnel considered the process airflow

volume specification provided by 3M to be lower than the minimum

airflow needed for the oxidizer. Accordingly, CPI personnel determined

to include in the design a recirculation duct that would recycle cleaned

air from the exhaust stack back to the process inlet to achieve the

necessary minimum airflow.

In November 2013 CPI submitted a proposal to 3M for a

recuperative thermal oxidizer, which it described as a Quadrant SRSSilicone Series.

The proposal included the process airflow

characteristics, as provided by 3M, such as the VOCs at issue and the

range of concentrations. The proposal stated, in relevant part, that the

proposal was based on the system’s “ability to offer assured destruction

without worry about Silicone plugging while offering the lowest

maintenance costs and highest uptime reliability.” The proposal also

stated that the system was “designed to minimize the effects of SiO2

build up for fast and efficient cleanout,” by including ports to

“accommodate future inspections and cleaning” out of the SiO2

particulate. The proposal included a standardized page discussing the

problem of silicone dioxide and stating that the Quadrant SRS Silicone

Series thermal oxidizer had been developed “to provide an economical

answer to the disastrous effects of SiO2.” CPI had developed the

Quadrant SRS Silicone Series over a period of years and considered it to

be a unique, proprietary technology that it could market to the specific

industry of manufacturers using silicone coating. Also in November

2013 CPI issued a sales order to 3M for the thermal oxidizer, for a total

price of $1,569,700. The terms of the master agreement governed CPI’s

contract with 3M on the Hartford project.

CPI personnel, including Mr. Betz, ran a number of calculations

as to the sizing of components, such as the combustion blower and the

burners.

In December 2013 G.B. completed an initial general

arrangement drawing for the oxidizer, which was checked by J.Y. In

February 2014 R.J. completed a P&ID drawing for the oxidizer. CPI

engaged PRE-Heat for the fabrication and supply of the recuperative

oxidizer system and components. In April 2014 R.J. completed control

enclosure schematic drawings for the oxidizer. CPI engaged Quantum

Design for the fabrication of control panel enclosures for the oxidizer,

based on CPI’s drawing set.

[*25] In June 2014 3M provided CPI with revised information about the

process airflow volume, which allowed CPI personnel to make the

recirculation duct component smaller. Also in June 2014 Mr. Harmsen

contacted a 3M representative to provide notice of a scope change; 3M

personnel had become concerned that the sand particulate would affect

the booster fan, so CPI proposed to change to a radial blade fan that

could handle the particulate. Also in June 2014 CPI personnel visited

PRE-Heat to inspect the progress on the fabrication, at which point the

oxidizer was nearly finished. After installation at the Hartford City

facility, the oxidizer passed third-party compliance testing.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*26]

Component

Booster fan

$49,746

Burner

23,226

Combustion air piping

615

Ductwork

521

Electrical loose parts

2,047

Electrical panel

64,452

External assembly combustion chamber

10,002

Field assembly

10,239

Gas train

45,880

Heat exchanger

43,710

Hot side bypass damper

19,539

Seal air blower

9,864

Barometric relief damper

4,392

Total

Cost

$284,233

C&D Zodiac (#13-07583)

During the years at issue, Zodiac Aerospace Composites &

Engineered Materials (C&D Zodiac) manufactured composites for

commercial aircraft at a facility in Marysville, Washington. C&D

Zodiac’s manufacturing process generated VOC byproducts such as

phenol and formaldehyde. In 2013 Messrs. Betz and Harmsen visited

the Marysville facility to measure flow rates and then delivered to C&D

Zodiac an engineering study stating that their existing oxidizer had

insufficient volume. Before submitting a proposal to C&D Zodiac, Mr.

Harmsen input the measured values into a spreadsheet, which output

the potential BTUs per pound and pounds per hour of potential VOCs in

the process airflow, which would in turn determine the necessary size of

[*27] the oxidizer. Using various process airflow measurements, Mr.

Harmsen determined that the oxidizer size would be smaller than he

had anticipated and thus would allow for a more efficient heat

exchanger and avoid the need for a hot gas bypass. C.H. was the sales

engineer on the project.

In October 2013 CPI submitted a proposal for a 9,400 SCFM

regenerative thermal oxidizer. The proposal described the VOC levels

and characteristics of the process airflow. The proposal also included a

98% destruction efficiency performance guarantee. Also in October 2013

CPI issued a sales order to C&D Zodiac for the thermal oxidizer, for a

total price of $374,500. On November 4, 2013, the CPI project team,

which included Messrs. Betz, Harmsen, J.O., and C.H., held an internal

kickoff meeting to discuss the project and particular elements of the

oxidizer design. At the meeting, Mr. Harmsen discussed the inclusion

of a duct heater in the design, in order to heat the process air to an extent

sufficient to avoid buildup of resin condensation in the ducts.

CPI engaged Quantum Design to fabricate and supply a control

panel enclosure for the oxidizer. In late November 2013 J.O. exchanged

emails with David Foster, the project manager at C&D Zodiac,

regarding minor changes to the design drawings. At J.O.’s request, Mr.

Foster provided the earthquake rating for the Marysville area, which

had to be accounted for in the design of the exhaust stack. In late

November 2013 J.O. prepared an initial general arrangement drawing

and a P&ID drawing for the oxidizer and emailed them to Mr. Foster for

approval. After reviewing the drawing set, Mr. Foster informed J.O.

that the P&ID drawing’s placement of the Marysville facility’s print

room was inaccurate and should be updated. In December 2013 the

P&ID drawing was revised per C&D Zodiac’s comments.

CPI engaged Lantec to fabricate and supply multilayer ceramic

media, PRE-Heat to fabricate and supply a regenerative thermal

oxidizer and various components, and IVI North to fabricate and supply

an exhaust stack. In December 2013 C.D. completed initial electrical

schematic drawings for a control panel. On February 16, 2014, R.T.

visited PRE-Heat to inspect the oxidizer and media assembly and poppet

valve housing. On February 26 and March 13, 2014, R.T. again visited

PRE-Heat to inspect various components in the fabrication process.

In March 2014 R.J. provided Quantum Design with updated

electrical schematic drawings to be revised in order to comply with thirdparty certification standards. CPI engaged Quantum Design to have its

[*28] technicians travel to PRE-Heat’s facility and make additional

revisions to the control system to meet certification standards. During

installation at the Marysville facility, CPI discovered that the control

panel enclosure door was too close to the booster fan; CPI moved the

control panel enclosure over to resolve the issue.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*29]

Component

Booster fan

$22,668

Burner

2,165

Ceramic media

13,200

Combustion air piping

1,693

Combustion blower

3,418

Electrical boxes

1,298

Electrical loose parts

1,317

Electrical panel

68,456

Exhaust stack

19,835

External assembly combustion chamber

6,202

Field assembly

163

Fresh air damper

3,134

Gas train

7,059

Internal assembly combustion chamber

18,595

Engineering add-ons

1,781

Total

Cost

$170,984

Teva (#14-07808)

During the years at issue, Teva Pharmaceuticals USA (Teva)

operated a pharmaceutical facility in Salt Lake City, Utah. In 2014

Teva was in the process of installing a new manufacturing line that

required pollution control, pursuant to EPA standards. The primary

VOC byproduct of Teva’s manufacturing process was ethanol.

CPI was invited to bid on the project and determined that a

catalytic oxidizer would be optimal. CPI personnel reached this

[*30] determination partly because of the limited space at Teva’s

facility.

Teva also provided CPI with specifications about the

characteristics of the airflow exhaust at the Salt Lake City facility. In

April 2014 CPI submitted a proposal for a catalytic oxidizer, described

as a Vector series. The proposal included extensive specifications and a

performance guarantee that total VOC concentration would be reduced

by at least 98%. The proposal also stated that the system would include

a self-cleaning ceramic guard bed; after discussions with Teva, CPI had

determined that the guard bed would be necessary to protect the

catalyst from other particulates in the facility’s airflow. T.S. was the

sales engineer on the project.

In May 2014 Teva and CPI exchanged purchase and sale orders

for the catalytic oxidizer, for a total price of $217,600. The purchase

order attached Teva’s standard terms and conditions; clause 14 provided

that CPI would “not use, sell, loan or publicize any of the tools,

specifications, blueprints, designs or artwork supplied or paid for by

Buyer for the fulfillment of this order without Buyer’s written consent.”

Similarly, clause 15 provided that “[a]ll tools, dies, molds, printing

plates, mechanical, etc. created for use on this order shall be the

property of Buyer, and Buyer may withdraw them from Sellers’s

premises on demand in writing.”

CPI personnel calculated the size of components, such as the

catalyst bed chamber, the exhaust stack, and the burners, using the

information about the process airflow provided by Teva. CPI engaged

PRE-Heat for the fabrication and assembly of a heat exchanger, exhaust

stack, and various other components. In June 2014 C.D. completed

electrical schematic drawings for a control panel enclosure.

Subsequently, CPI engaged Quantum Design to fabricate and supply a

control panel and enclosure based on CPI’s drawings. From June to

October 2014 CPI purchased a number of physical components and

materials from vendors, with shipping typically made to PRE-Heat.

PRE-Heat completed fabrication and assembly of the oxidizer, at

which point CPI personnel visited its facility to conduct “a final quality

audit.” The quality audit included dye penetrant testing of the oxidizer

body and testing of the control system. The oxidizer was then shipped

to Teva’s facility in Salt Lake City. Teva personnel installed the oxidizer

at the Salt Lake City facility, with CPI personnel present to supervise.

After installation, the oxidizer’s heat exchanger was preheating too

high. CPI resolved this issue by modifying the control system in order

to introduce additional fresh air into the process to bring down the

[*31] temperature via a damper on the inlet side of the system fan. The

system later passed its third-party compliance testing.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

Component

Booster fan

$8,959

Burner

1,960

Catalyst – 8800 = ECO#1 3000

11,880

Combustion air piping

1,170

Combustion blower

1,441

Electrical panel

25,626

Exhaust stack

1,141

Fresh air damper

2,744

Gas train

8,323

Heat exchanger

56,666

I Asbly combustion chamber 15500 = ECO#1 500

6,200

PIT Sitrans

963

Tee damper

3,107

Total

Cost

$130,178

Mitsubishi (#14-07899)

During the years at issue. Mitsubishi Electric Automotive

America, LLC (Mitsubishi), operated a facility in Mason, Ohio, that

manufactured motor starters and other engine components for engine

suppliers. Mitsubishi’s manufacturing process generated the chemical

styrene as a VOC byproduct. Mitsubishi’s existing 12,000 SCFM

catalytic oxidizer system had been supplied by CPI 14 years earlier. The

[*32] catalytic oxidizer had been experiencing a buildup of condensates

in recent years, creating a maintenance problem and reducing the

system’s capacity to approximately 10,000 SCFM. Mitsubishi requested

that CPI provide suggestions for a larger (either 35,000 or 25,000

SCFCM), more efficient, and maintenance-friendly oxidizer, as it

planned to expand the Mason facility. Using the two potential airflow

volumes, Mr. Harmsen performed simple calculations for the potential

size of several components.

In July 2014 CPI submitted a revised proposal for either a 35,000

or a 25,000 SCFM regenerative thermal oxidizer. The proposal

described the process airflow as “styrene with a heat content of

approximately 17,000 BTU/lb.” The proposal also included a 98%

destruction efficiency performance guarantee.

In August 2014

Mitsubishi sent CPI a purchase order for the 35,000 SCFM oxidizer, for

a total price of $675,750. Mr. Betz prepared a P&ID drawing for the

oxidizer that was based on CPI’s existing knowledge of the Mitsubishi

facility and Mitsubishi’s expansion plans. C.D. completed initial

electrical schematic drawings for a control panel. S.F. completed an

initial general arrangement drawing for the oxidizer.

CPI engaged Lantec to fabricate and supply multilayer ceramic

media, Quantum Design to fabricate and supply the control panel

enclosure of the oxidizer, and both Global Fab and PRE-Heat to fabricate

and supply various components of the oxidizer. CPI engaged a general

contractor located near Mitsubishi to perform the installation of the

system at the facility, under the supervision of Messrs. Harmsen and

E.M.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*33]

Component

Booster fan

$31,537

Burner

44,333

Ceramic media

47,880

Combustion air piping & weather hood

2,710

Combustion blower

3,484

Electrical loose parts

2,112

Electrical panel – SEE EXCEL for details

31,067

Exhaust stack

21,870

Fresh air damper

4,142

Gas train

11,500

Mechanical loose parts

3,328

BF outlet exp jnt

967

BF VFD NEMA 1 250HP w/disconnect

15,543

Engineering add-ons

4,484

Ex stack exp jnt

1,377

Poppet valve assemblies

26,849

Total

Cost

$253,183

3M Monrovia (#14-07784)

During the years at issue 3M manufactured silicone rubber

gasketing for the aerospace industry at a facility in Monrovia,

California. Before engaging CPI, 3M used an existing recuperative

thermal oxidizer supplied years earlier by a different oxidizer

contractor. As of 2013 that oxidizer was no longer meeting California

environmental regulatory standards. In February 2013 3M provided

[*34] CPI with an extensive and detailed list of required specifications

for a 12,000 SCFM recuperative thermal oxidizer. The specifications

included the requirements that the oxidizer “include design features

necessary for cleaning of SiO2 dust from the heat exchanger and

combustion chamber”. The specifications also provided information

about the process airflow, including minimum and maximum airflow

rates, temperatures, solvent rates, and the VOC at issue (toluene).

In April 2014 CPI submitted a revised proposal, which 3M

accepted via a purchase order, for a total price of $1,277,400. The final

proposal stated that CPI would supply 3M with a silicone recuperative

oxidizer from CPI’s Quadrant SRS product line. The proposal also

included a 99% destruction efficiency performance guarantee. CPI also

provided 3M with general arrangement and P&ID drawings for the

oxidizer. The terms of the master agreement governed CPI’s contract

with 3M on the Monrovia project. Mr. Harmsen was the lead

applications engineer on the project and assisted with project

management.

3M had informed CPI personnel that the oxidizer would need to

meet California state law requirements with respect to its emissions. In

particular, the specifications provided by 3M noted the requirement for

low nitrogen oxide-emitting burners. In May 2014 G.B. completed an

initial general arrangement drawing for the oxidizer, which was checked

by F.C. In June 2014 CPI personnel input the provided specifications

into a spreadsheet, which output a possible size for the burner. CPI also

submitted its design drawings to a third party, Larson Engineering, Inc.

(Larson), for review; Larson reviewed the drawings for the purpose of

determining whether they complied with California requirements with

respect to seismic activity. Also in June 2014 Larson issued a report

certifying the drawings as acceptable. Similarly, CPI submitted the

design drawings to a different third-party engineer who performed

calculations and made suggestions as to how the stack could comply with

California requirements.

In July 2014 R.J. prepared electrical

schematic drawings for the oxidizer. Ultimately, after consulting with

Maxon Corp., CPI’s typical burner supplier, CPI personnel included a

low emissions burner in the design. In August 2014 CPI submitted to

3M several design drawings, including the general arrangement

drawing, for approval.

CPI engaged IVI North to fabricate and supply an exhaust stack,

PRE-Heat to fabricate and supply the oxidizer and various components,

and Quantum Design to modify the existing control panel enclosure and

[*35] fabricate a new control panel. In July 2014 R.J. completed

electrical schematic drawings for a control panel enclosure. In

September 2014 CPI and 3M conducted a joint process hazard analysis

(PHA), to review the design drawings and relevant possible safety issues

at the Monrovia facility. Mr. Harmsen and F.C. participated on CPI’s

side. As a result of the PHA, CPI made several design changes to the

design drawings.

In February and March 2015 CPI submitted to 3M additional

revised design drawings for approval. After assembly was completed,

the oxidizer was installed at the Monrovia facility by a third-party

contractor, under the supervision of F.C.

At some point after

installation, an inspection of the oxidizer by 3M found that the cone

installed around the burners was cracking and failing; pursuant to the

contractual warranty, CPI repaired the problem.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*36]

Component

Cost

Barometric relief damper

$8,011

Burner

7,565

Combustion air blower

7,777

Combustion air piping

38,183

Control house

33,866

Davit arm

2,724

Ductwork

5,425

Electrical panel

54,920

Exhaust stack

62,068

Field assembly

12,927

Filter box

14,996

Filter box dampers

21,649

Gas train

30,690

Hardware & gasket

1,988

Heat exchanger

352,290

Process booster fan

50,352

Seal air blower

5,929

Total

$711,360

Celanese (#14-07852)

During the years at issue, Celanese Corp. (Celanese)

manufactured ethylene-vinyl acetate beads for use in other chemical

manufacturing processes at a facility in Edmonton, Alberta, Canada.

[*37] The manufacturing process generated VOC byproducts of acetic

acid, ethylene, vinyl acetate, and naphtha.

In August 2013 Celanese issued to CPI terms and conditions for

a project, which included a clause 11 entitled “Rights in Deliverables;

No License.” Clause 11 stated that CPI agreed “that any deliverables or

other work product arising from the Services shall be the property of

and owned by Celanese, and shall be considered Confidential

Information hereunder.” Clause 11 further stated in relevant part that

CPI “hereby assigns to Celanese any and all (a) inventions, discoveries

or improvements thereof, patentable or otherwise” and “(b) all other

arise out of the performance of the Services or that are applicable to any

deliverables under the Purchase Order.” Clause 11 further stated that

any deliverables that are eligible for copyright protection “shall be

considered “work made for hire” and Celanese will be considered the

author of such work.” Finally, clause 11 provided that, in the event that

such deliverables were “deemed for any reason not to be a work for hire,”

CPI “hereby assigns all rights, title and interest in the copyright of such

work” to Celanese.

Next, clause 12 provided restrictions on Confidential Information,

requiring CPI to “hold the Confidential Information in strictest

confidence” and “not disclose the Confidential Information, or cause or

allow it to be disclosed to any third party or use the Confidential

Information for any purpose other than as expressly contemplated by

the Purchase Order. Clause 12 provided that CPI could “not disclose

any Confidential Information to any third party . . . unless and until

Celanese has furnished written consent.”

In December 2013 WorleyParsons, an engineering firm retained

by Celanese to supervise the project, provided CPI with an extensive

report detailing the specifications and requirements for the oxidizer.

The report stated that Celanese required a regenerative thermal

oxidizer with destruction efficiency of 98%; the report also provided a

design basis for the oxidizer, which provided a number of relevant

measurements and calculations (including a minimum winter

temperature of −46 degrees Celsius and the various concentrations of

VOCs in the airflow), and a drawing setting out the process flow for the

oxidizer. The report also provided a list of Celanese’s preferred vendors

for the various components and control systems. In addition, Celanese

provided CPI with copies of (1) its standard engineering practices for

[*38] control systems; (2) standard maintenance procedures for bolted

joint assembly; and (3) electrical specifications.

CPI began work on a proposal. CPI identified several potential

issues, for example, the extreme winter temperatures in Edmonton,

which might require design changes. Using the information provided by

Celanese and WorleyParsons, CPI personnel input the provided VOC

levels into Bessy spreadsheets, which calculated that the LEL of the

airflow would be 4.2%. 17 That low LEL allowed CPI to omit a hot gas

bypass from the design. Similarly, CPI personnel entered the provided

specifications into a spreadsheet, which output the appropriate size of

the fan components. With respect to the gas train component, on

January 8, 2014, Mr. Betz emailed a representative at Maxon to ask

about how to design the component for use in a minimum temperature

of −50.8 degrees Fahrenheit. The Maxon representative responded that

CPI should try to work with the customer to have the component meet

−45 or −40 degrees Fahrenheit minimum temperatures instead, because

of the difficulty in supplying components that met such low

temperatures.

In May 2014 CPI submitted a revised proposal to Celanese. In

the proposal, CPI stated that it “accepts Celanese terms and conditions

8-1-2013 with the termination language detailed on page 36 of this

proposal.” The proposal also stated in relevant part that the system was

being “designed for outdoor installation and a temperature rating of −40

[degrees] C (−40 [degrees] F) [sic].” In June 2014 Celanese issued a

purchase order to CPI for the oxidizer, for a total price of $897,000. 18

In July 2014 S.F. completed an initial general arrangement

drawing for the project, which was checked by F.C. Also in July 2014,

R.J. completed P&ID drawings for the oxidizer. CPI engaged Quantum

Design to fabricate a control panel enclosure, Lantec to supply a ceramic

heat exchanger, and IVI North to fabricate and supply an exhaust stack

for the system, including “[e]ngineering and design (fabrication

drawings).” In August 2014 R.J. completed initial electrical schematic

CPI personnel also entered different combinations of VOCs at higher

volumes into several alternative Bessy spreadsheets to account for a possible worstcase scenarios, which resulted in an 8% LEL.

18 In February 2015, Celanese issued a change order, memorializing an

additional $33,000 in unplanned services to be performed by CPI. Those services

largely related to an apparent misunderstanding between the parties as to the scope

of CPI’s work on the electrical system.

[*39] drawings for a control panel. R.J. later requested that Quantum

Design complete the final design drawings for the electrical schematics,

in part because CPI’s work was being closely scrutinized by

WorleyParsons. Quantum Design provided CPI with a quote to design

the control enclosure for the oxidizer. Under its terms Quantum Design

would provide engineering design and drawings “using CPI provided

standard templates and nameplates.” As the project progressed,

WorleyParsons and Celanese requested revisions to the design, which

CPI incorporated. In September 2014 R.J. traveled to Canada for

meetings with Celanese representatives; in those meetings, Celanese

requested a number of changes to the design of the control panel, which

R.J. conveyed to Quantum Design.

As of early February 2015 the oxidizer was not yet assembled or

installed. Celanese had informed CPI that it needed to meet Canadian

building code standards for the control house component of the system,

which delayed the project; eventually CPI and Celanese agreed to

purchase a control house in Canada and have CPI pipe and wire it to

meet the Canadian standards. In early April 2015 R.J. prepared a

document that described the details of the control house. At some point

thereafter, the oxidizer was installed at the Celanese facility by a thirdparty contractor. In March 2016 the oxidizer system underwent thirdparty emissions testing and failed the efficiency requirements. As with

the 3M Hutchinson project, CPI discovered that a poppet valve was

failing to seal and sent a service technician to fix it.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*40]

Component

Booster fan

Cost

$22,056

Burner

6,416

Ceramic media

32,106

Cold face support

89,288

Combustion air piping

1,680

Combustion blower

4,894

Control house

4,936

Electrical loose parts

7,196

Electrical panel

95,371

Exhaust expansion joint

837

Exhaust stack

43,550

Fresh air damper, pneu. act.

4,255

Gas train

4,382

Isolation damper, pneu. act.

5,801

Manual balancing damper

1,344

Mechanical loose parts

2,732

Media chamber

28,408

Poppet housing

25,261

Poppet valve assemblies

23,044

Total

$403,556

[*41] J.

Smalley (#14-07658)

During the years at issue, Smalley Steel Ring Co. (Smalley)

manufactured heat-treated fasteners for aircraft engines at a facility in

Lake Zurich, Illinois. Smalley’s heat-treating process generated oil and

grease byproducts that burned off into visible smoke. Before contacting

CPI, Smalley relied upon condenser equipment, evocatively known as

Smog-Hogs, which intake and cool smoke-filled air, causing the oil and

grease droplets to condense, before then releasing the cleaned air back

into the manufacturing area. However, the condenser process created

an oil byproduct that could leak, presenting a potential quality and

maintenance problem that Smalley wished to avoid. CPI personnel

visited the jobsite, took measurements of the airflow, and ran tests.

Because of the variety of chemical compounds CPI found present at the

site and constraints on using blowers at the site, CPI determined that a

thermal oxidizer with a vertical combustion chamber would be

optimal. 19

In December 2013, after completing onsite measurements, CPI

submitted a proposal for an 800 SCFM direct thermal oxidizer,

described as a “smoke abatement” system, which Smalley accepted. The

proposal stated, in relevant part, that the system would convert the oil

smoke and mist emissions to carbon dioxide and water vapors, creating

a “cleaner, more maintenance-free abatement system.”

Also in

December 2013 Smalley sent CPI a purchase order for the oxidizer, for

a total price of $153,500; the purchase order attached terms and

conditions. Clause 6 of the terms and conditions provided:

Seller will keep confidential all information, drawings,

specifications or data furnished by Buyer and shall not

divulge or use such information, drawings, specifications or

data for the benefit of any third person or entity or for any

purpose other than the performance of this Order. Except

as required for the performance of this Order, Seller will

not make copies or permit copies thereof to be made

without the prior written consent of Buyer; Seller will,

upon completion of this Order, return such information,

drawings, specifications and data to Buyer and make no

further use, either directly or indirectly, of any such data

19 A vertical combustion chamber is essentially akin to a chimney, in which hot

air is induced to rise upward.

[*42] or of any information derived therefrom without obtaining

Buyer’s prior written consent.

Clause 10 of the terms and conditions provided in relevant part:

Unless Buyer and Seller otherwise agree in writing, the

following provisions shall apply to any tools, tooling,

patterns, equipment, materials or other properties used in

the manufacture of the Goods for Buyer or in the

performance of this Order, that are either supplied to

Seller by Buyer or have been acquired by Seller and

specifically paid for by Buyer. All such properties

(including scrap) shall hereafter be referred to as “BuyerOwned Property”. (a) Seller shall have the right to use

Buyer-Owned Property without payment for usage as

required in the performance of this Order or other work for

Buyer, but shall not use Buyer-Owned Property in the

performance of any other work without prior written

approval of the Buyer. Title to all Buyer-Owned Property

shall at all times remain with Buyer. Title to all BuyerOwned Property which is procured or manufactured by

Seller for Buyer shall be fully invested in Buyer upon

payments for same by Buyer.

In January 2014 CPI personnel collected samples of the oil

condensation, coated a steel sample with the condensation, and then

placed the sample in a furnace at the Smalley facility, in order to observe

at what temperature the smoke emissions from the condensation were

no longer present. CPI personnel also entered specifications into

spreadsheets and performed calculations in order to size components,

such as the combustion chamber and the burners. Also in January 2014

R.J. completed electrical schematic drawings for a control panel. The

control system was designed to automatically turn the burners on and

off according to whether Smalley’s heat furnaces were generating visible

smoke emissions. CPI engaged Quantum Design to fabricate a control

panel enclosure and Modern Equipment Co. (Modern Equipment) to

fabricate and assemble the oxidizer. After the oxidizer was assembled,

a quality audit conducted by CPI personnel revealed that Modern

Equipment had not followed CPI’s drawings closely enough, leading to

some components’ needing to be reassembled by CPI personnel. CPI

personnel then installed the oxidizer at the Smalley facility. After

installation, CPI personnel modified the control system’s sequence of

[*43] operations to account for the system’s delay in responding to

measured temperatures.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

Component

Burner

$1,462

Combustion air piping

1,356

Combustion blower

1,374

Electrical panel

10,504

Gas train

2,337

Total

Cost

$17,033

Isola I—IR (#14-07607)

During the years at issue Isola Laminate Systems Corp. (Isola)

manufactured plastic and fiberglass boards at a facility in Chandler,

Arizona. That manufacturing process generated VOC byproducts such

as various plasticizers and phenolic resin. Before engaging CPI, Isola

used an older thermal oxidizer (supplied previously by CPI) that had

caught fire and was no longer achieving the necessary destruction

efficiency.

In October 2013 CPI submitted a proposal for replacing various

components of the oxidizer.

The proposal provided extensive

specifications for the oxidizer, including sizes and manufacturers for the

various components, and provided a 99% destruction efficiency

guarantee. The proposal specifically noted that the design would

incorporate several enhancements that had “proved very successful” on

similar recent oxidizers.

Finally, the proposal noted that the

replacement components would “maintain the same footprint as the

original making the installation as seamless as possible and providing

little disruption to the process.” After some revisions, Isola accepted

CPI’s proposal. In November 2013 Isola sent CPI a purchase order for

the thermal oxidizer equipment, for a total price of $480,000.

[*44] CPI personnel performed calculations to determine the sizing of

components, such as the combustion chamber and the burner. After

sizing the fan component, CPI sought to reduce the risk of resins’

catching fire by engaging a subcontractor to make a hinged fan that

could be easily cleaned. After installation, CPI encountered an issue

where a leg of the system had incurred some shell fracturing due to heat.

CPI resolved this by reinforcing the leg. The system passed its thirdparty compliance testing and was accepted by the customer.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

Component

Booster fan

$11,931

Burner

8,976

CO#1 EXP JT MB

22,656

Combustion blower

3,562

Compressed air piping

487

Electrical boxes

553

Gas train

Mechanical loose parts

Total

Cost

6,986

293

$55,444

Isola II—SR (#14-07890)

At this plant, located at the same facility as the Isola I project,

Isola manufactured coating for plastic and fiberglass boards. CPI

determined that a self-recuperative thermal oxidizer, in which the heat

exchanger is separated from the combustion chamber, would be optimal.

In June 2014 Mr. Betz completed an initial P&ID drawing for the

oxidizer. In June 2014, CPI sent Isola a revised proposal for a 6,000

SCFM recuperative thermal oxidizer. The proposal described the

applicable VOCs as including acetone, MEK, butanol, PM, PMA, and

PNB and described the maximum air temperature and maximum VOC

[*45] concentration of the process airflow. The proposal provided a 99%

destruction efficiency performance guarantee. C.H. was the sales

engineer on the project.

In July 2014 Isola and CPI exchanged purchase and sale orders

for the thermal oxidizer, for a total price of $628,200. CPI personnel

performed calculations as to the sizing of components, such as the

combustion chamber and the burners. CPI revised their sizing

calculations and design several times because of the system’s potentially

not fitting in the allocated space of Isola’s facility. In September 2014

R.T. completed an initial general arrangement drawing for the oxidizer,

which was submitted to Isola for approval on September 22, 2014. CPI

engaged PRE-Heat to fabricate and supply the oxidizer system

(including an exhaust stack) and engaged Quantum Design to fabricate

and supply the control panel enclosures. After installation of the

oxidizer by the customer, CPI’s supervising startup technicians

discovered an air pressure issue that required modifications to the

control system programming.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*46]

Component

(3) VFD’s

BF DPS & enclosure

BF inlet PSH

Cost

$5,953

307

1,175

BF inlet PT & enclosure

880

BF outlet EXP J S/S

912

Booster fan NON insulated

10,982

Ceramic saddle

6,164

Cleanout platform and ladder

8,610

Flame safety

Fresh air damper & actuator 18”

Hx DPS

681

4,993

245

Inlet plenum w/door

3,851

Insulated inlet

14,381

Isolation dampers & act (2) 26”

7,823

Oxidizer fabrication

176,210

Oxidizer fasteners

1,206

PLC

29,760

Pre-filter

149

Press control dampers & act (2) 22”

9,440

Primary heat exchanger

55,602

Secondary heat exchanger

25,096

Secondary Hx EXP joint

3,356

Secondary Hx PIT

1,125

Secondary Hx TE

Thermocouples

253

Burner

10,258

Gas train

5,593

Manual shut off valve

Seal air blower (heat exchanger)

Engineering add-ons

Exhaust stack ECO #1

Total

260

2,701

11,553

$399,674

[*47] M.

Goodyear Lawton (#14-07925)

During the years at issue, the Goodyear Tire & Rubber Co.

(Goodyear) operated a tire manufacturing facility in Lawton, Oklahoma.

As of 2014 Goodyear used an older regenerative thermal oxidizer at the

Lawton facility, which had been experiencing regular repair issues with

its heat exchanger because of clogging from talcum powder used in the

manufacturing process. The primary VOC byproduct of the Lawton

facility was ethanol.

CPI was invited to submit a proposal to replace the existing

oxidizer. In August 2014 CPI submitted a revised, final proposal for a

50,000 SCFM regenerative thermal oxidizer for a total price of $827,500,

described as a TRITON system, which Goodyear accepted. The proposal

memorialized the characteristics of the process airflow at the Lawton

facility, including temperature, volume, heat content, and type of VOC.

The proposal also stated that the process airflow would be ducted to an

existing mixer dust system to filter out particulate before it reached the

oxidizer inlet. Finally, the proposal included a 98.5% destruction

efficiency performance guarantee. Goodyear accepted the proposal.

After the acceptance of the proposal, Mr. Harmsen determined

that a more expensive, plug-resistant type of ceramic heat exchanger

might be optimal for the project, as it would allow particulate to more

easily pass through. Mr. Harmsen proposed the different heat

exchanger to Goodyear, which agreed to incorporate it into the design at

a higher cost. In September 2014 C.D. prepared an initial P&ID

drawing, which was checked by F.C. Also in September 2014 S.F.

prepared an initial general arrangement drawing for the oxidizer, which

was also checked by Mr. Costanzo.

CPI engaged IVI North to fabricate and supply various

components of the oxidizer and Lantec to supply the multilayer ceramic

media component. After fabrication was completed, Goodyear hired a

crew to install the oxidizer itself at the Lawton facility. In August 2015

Goodyear contacted CPI to inform them that the oxidizer had failed

performance testing, reaching only 93% destruction efficiency. CPI

resolved the issue during a subsequent inspection.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*48]

Component

Booster fan

$38,657

Burner

3,396

Ceramic media

2,936

Cold face support

103,840

Combustion air piping

575

Combustion blower

2,202

Control house

19,135

Electrical panel

45,642

Exhaust stack

80,275

Fresh air damper

5,302

Gas train

11,292

Mechanical loose parts

8,026

Media chamber

4,884

Poppet housing

35,496

Poppet valve assemblies

30,848

Exhaust stack expansion joint

1,195

System insulation & paint

55,000

Total

Cost

$448,702

Wenner (#14-0800)

During the years at issue Wenner Bread Products, Inc. (Wenner),

manufactured artisanal bread at a site in Baltimore, Maryland. During

testing for Clean Air Act compliance, Wenner discovered that its

specialized yeasts were emitting high levels of ethanol when in the

[*49] baking ovens. Wenner did not have a pollution control system in

place and thus contacted CPI for a quote. Wenner provided CPI with

specifications about the airflow and ethanol quantities. After reviewing

the specifications, CPI determined that a catalytic optimizer would be

appropriate, because of the high heat release caused when burning

ethanol.

In September 2014 CPI submitted a proposal for a 3,000 SCFM

catalytic oxidizer.

The proposal included the assumed ethanol

concentrations of the process airflow from the baking ovens. The

proposal stated that the system would incorporate a ceramic monolith

catalyst, which would, in relevant part, provide the ability to “wash” the

catalyst. The proposal also stated the system would incorporate a

ceramic guard, in order to capture fats, oils, and greases before they

reached the catalyst, which would “greatly increase catalyst life by

prohibiting active surface area being coated with airborne droplets and

particulate.” Finally, the proposal included a 98% destruction efficiency

performance guarantee. In October 2014 CPI and Dennis Engineering

Group LLC (Wenner’s engineering consultant) entered into a sales

agreement for the purchase and sale of the oxidizer, for a total price of

$281,700. C.H. was the sales engineer on the project.

CPI personnel input the provided VOC levels into a Bessy

spreadsheet, which calculated that the LEL of the airflow would be

9.68%. Because of the high heat release in the process airflow, CPI thus

determined to include a hot gas bypass that vented air directly to the

stack and thus avoided excessively preheating the heat exchanger. CPI

personnel performed calculations in order to determine the optimal size

of various components, including the fan, burner, exhaust stack, and

fresh air damper.

In October 2014 C.D. completed electrical schematic drawings for

a control panel and CPI engaged Quantum Design to fabricate a control

panel and enclosure. In December 2014 R.T. completed an initial

general arrangement drawing. CPI engaged PRE-Heat to fabricate and

assemble the oxidizer system. Once it was assembled, CPI personnel

conducted a quality audit of the oxidizer at PRE-Heat’s facility, before

the oxidizer was shipped to the Wenner facility. CPI personnel

supervised the installation of the system at Wenner’s facility. The

system successfully passed emissions compliance testing by a third

party.

[*50] As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*51]

Component

BF outlet exp jnt

$534

BF VFD

1,623

Booster fan

13,945

Burner

3,286

Catalyst

15,540

Catalyst – guard bed

1,400

Combustion air piping & weather hood

1,060

Combustion blower

1,523

Combustion chamber

62,714

Ductwork

4,550

Electrical panel – SEE EXCEL for details

23,890

Exhaust stack

2,468

Fresh air damper

1,723

Gas train

5,907

Heat exchanger

5,143

Mechanical loose parts

4,858

Tee damper

13,613

Total

Cost

$163,778

East Balt (#14-07950)

During the years at issue East Balt Commissary, Inc. (East Balt),

operated a bakery facility that specialized in making hamburger buns

for McDonald’s restaurants. East Balt engaged CPI to resolve issues

related to ethanol emissions produced by the baking ovens, which had

[*52] been identified as a violation of the Clean Air Act. Mr. Betz was

the lead applications engineer on the project, and C.H. was the sales

engineer. CPI began its initial bid proposal by visiting East Balt’s

facility in order to measure the airflow and temperature from the baking

oven exhaust. CPI personnel determined that a catalytic oxidizer was

the appropriate system for the facility, in part because catalytic

conversion was fairly effective with respect to ethanol.

In August 2014 CPI submitted a revised proposal for the design

of a catalytic oxidizer, described as a Vector-5. The proposal described

the baking oven exhaust as being assumed to be 2,343 and 2,560 SCFM

for the two baking ovens, with ethanol at 15–25 lb/hr as the VOC

byproduct.

The proposal provided a 98% destruction efficiency

performance guarantee. The proposal also stated that the oxidizer

would include a “ceramic guard bed” downstream from the burner but

before the catalyst, which would be “optimum for ensuring all fats, oils,

and greases are in vapor phase prior to that catalyst.” The guard bed

would thus “greatly increase catalyst life by prohibiting active surface

area being coated with airborne oil droplets and particulate.” In

September 2014 East Balt and CPI exchanged purchase and sale orders

for the oxidizer, for a total price of $571,500.

In September and October 2014 C.D. completed electrical

schematic drawings for a control panel enclosure. In October 2014 R.T.

completed an initial general arrangement drawing for the oxidizer. In

October 2014 C.D. completed an initial P&ID drawing for the oxidizer.

CPI engaged Quantum Design to fabricate the control panel enclosure

and PRE-Heat to fabricate and assemble the oxidizer. During the

fabrication stage of the oxidizer, the EPA informed East Balt that a

system that dispersed air exhaust at a higher elevation would be

necessary. CPI extended the exhaust stack design and added structural

support in order to prevent it from collapsing in the event of high winds.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*53]

Component

Booster fan

$16,832

Burner

466

Catalyst

31,280

Combustion air piping

1,086

Combustion blower

210

Electrical panel

26,052

Expansion joints

2,560

Fresh air damper

4,612

Gas train

7,810

Hardware and gasket

I Asbly combustion chamber

196

58,747

PIT Sitrans

896

Tee damper

20,898

Total

Cost

$171,646

M&W Ireland (#14-07718)

During the years at issue M&W Group (M&W) was the general

contractor at an Intel Corp. facility in Leixlip, Ireland, which

manufactured computer chips and wafers. The primary byproduct of

the manufacturing process was liquid ammonium fluoride.

In January 2014 CPI sent a proposal to M&W for a “Trimix Waste

Water Treatment System.” The proposal stated in relevant part that

“this proposal captures the request made during our January 6, 2014

conference call, for CPI to provide an exact copy to the current TRIMIX

system that was recently completed.” The proposal closely followed

specifications provided by Intel. The proposal made some site-specific

[*54] modifications to the previous TRIMIX system design, some of

which were made in order for the system to meet European product

standards. Those modifications generally involved finding components

from Europe that were equivalent to components that CPI had used in

the previous TRIMIX system design and then making some sizing

adjustments to conform to the differing components. For the project,

CPI personnel used a general arrangement design drawing for an

ammonia removal system, originally drawn on September 25, 2009. The

system was designed to first adjust the pH of the ammonium fluoride in

order to separate out the fluoride from the ammonia. From there, the

ammonia would be removed from the liquid stream into the air by an air

stripper, with the process airflow then being blown into a catalytic

oxidizer and converted to nitrogen oxides. The airflow would next

encounter a secondary “selective reduction catalyst,” which would

convert the nitrogen oxides into regular nitrogen.

In February 2014 M&W sent to CPI a purchase order for the

oxidizer system and components, for a total price of $3,836,100. CPI

engaged PRE-Heat to fabricate and assemble various components of the

system. CPI engaged Murphy Matson O’Sullivan, an Irish engineering

consulting firm, to determine the location of the oxidizer’s foundation

and calculate the necessary depths for anchoring the system. This was

a relevant aspect of the design, because the Leixlip facility experienced

high winds. Using information provided by M&W as to the gallons per

minute and VOC concentration range, CPI personnel entered

specifications into a spreadsheet to determine the potential size of

components and the system’s energy requirements. CPI submitted

design drawings to M&W, which provided comments and asked for

certain modifications. Ultimately, the system was installed at the

Leixlip facility and passed performance testing.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*55]

Component

Booster fan – parts

$160,974

Loose ship – parts

51,776

Oxidizer – parts

247,629

S4 – parts

48,648

Spares – parts

79,563

Sparge – parts

121,614

Stripper/Eff pump – parts

34,580

TRIMIX – parts

19,774

Total

Cost

$764,559

Enterprise (#14-07851)

During the years at issue Enterprise Products Partners L.P.

(Enterprise) operated a natural gas production facility in Rifle,

Colorado. Enterprise had two existing 20,000 SCFM regenerative

thermal oxidizers that were experiencing an operational problem where

ice built up on the system’s inlet during cold temperature periods in the

winter. Before 2014 CPI had developed a solution to the problem of

extreme temperature, by which airflow was recirculated back to the fan

inlet in order to prevent condensation and freezing from low

temperatures. CPI personnel had written an article about this solution;

personnel at Enterprise read the article and then asked CPI to visit its

facility and inspect its oxidizer system.

At Enterprise’s request, Messrs. Betz and Harmsen visited the

Rifle facility to inspect the regenerative thermal oxidizers in use there.

Enterprise also provided Mr. Harmsen with the general arrangement

design drawing for one of the existing oxidizers. On January 2, 2014,

Mr. Harmsen provided Enterprise with a report on the operations of the

regenerative thermal oxidizers, including the characteristics of the

process airflow. The report identified some pin hole leaks in the current

system and described inadequacies with the process air fan inlet design,

hot gas bypass damper, and fresh air fan. The report described how the

[*56] existing hotside bypass dampers, which had failed multiple times,

differed from CPI’s standard hotside bypass damper. The report

recommended that Enterprise install a hot gas bypass recirculation

system, as designed by CPI, and an internally insulated VOC hot gas

bypass. The report also included a version of the general arrangement

drawing, which Mr. Harmsen had modified by pasting in the ductwork

component from a previous project, in order to represent how the

oxidizers could circulate fresh air without temperature issues at the

inlet of the oxidizer.

In June 2014 CPI sent Enterprise a proposal for the supply of

(1) two designed hot air recirculation systems and (2) two internally

insulated VOC hot gas bypasses. The proposal described the hot gas

bypass recirculation system as intended to “maintain 300 F inlet

temperatures and allow for more accurate control and adjustment to

process changes” and “keep the inlet side of the RTO above the acid dew

point and prevent freeze ups.” The proposal described the VOC hot gas

bypass as intended to “direct clean hot air directly into the exhaust stack

to de-rate the thermal efficiency of the Oxidizer.” Also in June 2014,

Enterprise sent CPI a purchase order for the components, for a total

price of $435,000; the purchase order attached terms and conditions.

Clause 16 of the terms and conditions was entitled “Data Ownership”

and provided the following:

Buyer shall, at all times, be the owner of all information

and materials resulting from Supplier's services, including

sketches, layouts, negatives, photographs, designs,

blueprints, and specifications relating thereto, and of the

work product of all services furnished or performed under

this order, including all creative ideas included therein, by

Supplier or any subcontractor of Supplier in connection

with this order. Upon the completion, or in the event of the

cancellation or termination of this order, all copies of such

information, materials, and work product shall be returned

and delivered to Buyer by Supplier. Buyer may copy or

reproduce any and all such information, materials, and

work product for any and all purposes and may use the

same in any and all media as often as it may so desire. No

copies or reproductions thereof shall be made or retained

by Supplier except as authorized in writing by Buyer.

Clause 17 was entitled “Confidentiality” and stated that “[n]o

information relative to this order concerning the purchase or use of

[*57] goods or services may be published or disseminated by Supplier

without the Buyer’s prior written consent.”

In September 2014 G.B. prepared an initial general arrangement

drawing, which copied the general arrangement design of the existing

oxidizer and added the proposed components. CPI engaged Global Fab

to fabricate and assemble various aspects of the components. The

components were installed at the Rifle facility at some point in 2015.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

Component

Cost

Blower

$52,653

Damper & ductwork

158,370

Total

$211,023

DuPont La Porte (#14-07831)

During the years at issue, E.I. DuPont de Nemours & Co.

(DuPont) operated a chemical manufacturing facility in La Porte, Texas.

The manufacturing process at the facility generated VOCs such as

methyl methacrylate and acetic acid. CPI determined that a direct

thermal oxidizer would be optimal.

In May 2014 CPI sent DuPont a revised proposal, which DuPont

accepted. The proposal was more detailed than was CPI’s normal

practice and included extensive specifications for the various

components of the system. The proposal included a 99.9% destruction

efficiency performance guarantee. The proposal stated that the system

would incorporate “a low emissions burner specially designed to process

mixed gases” which would be sized for 6 million BTU/hour. Also in May

2014 CPI issued a sales order to DuPont for the thermal combustor,

which noted that no fabrication would begin until approval

documentation was received from DuPont. The sales order was for a

total price of $769,900.

Ultimately, CPI purchased a high intensity fuel-gas burner for

the system. DuPont provided CPI with the VOC levels for two particular

process airflows at the La Porte facility. CPI personnel input the

[*58] provided VOC levels for the first airflow, primarily consisting of

methanol and acetates, into a Bessy spreadsheet, which calculated that

the LEL of the airflow would be 62.5%. CPI personnel then input the

provided VOC levels for the second airflow, primarily consisting of

nitrogen from a tank farm at the facility, into a Bessy spreadsheet,

which calculated that the LEL of the airflow would be 330.4%. Because

of the high LEL, CPI personnel determined that the oxidizer would need

to burn the process airflow directly, without mixing it with additional

oxygen. CPI personnel entered the provided specifications into another

spreadsheet to determine the sizing of components, such as the process

fan.

In August 2014 R.T. completed an initial general arrangement

drawing for the system, which was checked by F.C. The extremely large

size of the exhaust stack was somewhat unusual for CPI and was outside

their design capability. Accordingly, CPI engaged IVI North to both

design and fabricate a stack to a number of provided sizing and feature

specifications.

With respect to the electrical system, CPI was responsible for

designing only the burner control and management system, with the

remainder of the oxidizer’s operations being programmed by DuPont

into its existing control system at the La Porte facility. The design of

the burner control system went through an extensive design review with

DuPont. R.J. started from CPI’s standardized P&ID drawings but

eventually made a number of revisions at DuPont’s request. The process

of revising CPI’s standardized designs for the various components of the

system was similarly extensive, with DuPont offering multiple

revisions. The oxidizer was installed by DuPont at the La Porte facility

at some point in 2015 or 2016 and subsequently passed third-party

compliance testing.

As part of the research credit study, Alliantgroup did not include

any supply costs associated with the DuPont project in its qualified

research expenditures calculations.

Reclaimed Energy (#14-07981)

During the years at issue Superior Oil Co., Inc.’s Reclaimed

Energy Division (Reclaimed Energy) operated a facility in Connersville,

Indiana. At the facility, Reclaimed Energy recycled used chemical

solvents from other manufacturing processes and distilled them down to

clean elements. Because of that business model, Reclaimed Energy’s

[*59] process involved a wide variety of VOCs. Reclaimed Energy was

a longtime customer of CPI and, in 2014, already used two CPI-supplied

catalytic oxidizers at its facility. Because of that customer relationship,

CPI already had a significant amount of institutional knowledge and

information about the Connersville facility and the process airflow. CPI

personnel determined that the existing catalytic oxidizers lacked

sufficient capacity during high VOC emission periods.

CPI personnel determined that a new regenerative thermal

oxidizer would be appropriate, sized at 15,000 SCFM. In September

2014 CPI submitted a proposal for a 15,000 SCFM regenerative thermal

oxidizer, described as a Triton 15.95. The proposal included the

characteristics of the process airflow, including the volume,

temperature, heat value, and maximum estimated VOC load. The

proposal also included a 98% destruction efficiency performance

guarantee. Reclaimed Energy then sent to CPI a purchase order for the

oxidizer, for a total price of $449,800. Using the known characteristics

of Reclaimed Energy’s process airflow, Messrs. Betz and Harmsen

calculated the sizes of various components, such as the fan and fresh air

damper, basing them upon the volume, air pressure, and inlet

temperature. In October 2014 Mr. Betz completed a P&ID drawing for

the oxidizer; the P&ID drawing was based on a previous one completed

for Reclaimed Energy with modifications. Also in October 2014 S.F.

completed an initial general arrangement drawing for the oxidizer,

which was checked by T.Z.

CPI engaged Lantec to fabricate and supply the multilayer

ceramic media component, Global Fab to fabricate and assemble various

components of the oxidizer, and IVI North to fabricate and supply an

exhaust stack. In October and November 2014 C.D. completed various

electrical schematic drawings. In November 2014, Quantum Design

made a number of suggested revisions to the drawings, to which CPI

agreed. CPI then engaged Quantum Design to fabricate and supply the

control panel and enclosures. In early 2015 S.F. and other CPI

employees completed a number of other design drawings for components

of the oxidizer. A number of components of the oxidizer were ordered

from suppliers in 2015. Ultimately, the oxidizer was installed by

Reclaimed Energy at the Connersville facility at some point in 2015.

As part of the research credit study, Alliantgroup calculated that

the following supply costs were qualified research expenditures:

[*60]

Component

BF outlet exp joint

$681

BF VFD

6,060

Booster fan

17,124

Burner

1,097

Ceramic media

22,695

Cold face support

8,798

Combustion air piping

5,112

Combustion blower

2,450

Duct from CC to stack

3,349

Electrical loose parts

1,260

Electrical panel

37,407

Exhaust stack

41,085

Exhaust stack flex

875

Fresh air damper, pneu. act.

4,142

Gas train

11,765

Hardware and gaskets

3,076

Hot gas bypass damper – insulated

13,088

Inlet transition duct

979

Mechanical loose parts

3,918

Media chamber

92,627

Poppet housing

19,019

Poppet valve assemblies

35,270

Total

VII.

Cost

$331,877

Tax Reporting

On April 20, 2015, CPI filed a Form 1120S, U.S. Income Tax

Return for an S Corporation, for tax year 2014. On Form 6765 for tax

year 2014 CPI reported a research credit of $501,531 under section 41

after electing a reduced credit under section 280C(c). 20 Schedules K–1,

Shareholder’s Share of Income, Deductions, Credits, etc., were issued to

petitioners Mark Betz and Julia Lincoln, reporting $250,765 as a

research credit on line 13. On April 15, 2015, petitioners Mark and

Christine Betz and petitioners Julia and Dennis Lincoln jointly filed

Forms 1040, U.S. Individual Income Tax Return, for tax year 2014. On

their Form 3800, General Business Credit, Mr. and Mrs. Betz reported

20 CPI also claimed a deduction of $171,489 for research and development.

[*61] a research credit of $250,766, of which they claimed $128,898 on

line 54 of their Form 1040. On their Form 3800, Mr. and Mrs. Lincoln

reported a research credit of $250,765, of which they claimed $122,651

on line 54 of their Form 1040.

Mr. and Mrs. Betz jointly filed Form 1040 for tax year 2015. On

Form 3800 they reported a carryforward of the research credit of

$104,708, of which they claimed $58,198 on line 54 of their Form 1040.

Mr. and Mrs. Lincoln jointly filed a Form 1040 for tax year 2015. On

Form 3800 they reported a carryforward of the research credit of

$129,682, of which they claimed $31,718 as part of their other credits

total on line 54 of their Form 1040.

Mr. and Mrs. Betz jointly filed Form 1040 for tax year 2016. On

Form 3800 they reported a carryforward of the research credit of

$46,510, of which they claimed $43,780 on line 54 of their Form 1040.

Mr. and Mrs. Lincoln jointly filed Form 1040 for tax year 2016. On Form

3800 they reported a carryforward of the research credit of $97,964, of

which they claimed $32,866 on line 54 of their Form 1040.

The 2014 Form 1120S and the 2014, 2015, and 2016 Forms 1040

for both couples were prepared by the accounting firm Porte Brown LLC.

Jeffery R. Smiejek, a partner at Porte Brown, signed all seven returns

as preparer. Porte Brown prepared the original underlying Form 6765,

which reported the section 41 credit, by transcribing the numbers from

the pro forma Form 6765 that Alliantgroup delivered to petitioners on

April 10, 2015. On November 2, 2015, Alliantgroup emailed Porte

Brown a brief memo describing the research credit’s requirements and

attaching spreadsheets with the claimed wage and supply costs.

VIII. The Notices of Deficiency and Petitions

On July 26, 2018, respondent issued to petitioners Mark and

Christine Betz a notice of deficiency, which made the following

determinations:

Year

Deficiency

Penalty § 6662

2014

$128,898

$25,779.60

2015

58,198

11,639.60

2016

43,780

8,756.00

[*62] On July 26, 2018, respondent also issued to petitioners Julia and

Dennis Lincoln a notice of deficiency, which made the following

determinations:

Year

Deficiency

Penalty § 6662

2014

$121,083

$24,216.60

2015

31,718

6,343.60

2016

32,866

6,573.20

Each couple timely filed a Petition with this Court.

OPINION

Jurisdiction and Burden of Proof

Where a notice of deficiency issued to an S corporation

shareholder includes adjustments to both S corporation items and other

items unrelated to the S corporation, we have jurisdiction to determine

the correctness of all adjustments in the shareholder-level deficiency

proceeding. See Johnson v. Commissioner, No. 19973-18, 160 T.C., slip

op. at 11 (Jan. 25, 2023) (citing Winter v. Commissioner, 135 T.C. 238,

245–46 (2010)). We thus have jurisdiction to determine the correctness

of both respondent’s adjustments to petitioners’ pro rata shares of CPI’s

claimed research credit and any other determinations in the notices of

deficiency.

The Commissioner’s determinations as expressed in the notice of

deficiency are presumed correct, and the taxpayer bears the burden of

proving that they are erroneous. Rule 142(a)(1); Welch v. Helvering, 290

U.S. 111, 115 (1933); VHC, Inc. v. Commissioner, 968 F.3d 839, 841 (7th

Cir. 2020), aff’g T.C. Memo. 2017-220. Credits are a matter of legislative

grace, and taxpayers must demonstrate their entitlement to credits

claimed. See Feigh v. Commissioner, 152 T.C. 267, 270 (2019) (citing

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992)); see also United

Stationers, Inc. v. United States, 163 F.3d 440, 443 (7th Cir. 1998).

Petitioners have neither alleged nor established that they meet the

requirements of section 7491(a) as necessary to shift the burden of proof

to respondent on any factual issues.

[*63] II.

Section 41 Research Credit

Basic Structure

Section 38 provides taxpayers with a current-year business credit

that includes a credit for research expenses as determined under section

41(a). Section 41(a)(1) specifies that the research credit shall be an

amount equal to 20% of the excess of the taxpayer’s qualified research

expenses (QREs) over the base amount. QREs are limited to amounts

“paid or incurred by the taxpayer during the taxable year in carrying on

any trade or business.” 21 § 41(b)(1); see § 7701(a)(25). QREs may be

either in-house research expenses or contract research expenses.

§ 41(b)(1). In-house research expenses include (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.” Id. para. (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 research

activities which constitute qualified research.” Id. subpara. (B); see

Treas. Reg. § 1.41-2(c) (defining “direct supervision” and “direct

support”). If at least 80% of the services an employee performed during

the taxable year were qualified services, then the taxpayer may treat

100% of that employee’s wages as being paid or incurred for qualified

services. Treas. Reg. § 1.41-2(d)(1) and (2).

To constitute qualified research, a research activity must satisfy

a four-part statutory test. § 41(d)(1). If the research activities

corresponding to a particular product as a whole fail to satisfy the fourpart test, we may re-apply the test to subsets of the product. See Treas.

Reg. § 1.41-4(b)(2) (providing the “shrinking-back rule”). Several

statutory exclusions, see § 41(d)(4), set forth categories of activities that

are excluded from the definition of qualified research (and thus cannot

be creditable), see § 41(d)(1) (flush language) (“[Qualified research] does

not include any activity described in paragraph (4).”); see also Eustace v.

Commissioner, 312 F.3d 905, 908 (7th Cir. 2002) (“Sections 41(d)(1) and

(d)(4) are independent rules, which deserve, and have received,

independent constructions.”), aff’g T.C. Memo. 2001-66, 81 T.C.M.

21 For an accrual method taxpayer such as CPI, a liability is incurred and taken

into account for the taxable year in which (1) all the events have occurred that establish

the fact of the liability; (2) the amount of the liability can be determined with

reasonable accuracy; and (3) economic performance has occurred with respect to the

liability. See VECO Corp. & Subs. v. Commissioner, 141 T.C. 440, 459 (2013); see also

§ 461(h); Treas. Reg. § 1.461-1(a)(2)(i).

[*64] (CCH) 1370. One such exclusion provides that “[a]ny research

related to the adaptation of an existing business component to a

particular customer’s requirement or need” is excluded from the

definition of qualified research. § 41(d)(4)(B).

The base amount for purposes of section 41 is equal to the product

of the average of the taxpayer’s annual gross receipts for the four

preceding years, multiplied by a fixed-base percentage. 22 § 41(c)(1). The

fixed-base percentage is generally the percentage calculated by dividing

(1) the taxpayer’s aggregate QREs for tax years beginning after

December 31, 1983, and before January 1, 1989, by (2) the taxpayer’s

aggregate gross receipts for those same tax years. Id. para. (3)(A). The

fixed-based percentage cannot exceed 16%. Id. subpara. (C). The base

amount cannot be less than 50% of the QREs for the credit year. Id.

para. (2).

In the case of an S corporation, the amount of a claimed section

41 credit is allocated among the shareholders pro rata. See Treas. Reg.

§ 1.41-7(a)(1)(i); see also §§ 1366(a)(1)(A), 1377(a)(1). Each S corporation

shareholder may then claim the section 41 credit on his or her income

tax return in an amount “equal to the amount of tax attributable to that

portion” of the taxable income “allocable or apportionable” to their

shareholder interest. § 41(g). To the extent an S corporation

shareholder’s pro rata portion of the section 41 credit for the taxable

year exceeds this limitation, that shareholder may carry forward the

unused amount of credit to a future taxable year. Id. subsec. (g).

Substantiation Principles

Section 6001 requires, inter alia, that taxpayers keep records in

compliance with the rules and regulations prescribed by the Secretary

of the Treasury. Accordingly, taxpayers are required to “keep such

permanent books of account or records . . . as are sufficient to establish

the amount of gross income, deductions, credits, or other matters

required to be shown” on a tax return. Treas. Reg. § 1.6001-1(a). With

respect to the research credit, the taxpayer specifically “must retain

records in sufficiently usable form and detail to substantiate that the

expenditures claimed are eligible for the credit.” Treas. Reg. § 1.41-4(d).

To substantiate wages paid or incurred for qualified services, the

taxpayer need not necessarily maintain and produce contemporaneous

22 Respondent did not address petitioners’ calculation of the base amount in his

posttrial briefing, and we thus deem that issue conceded.

[*65] time-tracking records for its employees. See Union Carbide Corp.

& Subs. v. Commissioner, T.C. Memo. 2009-50, 97 T.C.M. (CCH) 1207,

1268 (“[Treasury Regulation § 1.41-4(d)] does not require that a

taxpayer substantiate its research credit claim with any particular types

of documents . . . .”), aff’d, 697 F.3d 104 (2d Cir. 2012); Fudim v.

Commissioner, T.C. Memo. 1994-235, 67 T.C.M. (CCH) 3011, 3012

(accepting “testimony and other evidence in the record” as basis for

Cohan rule estimate of time spent in performing qualified services

(citing Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930)); see also

United States v. McFerrin, 570 F.3d 672, 679 (5th Cir. 2009).

However, we do not apply the Cohan rule to estimate wages paid

or incurred if the taxpayer fails to make a threshold showing that a

particular employee performed activities that constituted qualified

services with respect to a business component.

See Shami v.

Commissioner, 741 F.3d 560, 568 (5th Cir. 2014) (“[T]he Cohan rule is

not implicated unless the taxpayer proves that he is entitled to some

amount of tax benefit[;] [i]n the context of the § 41 credit, a taxpayer

would do so by proving that its employee performed some qualified

services.”), aff’g in relevant part T.C. Memo. 2012-78; Moore v.

Commissioner, T.C. Memo. 2023-20, at *11 (“Even if some of

[employee’s] activity on these three products was qualified research, we

have no basis for estimating how much of his time was so spent.”); see

also Mendes v. Commissioner, 121 T.C. 308, 316 (2003) (“Even under

Cohan, there must be sufficient evidence in the record to provide a basis

upon which an estimate may be made.” (citing Vanicek v. Commissioner,

85 T.C. 731, 742–43 (1985))); Coors Porcelain Co. v. Commissioner, 52

T.C. 682, 697–98 (1969), aff’d, 429 F.2d 1 (10th Cir. 1970).

If a business component as a whole fails any of the four qualified

research tests, the taxpayer must still show that a particular employee

performed qualified services with respect to a particular subset of the

component, in order to implicate Cohan. See Eustace, 81 T.C.M. (CCH)

at 1372, 1374 (rejecting taxpayers’ attempt to invoke Cohan rule when

they lacked “the substantiation necessary to tie salaries to activities at

the subcomponent level” and merely “delineated the employees and

activities” believed to qualify for research credit); Trinity Indus., Inc. v.

United States, 691 F. Supp. 2d 688, 693 (N.D. Tex. 2010) (declining to

apply shrinking-back rule because taxpayer “offered no evidence of the

costs associated with any subset” of the product), aff’d in part and

remanded, 757 F.3d 400 (5th Cir. 2014). Finally, the U.S. Court of

Appeals for the Seventh Circuit—to which an appeal in this case would

lie, absent stipulation to the contrary, see § 7482(b)(1)(A), (2)—has

[*66] previously described the Cohan rule as “rarely compulsory” and

suggested it is not applicable where the expenses at issue are of a sort

where the taxpayer should have been able to produce some form of

substantiating evidence, see Lerch v. Commissioner, 877 F.2d 624, 628,

629 n.9 (7th Cir. 1989) (quoting Williams v. United States, 245 F.2d 559,

560 (5th Cir. 1957) (describing estimate without reasonable basis as

“unguided largesse”)), aff’g T.C. Memo. 1987-295; see also Buelow v.

Commissioner, 970 F.2d 412, 415 (7th Cir. 1992) (affirming this Court’s

decision not to apply Cohan rule where taxpayer failed to question

knowledgeable trial witnesses about expenses at issue), aff’g T.C. Memo.

1990-219.

More recently, the Seventh Circuit has had occasion to address

the substantiation burden that taxpayers claiming the research credit

must bear. See Little Sandy Coal Co. v. Commissioner, 62 F.4th 289,

308 (7th Cir. 2023), aff’g T.C. Memo. 2021-15. In Little Sandy Coal Co.,

the Seventh Circuit encountered a similar research credit claim by a

taxpayer that relied on trial testimony as substantiation for its

estimated QREs; the Seventh Circuit characterized the taxpayer’s

evidentiary showing as asking this Court “to take on faith” that the

allocations of its employees’ wages were only for activities constituting

qualified research. Id. In affirming this Court’s decision that the

taxpayer had failed to show entitlement to the credit, the Seventh

Circuit emphasized that “shortcut estimates of experimentation-related

activities will not suffice . . . [s]omething more, such as documentation

of time spent on such activities, is necessary.” Id.

Petitioners largely relied on the trial testimony of Messrs. Betz

and Harmsen to carry their substantiation burden. We found Messrs.

Betz and Harmsen to be credible with respect to the basic facts of CPI’s

business process and the technical background of oxidizers, with which

they are evidently highly familiar. However, we found their testimony

at times to be vague, in conflict with the record, and lacking in credibility

with respect to their self-serving characterizations of some of the work

performed by CPI on specific projects. See Conti v. Commissioner, 99

T.C. 370, 375 (1992) (“It is our task to decide the credibility of any lay or

expert witness based upon objective facts, the reasonableness of the

testimony, the consistency of the statements made by the witness, and,

in some cases, the demeanor of the witness.”), aff’d and remanded, 39

F.3d 658 (6th Cir. 1994); see also Lerch v. Commissioner, 877 F.2d at 631

(“The Tax Court may disregard uncontradicted testimony by a taxpayer

where it finds that testimony lacking in credibility.”). We will note

[*67] below where our observations of the trial witnesses are

particularly relevant to our findings and conclusions.

Qualified Research

To constitute qualified research, research must satisfy a four-part

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

constitute elements of a process of experimentation

for a purpose described in paragraph (3).

Such term does not include any activity described in

paragraph (4).

The four-part test is applied separately to each business

component. Id. para. (2)(A). A “business component” is defined in

relevant part as a product or process that the taxpayer either (1) holds

for sale, lease, or license or (2) uses in its trade or business. Id. subpara.

(B). Any plant process, machinery, or technique for commercial

production of a business component is itself treated as a separate

business component from the underlying product. Id. subpara. (C).

Here, the business components claimed by petitioners are the oxidizer

systems or components of oxidizer systems supplied to CPI’s customers.

As noted above, if a business component as a whole fails any of

the qualified research tests, the regulations provide a fallback position

for taxpayers in the form of the shrinking-back rule. See Treas. Reg.

§ 1.41-4(b)(2). The shrinking-back rule instructs us to re-apply the fourpart test to the business component at its “most significant subset of

elements.” Id. If that too fails, we generally drill down to a more

[*68] granular subset of the business component, until either (1) a

subcomponent satisfies the tests or (2) the most basic level of the

component fails to satisfy the tests. Id.

We now turn to the four-part test. Respondent concedes that

CPI’s claimed activities in 2014 satisfied two parts: the technological

information test and the business component test. We thus largely focus

on the first requirement in section 41(d)(1) that respondent does

challenge: the section 174 test. 23

Section 174 Test

To be qualified, research must be research “with respect to which

expenditures may be treated as expenses under section 174.”

§ 41(d)(1)(A). We have previously interpreted section 41(d)(1)(A) as

incorporating the section 174 requirements on both the nature of the

activity and the nature of the expenditure. See Norwest Corp. & Subs.

v. Commissioner, 110 T.C. 454, 491 (1998) (interpreting section

41(d)(1)(A) as requiring “the taxpayer to satisfy all the elements for a

deduction under section 174”); Union Carbide Corp., 97 T.C.M. (CCH)

at 1255 (analyzing both whether taxpayer’s activities “constitute

research and development within the meaning of section 174” and

whether the costs of those activities “may be treated as expenses under

section 174”). To satisfy the section 174 test, the taxpayer thus 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., 110 T.C. at 491; Union Carbide Corp., 97 T.C.M.

(CCH) at 1274 (“[The taxpayer] cannot avoid the restrictions of section

174 by arguing that section 174 is relevant only for determining whether

activities constitute qualified research and has no bearing on whether

the costs of those activities may be QREs.”). If we conclude that the

taxpayer has failed to satisfy the section 174 test at “the level of a

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

23 The process of experimentation test (which respondent also raises) is a

higher bar, which requires “essentially the same uncertainty as is required by the

section 174 test” but “imposes a more structured method of discovering information

than section 174 requires and may not include all actions a taxpayer takes to resolve

uncertainty.” Union Carbide Corp., 97 T.C.M. (CCH) at 1256.

[*69] of the component or subcomponent of the product.” 24 Treas. Reg.

§ 1.174-2(a)(5) (providing a section 174-specific shrinking-back rule).

On its own, section 174 operates as a narrow, elective exception

to the general capitalization rules. See §§ 263(a)(1)(B), 263A(c)(2);

INDOPCO, Inc. v. Commissioner, 503 U.S. at 84 (“[D]eductions are

exceptions to the norm of capitalization . . . .”); see also Donald C.

Alexander, Research and Experimental Expenditures Under the 1954

Code, 10 Tax L. Rev. 549, 549–52 (1955) (contrasting pre-1954

treatment of research costs with section 174); David S. Hudson, The Tax

Concept of Research or Experimentation, 45 Tax Law. 85, 112–20 (1991)

(discussing the origins of section 174 as a practical solution to the

accounting difficulty of allocating and capitalizing research costs).

Section 174(a)(1) allows taxpayers to elect a current-year deduction for

“research or experimental expenditures which are paid or incurred by

[the taxpayer] during the taxable year in connection with [its] trade or

business.” 25 See Spellman v. Commissioner, 845 F.2d 148, 149 (7th Cir.

1988), aff’g T.C. Memo. 1986-403; see also Treas. Reg. § 1.174-1. The

corresponding regulations define “research or experimental

expenditures” as those that “represent research and development costs

in the experimental or laboratory sense” including costs “incident to the

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

The regulations further provide:

Expenditures represent research and development costs in

the experimental or laboratory sense if they are for

activities intended to discover information that would

eliminate uncertainty concerning the development or

improvement of a product. Uncertainty exists if the

information available to the taxpayer does not establish

the capability or method for developing or improving the

product or the appropriate design of the product.

The applicable regulatory preamble describes this rule as “intended to

ensure that section 174 eligibility is preserved in instances in which a basic design

specification of the product may be established, but there is uncertainty with respect

to certain components of the product.” T.D. 9680, 2014-32 I.R.B. 254, 256; see, e.g.,

Caltex Oil Venture v. Commissioner, 138 T.C. 18, 34 (2012) (consulting regulatory

preamble to resolve ambiguity in regulatory text).

25 Congress has since amended section 174 to eliminate the option of a currentyear deduction and provide instead for mandatory amortization of research and

development expenditures for taxable years starting after December 31, 2021. See Tax

Cuts and Jobs Act of 2017, Pub. L. No. 115-97, § 13206, 131 Stat. 2054, 2111–13.

[*70] Id.

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

activities constituted research and development within the meaning of

section 174. First, the taxpayer must show that the information

available to it did not establish (1) that the taxpayer was capable of

developing or improving the product; (2) the method by which the

taxpayer would develop or improve the product; or (3) 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 information was not

available to the taxpayer with respect to establishing either capability,

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

Carbide Corp., 97 T.C.M. (CCH) at 1255. In applying this first step, we

examine the information objectively available to the taxpayer, rather

than the taxpayer’s subjective understanding of that information. Id.

(“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 Max, T.C. Memo. 2021-37, at *30 (finding no uncertainty

where appropriate design may have been subjectively unknown to

taxpayer but taxpayer “already ha[d] the information necessary to

address that unknown”). Second, if uncertainty existed, the taxpayer

must still show that it undertook investigative activities that were

“intended to discover information that would eliminate uncertainty.”

Treas. Reg. § 1.174-2(a)(1); see Max, T.C. Memo. 2021-37, at *30–31. In

Little Sandy Coal Co. v. Commissioner, 62 F.4th at 298, the Seventh

Circuit recently clarified the nature of the uncertainty required by

section 174:

Generic uncertainty is inherent in constructing or

manufacturing a product. That involves questions like:

Will this tire fit? What kind of screws are needed to attach

this panel? Or will this weld hold up this truss? But

“uncertainty” in Section 174 means something more. . . .

Expenses incurred merely to determine whether a product

is built to satisfy a client’s desired specifications—without

any indication that the expenses were incurred to improve

or develop the concept of the product—do not qualify.

Continuing, the Seventh Circuit looked to the ordinary meaning of

“development,” as used in Treasury Regulation § 1.174-2(a)(1), and

concluded that the term requires some “advancement in technology or

product concept” as opposed to “mere construction.” Little Sandy Coal

[*71] Co. v. Commissioner, 62 F.4th at 298. The Seventh Circuit noted

the difficulty in establishing uncertainty at the level of a product as a

whole, emphasizing that “a manufacturer may not simply ‘add a few new

bells and whistles’ on a pre-existing product and claim uncertainty as to

the whole.” Id. at 299. Finally, the Seventh Circuit noted that, “[i]f

summed up in one word, expenses deductible under [s]ection 174 must

be ‘investigative.’” Id. (quoting Union Carbide Corp., 97 T.C.M. (CCH)

at 1255).

The section 174 test implicates one more relevant limitation.

Expenditures paid or incurred for “ordinary testing or inspection of

materials or products for quality control (quality control testing)” are

not deductible under section 174. Treas. Reg. § 1.174-2(a)(6)(i). Quality

control testing includes “testing or inspection to determine whether

particular units of materials or products conform to specified

parameters” but “does not include testing to determine if the design of

the product is appropriate.” Id. subpara. (7).

Supply QREs

We first focus on whether the claimed supply QREs for all 19

projects would be eligible for a deduction under section 174, as a

category of expenditure. The record demonstrates that the claimed

supply QREs correspond to payments made by CPI to various

subcontractors and suppliers for the costs of fabricating, assembling,

and supplying components of the oxidizers. CPI does not itself fabricate,

assemble, or manufacture any components at its own facility. The

“supply” label used by petitioners is thus partially a misnomer here, as

the claimed supply QREs appear to encompass not only payments CPI

made to its suppliers for the cost of supplies (i.e., physical components)

but also certain payments made to its subcontractors for services (e.g.,

payments labeled in CPI’s accounting system as for “assembly” of

components). 26 See § 41(b)(2)(C) (defining “supplies” as “any tangible

property” other than land, improvements to land, and depreciable

property).

26 Petitioners do not contend that the cost of the services the subcontractors

performed on the projects constituted contract research expenses incurred by CPI, nor

did the Alliantgroup study identify any contract research expenses as part of the credit

amount claimed. See § 41(b)(3)(A) (providing a limited credit for contract research

expenses for research performed by another). Given our conclusions below, we need

not speculate as to what amount of the claimed supply QREs would actually be

creditable in full.

[*72] Section 174 provides a deduction only for “‘expenditures of an

investigative nature expended in developing the concept of a model or

product’, as opposed to the construction or manufacture of the product

itself.” Union Carbide Corp., 97 T.C.M. (CCH) at 1255 (alteration in

original) (quoting Mayrath, 41 T.C. at 590); see Little Sandy Coal Co. v.

Commissioner, 62 F.4th at 298 (distinguishing between generic

construction uncertainty and uncertainty as to the underlying concept

of a model or product); Kollsman Instrument Corp. v. Commissioner,

T.C. Memo. 1986-66, 51 T.C.M. (CCH) 463, 466 (distinguishing between

nondeductible production activities and deductible research activities),

aff’d, 870 F.2d 89 (2d Cir. 1989). Consequently, a deduction under

section 174 is generally not available with respect to costs of production,

and claimed QREs incurred in the actual production of a product

typically fail the section 174 test. See Max, T.C. Memo. 2021-37, at *30–

31.

The relevant exception, as set forth in the regulations, is for costs

incurred in constructing a prototype or “pilot model,” which is defined

as “any representation or model of a product that is produced to evaluate

and resolve uncertainty concerning the product.” Treas. Reg. § 1.1742(a)(4); see Little Sandy Coal Co., T.C. Memo. 2021-15, at *38–39. The

regulations note that “a fully-functional representation or model of the

product or . . . component of the product” can still be a pilot model if

produced to evaluate and resolve uncertainty. See Treas. Reg. § 1.1742(a)(4). Expenditures incurred for the actual construction of a pilot

model are generally deductible under section 174, even if the model itself

is ultimately sold to customers. See Treas. Reg. § 1.174-2(a)(1) (“The

ultimate success, failure, sale, or use of the product is not relevant to a

determination of eligibility under section 174.”); see also id. subpara.

(11) (example 7). To qualify for the pilot model exception, the taxpayer

must show that (1) uncertainty existed (i.e., an objective lack of

information) as to capability, method, or appropriate design of a product,

(2) it constructed “a representation or model” of the product, and (3) its

purpose in constructing the representation or model was to “evaluate

and resolve uncertainty” about capability, method, or appropriate

design. See Little Sandy Coal Co., T.C. Memo. 2021-15, at *41 (“[T]he

classification of a product as a pilot model turns on the taxpayer’s

purpose in producing it.”); see also Little Sandy Coal Co. v.

Commissioner, 62 F.4th at 303 (“[T]he creator’s intent matters.”). Once

objective uncertainty is eliminated with respect to the underlying

product, any further costs of production do not qualify under section 174.

See Treas. Reg. § 1.174-2(a)(1), (11) (example 3).

[*73] In their pretrial memorandum, petitioners initially asserted that,

because each oxidizer was “uniquely designed for the particular

application on which it is being designed,” each oxidizer was a pilot

model, with costs of its production qualifying under section 174 until the

oxidizer was “running in a manner which meets the project

requirements.” However, petitioners failed to explicitly contend in their

posttrial briefing that the oxidizers were pilot models. Petitioners did

make on brief the broader, more general argument that the supply costs

were for materials “used in the development process, prior to the end of

uncertainty of appropriate design [sic].” Similarly, in their posttrial

briefing, petitioners referenced on one occasion that the supplies were

“utilized in the development of the prototypes.” Despite petitioners’

failure to explicitly brief the pilot model exception, we find that

petitioners’ more generalized contentions that the supply costs were

QREs necessarily raises this issue for decision. 27 See Purple Heart

Patient Ctr., Inc. v. Commissioner, T.C. Memo. 2021-38, at *35 n.10

(questioning taxpayer’s failure to explicitly brief issue but “nonetheless”

addressing issue as “entwined” with other issues properly raised by

taxpayer).

In any event, we conclude that petitioners have failed to carry

their burden of establishing that the oxidizer systems at issue were pilot

models. The record demonstrates that the supply QREs related to the

cost of producing functional systems for CPI’s customers. Accordingly,

in order to satisfy the section 174 test, petitioners are required to show

that the supply QREs related to the cost of producing pilot models.

While the regulations note that a fully functional representation or

model can qualify as a pilot model, the taxpayer must establish that its

purpose in producing that representation or model was to evaluate and

resolve uncertainty about the product (i.e., to obtain unavailable

information necessary to establish capability, method, or appropriate

design).

Treas. Reg. § 1.174-2(a)(1), (4); cf. Natkunanathan v.

Commissioner, T.C. Memo. 2010-15, 99 T.C.M. (CCH) 1071, 1074

(“Expenditures made to develop and deliver functional products for use

by customers do not usually constitute ‘research and development * * *

in the experimental or laboratory sense.’”), aff’d, 479 F. App’x 775 (9th

Cir. 2012). Petitioners have failed to make such a showing.

27 We typically treat a failure to adequately argue a point on brief as a

concession. See Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989); see also Mendes,

121 T.C. 308 at 312–13 (“If an argument is not pursued on brief, we may conclude that

it has been abandoned.”).

[*74] Instead, we conclude that the various projects were not

“representation[s] or model[s]” as a whole and that CPI’s purpose in

incurring their production costs was not to evaluate and resolve

uncertainty. First, any suggestion that CPI’s various subcontractors

and suppliers were constructing or supplying representations or models

is wholly unsupported by the record. A representation or a model is

generally defined as an accurate stand-in for something else.

Representation, Oxford English Dictionary (3d ed. 2009),

https://www.oed.com/view/Entry/162997 (last updated March 2023)

(“Something which stands for or denotes another symbolically . . . .”);

Model,

Oxford

English

Dictionary

(3d

ed.

2002),

https://www.oed.com/view/Entry/120577 (last updated December 2022)

(“Something which accurately resembles or represents something else,

esp. on a small scale . . . .”); accord Representation, Webster’s New World

College Dictionary (5th ed. 2016) (defining in relevant part as “a

likeness, image, picture, etc.”); Model, Webster’s New World College

Dictionary (5th ed. 2016) (“[A] preliminary representation of something,

serving as the plan from which the final, usually larger, object is to be

constructed . . . .”). The subcontractors and suppliers were not

constructing representations or models that stood in for the final

product in discovering information about whether a design was

appropriate; instead, they were constructing the final product itself. See

Little Sandy Coal Co., T.C. Memo. 2021-15, at *42–43 (observing that

example in regulations “draws a distinction between a model of a

product and the product itself” (citing Treas. Reg. § 1.174-2(a)(11)

(example 3))).

CPI’s process confirms the proposition. If the oxidizers were pilot

models, one might expect CPI to have conducted early-stage “testing to

determine if the design of the product [was] appropriate” and then to

have modified the design as necessary. Treas. Reg. § 1.174-2(a)(7), (11)

(example 3). However, the record demonstrates that testing of the

oxidizers as a whole occurred either at the subcontractor’s facility before

shipping or at the customer’s facility after installation. At this late

stage, CPI’s design drawings were typically finalized, having already

incorporated revisions earlier in the project in response to feedback from

the customer and/or the subcontractors. Further, by the time testing

occurred, CPI had incurred tens (sometimes hundreds) of thousands of

dollars of costs in ordering specially sized components, in reliance upon

the design drawings. If CPI still lacked information as to the

appropriate design of each oxidizer as a whole (i.e., the oxidizer’s basic

design specification), incurring such costs would have been economically

irrational in the extreme. See Little Sandy Coal Co., T.C. Memo.

[*75] 2021-15, at *35 (observing that any defects found in late-stage,

postconstruction testing would not have caused taxpayer to “scrap” the

entire project and start over); Treas. Reg. § 1.174-2(a)(11) (example 4).

We do not accept the circular argument that CPI incurred the

substantial costs of implementing its designs with the purpose of

discovering information about whether those designs as a whole were

appropriate. We conclude that the claimed supply QREs incurred in the

actual production of the oxidizers were not deductible under section 174.

Having failed the section 174 test, these costs were not “incurred for

supplies used in the conduct of qualified research” and thus are not

creditable QREs. See § 41(b)(2)(A)(ii).

This conclusion would not necessarily mean the end of the

inquiry. As noted above, the section 174 regulations provide a

shrinking-back rule, which would instruct us to next analyze whether

any particular components or subcomponents of the oxidizer systems

were pilot models, discretely constructed with the purpose of evaluating

and resolving uncertainty. See Treas. Reg. § 1.174-2(a)(5). However,

petitioners have failed to carry their burden of establishing that any

particular components or subcomponents were pilot models.

Consequently, we conclude that none of CPI’s claimed supply costs are

QREs, and we will partially sustain on this basis respondent’s

determination that petitioners are not entitled to a research credit.

Wage QREs

We now turn to the issue of whether the claimed wage QREs

satisfy the section 174 test. As a category of expenditure, such wages

are potentially deductible under section 174 if paid or incurred during

the taxable year. 28 However, we must still determine whether the

employee activities underlying the claimed wage QREs constituted

“research and development” within the meaning of section 174. To

recap, petitioners must show that (1) information was not available to

CPI establishing the appropriate design of the oxidizers and (2) CPI

undertook investigative activities intended to discover such information.

Respondent argues that CPI employees’ activities were not

intended to discover information that would eliminate uncertainty

regarding the development of the systems. Respondent focuses on the

28 For an accrual method taxpayer such as CPI, wages are generally incurred

and taken into account for the taxable year in which they are earned by the employee

providing services. See § 461(h)(2)(A)(i); see also Burlington N. R.R. Co. v.

Commissioner, 82 T.C. 143, 148 (1984).

[*76] fact that CPI had extensive experience in supplying commercially

viable oxidizer systems to customers and had developed substantial

industry-specific knowledge before 2014. Respondent also notes that

CPI guaranteed the performance of its systems to customers and never

failed such a guarantee; respondent thus suggests that CPI did not lack

information with respect to the appropriate design of its systems. 29

Petitioners counter that CPI faced uncertainty as to the

appropriate design of each system even beyond the initial starting point

of each system’s commercial production, because the appropriate design

of each system could not be established until after that system cleared

various onsite tests. Petitioners suggest that uncertainty existed,

because “[i]n all of these projects, the prospect of revising or altering the

design of the overall system existed.” Petitioners also point to several

projects where the oxidizer supplied by CPI failed postinstallation

testing and argue that “the appropriate design was not determined until

after the design failed onsite testing.”

The parties thus dispute whether CPI was uncertain as to the

appropriate design for all 19 projects. At the outset, we must reject

petitioners’ blanket assertions that uncertainty existed with respect to

the products as a whole simply because of the mere “prospect of revising

or altering the design” before completion of onsite testing. The

applicable regulations distinguish between objective 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 component or

subcomponent. See Treas. Reg. § 1.174-2(a)(5). As alluded to above,

conducting postproduction testing on a product does not establish that

its appropriate design as a whole “remained uncertain before those tests

were successfully completed.” Little Sandy Coal Co., T.C. Memo. 202115, at *53. Any failure of an oxidizer system to pass testing might have

resulted in some additional information-discovering activities with

respect to a redesign of a particular component or subcomponent (with

corresponding wage QREs then being potentially creditable) but would

not have required CPI “to scrap the entire [oxidizer] and start afresh.”

See id.

Our determination of whether the activities underlying the wage

QREs satisfied the section 174 test must necessarily be more granular,

examining the activities of CPI employees. The parties did not agree to

29 The record supports respondent’s factual contention that CPI ultimately

satisfied the provided performance guarantees for all 19 projects.

[*77] a sample of CPI’s projects for 2014, thus placing at issue all 19

projects for which CPI claimed the research credit. 30 See § 41(d)(2)(A);

cf. Little Sandy Coal Co., T.C. Memo. 2021-15, at *3, *20 (effecting

parties’ agreement to select only 4 of 11 projects as samples). We thus

must determine whether the wage QREs associated with each project

satisfied the section 174 test, at the level of both the projects as a whole

and particular subcomponents that petitioners identified at trial. 31

3M Hutchinson (#13-07520)

This project involved CPI’s design and supply of a 30,000 SCFM

regenerative thermal oxidizer for a 3M facility that manufactured sticky

notes. Petitioners suggest that CPI was uncertain as to the appropriate

design for the 3M Hutchinson project as a whole until the oxidizer

passed onsite testing. Petitioners emphasize that this was the first

regenerative thermal oxidizer designed by CPI.

Petitioners’ argument overlooks key facts. CPI submitted its

final, revised proposal to 3M on August 30, 2013, and 3M accepted the

proposal via a purchase order issued on September 3, 2013. Acceptance

of the proposal by 3M was a key date in the development of the basic

design of the oxidizer. The proposal, which relied upon and addressed a

detailed set of specifications provided by 3M, demonstrated that CPI

already had considerable information available to it with respect to the

appropriate design. For instance, the proposal observed that the

exhaust from the Hutchinson facility “is understood to come from the 2L

Coating Line at a volume of 18,000–25,000 SCFM at 125 F to 175 F and

contains a combination of methanol, ethyl acetate, IPA, toluene, and

other common solvents at loadings of 245–1750 lb/hr.” The proposal

further provided for a 99% destruction efficiency performance

Absent an agreement between the parties, project sampling improperly

relieves the taxpayer of its burden of proving entitlement to the research credit

claimed. See Bayer Corp. v. United States, 850 F. Supp. 2d 522, 538, 545–46 (W.D. Pa.

2012).

31 Petitioners allocated wage QREs project by project and did not further allege

or brief the amounts of wage QREs relating to specific components or subcomponents;

given petitioners’ “all or nothing” litigation strategy on this point, we could decline to

go deeper than the level of the 19 projects as a whole. Cf. Little Sandy Coal Co. v.

Commissioner, 62 F.4th at 303 (affirming this Court’s decision not to apply shrinkingback rule where taxpayer failed to document research activities corresponding to

project subcomponents). However, the trial testimony in this case addressed

particular components and subcomponents on some of the projects, and, for the sake

of completeness, we believe it appropriate to perform a shrinking-back rule inquiry, to

the extent the limited record allows us to do so.

[*78] guarantee. As Mr. Harmsen later testified: “The majority of the

[3M Hutchinson] oxidizer design was decided upon with the 99 percent

destruction efficiency and the air flow rate and the VOCs that [we] are

talking about.” Further bearing this out, CPI prepared initial general

arrangement and P&ID drawings for the oxidizer soon after acceptance

of the proposal, in October 2013.

While minor revisions were

subsequently made to those drawings in late 2013 and 2014, the basic

design specification of the oxidizer did not change as a result of those

revisions. 32 We find that information available to CPI in 2013

established the appropriate design of the oxidizer as a whole.

Consequently, corresponding wage expenditures for any

theoretical investigative activities with respect to the oxidizer as a whole

would have been incurred in 2013, rather than 2014, the taxable year at

issue. See § 174(a)(1) (requiring that expenditures be “paid or incurred

. . . during the taxable year”), § 41(b)(1). We conclude that the

appropriate design of the oxidizer as a whole had already been

established by information gathered in 2013; thus the product as a

whole fails the section 174 test. We look next to whether the shrinkingback rule is applicable with respect to particular components or

subcomponents.

At trial, Mr. Harmsen identified a number of further “difficulties”

that CPI encountered “during the design and development” of the 3M

Hutchinson project, some of which related to particular components of

the oxidizer design. These identified difficulties included (1) 3M’s

preference for an induced draft fan; (2) 3M’s preference for a two-burner

system; and (3) 3M’s discovery of discrepancies in the electrical design.

With respect to the induced draft fan, CPI already had extensive

specifications provided by 3M that provided information about the

necessary fan design.

In July 2013 Mr. Harmsen used those

specifications to initially calculate the size of the fan as 23 inches. The

final proposal then further detailed key elements of fan design,

including the horsepower, temperature rating, and arrangement of the

fan. In December 2013 CPI then provided that information to a fan

supplier, AirPro, which provided design drawings for a 300 horsepower

booster fan component. Those design drawings were then incorporated

into the final oxidizer design. The record is unclear as to (1) what

32 When prompted at trial to describe what subsequent changes were made to

the design, Mr. Harmsen described (1) the addition of a walkway to the front of the

oxidizer, (2) moving the gas trains to the back of the oxidizer, and (3) adding crane

davits in order to lift components off the oxidizer.

[*79] additional, unavailable information CPI needed to determine the

appropriate fan design and (2) what investigative activities particular

CPI employees undertook in 2014.

With respect to the two-burner feature, CPI similarly already had

extensive specifications provided by 3M, specifying the brand of burner

to be used and various operational requirements. Mr. Harmsen further

testified that the particular burner size was determined by 3M’s choice

of brand (Maxon Kinemax). In February 2014 CPI purchased two fourinch Kinemax burners to be shipped to Pre-Heat. Petitioners did not

produce further evidence establishing (1) what additional, unavailable

information CPI needed to determine the appropriate design of the

burners and (2) what investigative activities particular CPI employees

undertook with respect to the burners in 2014. Cf. Union Carbide Corp.,

97 T.C.M. (CCH) at 1261 (finding no uncertainty as to appropriate

design where manufacturer designed and supplied component and

taxpayer presented no evidence of adaptation).

Finally, with respect to the change in the electrical components,

we find that CPI employees did not perform any investigative activities

that would constitute research and development. To the contrary, Mr.

Harmsen’s testimony established that 3M’s electrical engineer simply

noticed certain discrepancies where the design drawings differed from

the specifications and requested specific changes. In response, CPI

directed Quantum Design to make those changes. At the shrunk-back

component level, we conclude that petitioners have failed to satisfy the

section 174 test.

We conclude that petitioners have failed to carry their burden of

establishing that they satisfied the section 174 test with respect to the

claimed wage QREs on the 3M Hutchinson project.

Akzo Nobel (#13-07645)

This project involved CPI’s design and supply of a 6,000 SCFM

regenerative thermal oxidizer for an industrial paint manufacturer.

CPI’s final proposal was accepted in December 2013. Consequently, as

with 3M Hutchinson, any theoretical investigative activities performed

by CPI before submission of the final proposal corresponded to wage

QREs that were not incurred in tax year 2014. Given that the proposal

memorialized many of the already-determined basic design

considerations and specifications (e.g., type of oxidizer, airflow volume,

VOCs at issue), we conclude that any objective uncertainty as to the

[*80] design of the oxidizer as a whole was resolved before 2014, and

thus petitioners have failed to satisfy the section 174 test.

In contrast, petitioners have established that they performed

some investigative activities in 2014 at the shrunk-back component

level. Namely, Mr. Harmsen and J.O.’s meeting with Akzo Nobel

personnel in February 2014 appears to constitute research and

development within the meaning of the section 174 regulations. Mr.

Harmsen documented that meeting in contemporaneous notes, which

demonstrate that he and J.O. elicited further information and

specifications from Akzo Nobel about necessary design features for

oxidizer components, particularly the flame arrestor component.

However, allocating an estimated amount of wages to the activities of

Messrs. Harmsen and J.O., pursuant to the Cohan rule, would be futile,

because we alternatively hold that the activities performed on the Akzo

Nobel project were not part of a process of experimentation, as required

by section 41(d)(1)(C). See Union Carbide Corp., 97 T.C.M. (CCH) at

1256 (observing that process of experimentation test “requires the use

of the scientific method” and “imposes a more structured method of

discovering information than section 174”); Treas. Reg. § 1.41-4(a)(5)(i)

(setting out process of experimentation test’s requirements); see also

Eustace v. Commissioner, 312 F.3d at 907 (“Experimentation is a subset

of all steps taken to resolve uncertainty; otherwise searching for a place

to park a car would be a ‘process of experimentation’.”). We thus more

broadly conclude that CPI’s activity with respect to the flame arrestor

component did not constitute qualified services.

Further, petitioners have failed to demonstrate any additional

investigative activities that CPI personnel performed to resolve design

uncertainty with respect to the flame arrestor or any other shrunk-back

components of the oxidizer. We conclude that petitioners have failed to

carry their burden of establishing that they satisfied the section 174 test

with respect to the claimed wage QREs on the Akzo Nobel project.

HA International (#13-07615)

This project involved CPI’s design and supply of two 13,700 SCFM

recuperative thermal oxidizers for a manufacturer of fracking sand. At

trial Mr. Betz identified several potential uncertainties as to the

appropriate design of the oxidizers as a whole, including the potential

for phenolic resin buildup and the presence of water and sand

particulates in the process airflow.

[*81] However, the record demonstrates that by November 6, 2013,

when CPI delivered to HAI a final proposal for the oxidizers, CPI had

extensive information available to it that established the appropriate

design of the oxidizer as a whole. In early 2013 CPI personnel had

visited HAI’s facility and had received emissions testing information as

to the facility’s air exhaust. That testing informed CPI of the airflow

volume at the facility and the particular VOCs at issue, both of which

dictated the basic design specification of the oxidizer. Cf. Siemer Milling

Co. v. Commissioner, T.C. Memo. 2019-37, at *33–34 (concluding that

project failed section 174 test where taxpayer already had prior year

testing information resolving uncertainty). CPI also had extensive

generalized information available to it as to the appropriate design of a

system that dealt with sand particulate. As its proposal to HAI stated,

CPI had previously designed “+30 units in the sand resin coating

industry” and was highly experienced in dealing with the sand

particulate issue. Cf. Max, T.C. Memo. 2021-37, at *33 (concluding that

section 174 test was not satisfied where taxpayer regularly encountered

the claimed uncertainty in past and had developed standardized

solutions to it). To resolve the sand issue, CPI included in the November

2013 proposal hinged access doors to allow HAI to periodically clear sand

out of the bottom of the combustion chamber. We conclude that objective

uncertainty did not exist with respect to the appropriate design of an

oxidizer as a whole that could satisfy the customer’s needs and resolve

the sand particulate issue. See Union Carbide Corp., 97 T.C.M. at 1262

(looking to taxpayer’s “significant experience” in previously using

component to resolve issue and finding no uncertainty under section

174).

The November 2013 proposal similarly addressed other

“uncertainties” as to the appropriate design identified by Mr. Betz. The

proposal stated that the oxidizer would include a “direct fired duct

heater system” that was “designed to help reduce both water and resin

build up prior to” the oxidizers. At trial Mr. Shaver credibly testified

that CPI had encountered the resin buildup issue before 2014 and had

previously developed this particular design solution. We find that

information was available to CPI establishing the appropriate design of

the oxidizer as a whole during the proposal stage, before 2014.

We next look to the shrinking-back rule. At trial Mr. Betz

discussed space constraints at the HAI facility, which required that the

high horsepower booster fan be placed close to the oxidizer. That

proximity posed problems, as the air from the fan would come out in a

high-velocity jet aimed at the center of the oxidizer’s heat exchanger,

[*82] degrading the heat exchanger’s performance and running the risk

of pipe components’ burning up because of a lack of cooling airflow. Mr.

Betz testified that CPI addressed this issue by including baffles and

deflection plates in the design, both of which are components that can

dissipate and redirect airflow. Even assuming arguendo that this

implicated objective uncertainty, petitioners failed to establish that

investigative activities were performed by CPI employees in 2014 with

respect to the fan/baffle sheet components. 33

Mr. Betz also identified a pair of issues with components that

emerged during postinstallation testing.

First, a quality audit

performed by L.S. on the oxidizer, as installed at HAI’s facility in 2014,

revealed that several tubes in the heat exchanger had overheated

because of inadequate airflow and broken free from the heat

exchanger. 34 CPI replaced and rewelded the tubes and then installed a

different air splitting component (a turning vane) that more evenly

dispersed air throughout the heat exchanger. The second issue that

emerged during postinstallation testing was ruptured pressure release

valves from excess vibration. CPI resolved the issue by cutting down

the length of the damper blades.

The decisions to add the turning vane and cut down the damper

blades may well have implicated objective uncertainty and investigative

activities. However, on the record before us, we are unable to bridge the

vast evidentiary gap petitioners left. Aside from Mr. Betz’s vague

testimony, petitioners’ failure to produce evidence as to what

investigative activities were performed with respect to the turning vane

and

This text is long and has been trimmed here. Open the source document for the complete record.

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.