United States Tax Court

United States Tax Court

T.C. Memo. 2023-20

SCOTT MOORE AND GAYLA MOORE,

Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 18632-19.

Filed February 23, 2023.

—————

Mark Chandler Goldenberg, for petitioners.

Britton G. Wilson and Stephen A. Haller, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge:

Respondent determined deficiencies in

petitioners’ income tax of $68,263 for 2014 and $141,945 for 2015.

Petitioner Gayla Moore was the sole owner of Nevco, Inc. (Nevco), a

subchapter S corporation, during those years. Nevco claimed the section

41 1 credit for increasing research activities (research credit) on its 2014

and 2015 Forms 1120S, U.S. Income Tax Return for an S Corporation.

This credit flowed through to petitioners’ individual income tax returns

for 2014 and 2015.

Mr. Robert was Nevco’s president and chief operating officer

(COO) during 2014 and 2015. After concessions, the issue for decision

is whether (and if so to what extent) Nevco is entitled to a research credit

under section 41 for compensation paid to Mr. Robert during 2014 and

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

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

are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant

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

Served 02/23/23

2

[*2] 2015. We hold that (1) Mr. Robert did not engage in direct

supervision or direct support (as provided by section 41(b)(2)(B)(ii)) of

persons who performed qualified services during 2014 and 2015 and

(2) even though he was extensively involved in new product

development, the record does not show the portion of Mr. Robert’s work

on new product development which meets the requirements of “qualified

research” under section 41(b)(2)(B)(i). Thus, Nevco cannot consider Mr.

Robert’s wages in computing the research credit for 2014 and 2015.

FINDINGS OF FACT

A.

Petitioners

Mrs. Moore was the sole owner and chief executive officer of Nevco

in 2014 and 2015. 2 Nevco manufactures scoreboards for high school and

college athletic events, as well as LED video displays, score tables, and

other types of equipment for indoor and outdoor sports venues. Mrs.

Moore’s husband, Scott Moore, was the vice president of strategic

initiatives of Nevco during those years. Petitioners resided in Florida

when the Petition was filed.

B.

Nevco Personnel

1.

Mr. Robert

Mr. Robert was a software engineer early in his career. He later

was chief information officer at an electronics firm, vice president at

another electronics company where he focused on manufacturing

initiatives, manufacturing consultant at an international accounting

firm, and manufacturing consultant at his own consulting firm.

Mr. Robert was an independent consultant at Nevco from 2004 to

2006 and an employee from 2006 to 2016. When he arrived at Nevco in

2004, the company was losing market share because Nevco’s product

line had fallen behind those of other companies. From 2004 to 2006 he

advised petitioners on Nevco’s personnel and inventory requirements

and sometime before 2014 he reorganized the entire staff. He held the

position of COO from 2006 to 2016 and was president and COO during

2014 and 2015. During all those years he reported to Mrs. Moore. The

Moores wanted Mr. Robert to focus on new product development. As a

2 Mr. Moore testified that Mrs. Moore’s ownership of the stock was through a

trust, but the parties stipulated her direct ownership and we so find.

3

[*3] result, Mr. Robert spent 50%–65% of his time working on new

product development. 3

Mr. Robert’s base compensation was $85,092 in 2014 and

$178,956 in 2015. He also received (1) a “senior management bonus” of

$253,285 in 2014; and (2) a total bonus of $1,890,137 in 2015, comprising

$222,162 as a “senior management bonus” and $1,667,975 as an

“additional bonus.” The “additional bonus” was based on Nevco’s

increase in enterprise value as measured by a multiple of EBITDA

(earnings before interest, taxes, depreciation, and amortization) over a

four-year period. Mr. Robert could strive to increase the value of Nevco

in any way; thus, he was not limited to achieving that goal by performing

research or developing new products. In 2014 and 2015 he was the only

Nevco employee to receive an additional bonus tied to growth in the

value of Nevco.

The management of Nevco operated informally in many ways.

The high level of trust and informality that existed among Nevco’s top

management is illustrated by the fact that the formula for Mr. Robert’s

additional bonus was never written even though it potentially involved

substantial amounts of money. Neither Mr. Robert nor anyone at Nevco

kept records of his activity or the amount of time he spent on any

particular project. Mr. Robert did not report his activity or time

allocation to any other Nevco employee. No one at Nevco maintained

documents during 2014 and 2015 detailing any of the officers’ or

employees’ responsibilities and duties.

As president, Mr. Robert was responsible for the entire company.

Mrs. Moore managed many of the company’s financial initiatives, and

Mr. Moore supervised most of the marketing and sales initiatives. Their

assistance enabled Mr. Robert to focus his attention on overseeing

Nevco’s operations and new product development during 2014 and 2015.

Mr. Robert’s office was in the building across the street from the

factory where the engineering department was located during 2014 and

2015. Dave Paslay was the director of engineering at Nevco, and he

reported to Mr. Robert. During those years Mr. Paslay and Mr. Robert

had weekly project update meetings that lasted from one to three hours.

At those meetings Mr. Paslay updated Mr. Robert on the engineers’

progress on various projects at Nevco. The discussions were extremely

detailed. The front-line engineers did not attend those meetings. Mr.

3 As discussed below, the parties dispute this percentage.

4

[*4] Paslay and Mr. Robert also met in each other’s office daily or almost

daily, sometimes more than once daily, during 2014 and 2015.

2.

Other Senior Staff

The members of senior management during 2014 were Messrs.

Robert, Paslay, Phalan, Schulte, and Winkler. Mr. Robert chaired and

set the agenda for the weekly meetings of that group. No one kept

written minutes for any of the meetings conducted at Nevco during 2014

and 2015. The chief financial officer (CFO) of Nevco was Dan Phalen in

2014 and Chad Schnarre in 2015. 4 Jeffrey Schulte was the purchasing

manager, and Ed Caperton was the quality and service manager. In

2015 Mike Lane was vice president of sales, Mike West was plant

manager, Cheryl Corte was supervisor of shipping and receiving, and

Mr. Winkler was large project supervisor. 5 Mr. Robert directly

supervised those individuals.

3.

Engineering Department

Mr. Paslay was the direct supervisor of the six to ten engineers in

Nevco’s engineering department during 2014 and 2015. Mr. Paslay

supervised the engineers’ work on new product design, the development

and improvement of existing products and the manufacturing processes

for those products. During 2014 and 2015 Mr. Robert was the direct

supervisor of Mr. Paslay and the second-level supervisor of the other

engineers in the engineering department. Mr. Robert was not a member

of the engineering department.

The engineers engaged in qualified research during 2014 and

Some of Nevco’s engineers did not have a college degree in

engineering. Engineering department employees did not record how

they spent their time during 2014 and 2015.

2015. 6

4 The organizational chart names Mr. Phalen as CFO during May 2015;

however, the parties stipulated and we find that Mr. Schnarre was CFO throughout

2015.

The organizational chart says Mr. Winkler was director of new product

development, but the parties stipulated and we find that he was large project

supervisor. Exhibit 6–J spells his name “Winkeler,” but Exhibit 7–J spells it (and we

find it is) “Winkler.”

5

6 The parties stipulated this fact.

5

[*5] C.

New Products Under Development in 2014 and 2015

Mr. Robert contributed to Nevco’s new product development

during 2014 and 2015 through his numerous meetings with Mr. Paslay

and his visits to the engineering department and manufacturing area.

Five of those products are discussed next.

1.

Scoreboard Truss

A scoreboard truss is a structure or extension above the

scoreboard with visible girders to which personalizing items may be

added, such as school or team logos, names, and mascots. Nevco

historically purchased pre-engineered trusses from third parties. This

practice resulted in lost sales due to lead times and the costs of the preengineered trusses.

Mr. Robert concluded that Nevco could

manufacture scoreboard trusses in house. As a result Nevco developed

this capability and subsequently introduced larger trusses into its truss

product line. He developed processes to design the trusses, and to build

them using aluminum and Nevco’s existing equipment. Mr. Robert

worked with members of the engineering department to help ensure

that Nevco’s trusses were durable and feasible for Nevco to

manufacture. Through an experimental process, Mr. Robert, Mr.

Paslay, and the engineering staff developed technology for these new

scoreboard trusses which enabled them to withstand winds up to 180

miles per hour.

2.

Scorbitz

Scorbitz is a Nevco product that transmits scoreboard

information, such as the score and time remaining, to interested users’

personal devices. Mr. Robert was extensively involved with the

development of Scorbitz. Mr. Robert was project leader for Scorbitz until

2014 or 2015. The engineers, including Mr. Paslay, focused on the

technical aspect of what could be done. Mr. Robert directed the

engineering staff toward a design that Nevco could build which provided

value to potential customers and would be marketable. In addition, he

defined expectations for how the product would function.

Mr. Robert used his programming background to assist with

development of the database, which was an important part of the

project. He worked with the engineers to develop database technology

that could transfer scoreboard information to the cloud and back to user

devices. Mr. Robert, Mr. Paslay, Mr. Moore, and one other individual

were named on the Scorbitz patent issued March 15, 2016. In 2014 or

6

[*6] 2015 Mr. Moore supplanted Mr. Robert as project leader for

Scorbitz. Mr. Moore’s role was primarily customer-facing and Mr.

Robert remained focused on product development.

3.

New Caney Ribbon Board

The New Caney Ribbon Board is an LED display that extends 276

feet along both sides of the New Caney, Texas, high school stadium. It

can be programmed to show various images, such as the current score

and advertisements. Nevco’s New Caney ribbon board was a prototype.

At the outset of the project, Mr. Robert defined the requirements of the

product.

As the project progressed, he participated in product

development by sharing his ideas and suggesting modifications to how

the user would operate the ribbon. It was essential that the ribbon board

be affordable for small colleges and high schools and that one person be

able to operate it. Mr. Robert’s ideas and technical suggestions were

important in achieving these design objectives.

4.

MPCX–2

The MPCX was a hand-held device used to operate Nevco’s

scoreboards.

The product was popular among customers, but

interference problems arose when several MPCX devices were operated

near one another. At some time during 2014 and 2015 Mr. Robert

decided that the MPCX had to be redesigned in order to eliminate the

interference. The second version of the MPCX, the MPCX–2, was

designed by a team coordinated by Mr. Robert to eliminate this problem.

Mr. Robert was the leader of the MPCX–2 project. He made all

the decisions but delegated certain tasks including supplier selection

and circuit board design to the procurement and engineering

departments. Nevco employees administered a barrage of tests to

identify components to be obtained from third parties for installation by

Nevco on the circuit board. Both Mr. Robert and Mr. Paslay participated

in testing the components under consideration. The test results were

used by the engineering department in designing a circuit board that

could use the chosen component.

5.

Slim Shot Clock

When Mr. Robert became president of Nevco, the company had

produced the same bulky shot clock for several years. That shot clock

had protruding LEDs which could be damaged by errant basketballs.

7

[*7] Mr. Robert proposed a new design, the Slim Shot Clock, and

instructed his subordinates to begin building prototypes in house.

The prototypes employed different configurations for LED

viewing angles, impact resistance, plexiglass type, and structural

materials. Mr. Robert instructed the manufacturing and procurement

departments to build approximately 20 prototypes before ultimately

selecting a design that he believed was satisfactory. Designing the Slim

Shot Clock was an iterative process with many designs, experiments,

and failures. Each decision to reject a prototype was made by Mr.

Robert.

D.

Tax Returns

Petitioners filed their 2014 and 2015 joint income tax returns on

Forms 1040, U.S. Individual Income Tax Return. Nevco filed its 2014

and 2015 income tax returns on Forms 1120S. Nevco claimed research

credits on those returns, which flowed through to petitioners’ individual

income tax returns for 2014 and 2015. Nevco used the base period 1984

to 1988 to calculate the fixed-base percentage for its 2014 regular

research credit. Nevco used the alternative simplified credit method to

calculate its 2015 research credit. An accounting firm prepared

petitioners’ Forms 1040 and Nevco’s Forms 1120S for both 2014 and

2015.

OPINION

A.

Introduction

After concessions, 7 we must decide whether (and if so to what

extent) Nevco may take into account compensation paid to Mr. Robert,

Nevco’s president and COO during 2014 and 2015, in computing Nevco’s

research credit for those years. That in turn requires that we decide

whether Mr. Robert was engaged (1) in performing “qualified services,”

see § 41(b)(2)(B)(i), or (2) in direct supervision or direct support of

persons who performed qualified services during 2014 and 2015, see

§ 41(b)(2)(B)(ii).

7 Respondent concedes that Nevco is entitled to the research credit for wages

paid to personnel in Nevco’s engineering department, including Mr. Paslay.

8

[*8]

1.

Section 41

Section 41(a) establishes the method for computing the research

credit. § 38(b)(4). A taxpayer’s qualified research expenses include “inhouse research expenses” “which are paid or incurred by the taxpayer

during the taxable year in carrying on any trade or business of the

taxpayer.” § 41(b)(1)(A). A taxpayer’s “in-house research expenses”

include “any wages paid or incurred to an employee for qualified services

performed by such employee.” § 41(b)(2)(A)(i). Section 41(b)(2)(A)

includes as wages “all remuneration . . . for services performed by an

employee for his employer, including the cash value of all remuneration

(including benefits) paid in any medium other than cash.” See

§§ 41(b)(2)(D)(i), 3401(a). An employee performs “qualified services” by

either “(i) engaging in qualified research, or (ii) engaging in the direct

supervision or direct support of research activities which constitute

qualified research.” § 41(b)(2)(B).

2.

Time Spent by Mr. Robert on New Product Development

Petitioners contend that Nevco properly counted 65% of Mr.

Robert’s compensation in computing the research credits for 2014 and

2015. Respondent contends petitioners have not adequately proven that

percentage.

Mr. Robert testified that he spent two thirds or more of his time

working on new product development in 2014 and 2015. He also said he

spent “well north of 50%” on new product development. His testimony

was substantially corroborated by the credible testimony of Mr. Moore

and Mr. Paslay. In challenging that claim respondent properly relies on

the total lack of written records showing how Mr. Robert used his time.

Respondent also points out that, as president, Mr. Robert had many

other duties. But we are satisfied that with the assistance of petitioners,

who handled substantial duties that would otherwise have been

performed by Mr. Robert, Mr. Robert spent from 50% to 65% of his time

on new product development during 2014 and 2015. However, as

discussed below, the precise percentage does not affect the result

because not all of Mr. Robert’s work on new product development was

qualified services.

B.

Whether (and if so to What Extent) Mr. Robert Engaged in

Qualified Research

Under section 41(d), four requirements must be met in order for

an activity to be “qualified research.” First, the research expenditures

9

[*9] must be eligible to be treated as expenses under section 174.

§ 41(d)(1)(A). Under section 174(a)(1), “[a] taxpayer may treat research

or experimental expenditures which are paid or incurred by him during

the taxable year in connection with his trade or business as expenses

which are not chargeable to capital account.” Those “expenditures so

treated shall be allowed as a deduction.” § 174(a)(1). Treasury

Regulation § 1.174-2(a)(1) defines “research or experimental

expenditures” as “expenditures incurred in connection with the

taxpayer’s trade or business which represent research and development

costs in the experimental or laboratory sense.”

Second, the research must be undertaken to discover information

which is “technological in nature.” § 41(d)(1)(B)(i). Third, the

application of that research must be “intended to be useful in the

development of a new or improved business component of the taxpayer.”

§ 41(d)(1)(B)(ii). Fourth, “substantially all of the activities of” the

research must “constitute elements of a process of experimentation for

a purpose” related to “a new or improved function,” “performance,” or

“reliability or quality.” § 41(d)(1)(C), (3)(A). Section 41(d)(4) provides a

list of activities that are specifically excluded from the definition of

qualified research.

Treasury Regulation § 1.41-4(a)(5)(i) defines “process of

experimentation” as “a process designed to evaluate one or more

alternatives to achieve a result where the capability or the method of

achieving that result, or the appropriate design of that result, is

uncertain as of the beginning of the taxpayer’s research activities.”

Treasury Regulation § 1.41-4(a)(5)(i) also provides that a process of

experimentation

involves the identification of uncertainty concerning the

development or improvement of a business component, the

identification of one or more alternatives intended to

eliminate that uncertainty, and the identification and the

conduct of a process of evaluating the alternatives

(through, for example, modeling, simulation, or a

systematic trial and error methodology).

Treasury Regulation § 1.41-4(a)(4) provides as follows regarding

the use of technology in the process of experimentation:

For purposes of section 41(d) and this section, information

is technological in nature if the process of experimentation

10

[*10] used to discover such information fundamentally relies on

principles of the physical or biological sciences,

engineering, or computer science. A taxpayer may employ

existing technologies and may rely on existing principles of

the physical or biological sciences, engineering, or

computer science to satisfy this requirement.

The parties dispute whether (and if so, to what extent) Mr. Robert

performed qualified services in 2014 and 2015 by engaging in qualified

research; that is, whether or to what extent his work met these four

requirements, and he thus performed qualified research during those

years. As stated above, not all of Mr. Robert’s work on new product

development is qualified research, and thus, all of that work cannot be

considered in computing the credit. Petitioners seem to acknowledge

this point. They state in their opening brief that “at least some” of Mr.

Robert’s work on new product development was qualified research.

More specifically, in their opening brief petitioners state that “[t]he

testimony presented at trial supports the proposition that at least some

of the activities in which Mr. Robert engaged in during 2014 and 2015

as part of Nevco’s new product development were ‘qualified research’ as

defined under section 41(d)(1).”

Unfortunately from petitioners’ standpoint, the record provides at

best little on which to base a finding regarding the portion (i.e., the

number of hours) of his work on new product development which was

qualified research. The record provides no estimates of the amount of

time Mr. Robert spent on qualified research as distinguished from the

broader category of new product development.

On the truss project, he received (primarily from Mr. Paslay)

descriptions of the engineers’ progress and he specified the

requirements for the product. Those activities were not qualified

research (i.e., were not research applying technology in an experimental

process). His work with the engineers to identify a design that would

perform well in high winds may have involved qualified research, but

our record does not show how much time he spent on that activity.

For the Scorbitz project, Mr. Paslay testified that the engineers

knew “the technical aspect of everything that could be done.” Mr. Robert

urged finding the value for the customer, and he guided the concept into

something that would be marketable. He was also instrumental in

developing the requirements for the product. That activity was not

qualified research (i.e., was not research applying technology in an

11

[*11] experimental process). On the other hand, he was involved in the

technical details of programming how the scoreboard data would get to

the cloud and back to users’ phones. That work may have constituted

qualified research, but our record does not show how much time Mr.

Robert spent doing these things.

His work on Scorbitz led to his name with three others from Nevco

being included on a patent. This fact supports petitioners’ position here.

See Fudim v. Commissioner, T.C. Memo. 1994-235, 1994 WL 223280,

at *12 (finding that the contemporaneous award of two patents

supported the taxpayer’s claim to a research tax credit under section 41).

However, we may not overlook evidence suggesting that some of his

work on Scorbitz was not qualified research or estimate with no basis in

the record the amount of time he spent on activity which may have been

qualified research.

For the New Caney Ribbon Board, he defined product

requirements (e.g., that it be affordable by likely customers and operable

by one person) and made technical suggestions important to achieving

these goals. He led the MPCX–2 project and participated in testing

components to be used on the MPCX–2 circuit board. He proposed the

design for the new Slim Shot Clock and directed subordinates to build

prototypes, approximately 20 of which he rejected before accepting the

final version. Even if some of his activity on these three products was

qualified research, we have no basis for estimating how much of his time

was so spent. Thus, petitioners may not take any of the compensation

paid to Mr. Robert into account under section 41(b)(2)(B)(i) for directly

engaging in qualified research.

C.

Direct Supervision and Direct Support

We next consider whether petitioners may take any of the

compensation paid to Mr. Robert into account under section

41(b)(2)(B)(ii) (“engaging in the direct supervision or direct support of

research activities which constitute qualified research”).

1.

Direct Supervision

Petitioners contend that Mr. Robert directly supervised qualified

research conducted by Mr. Paslay and Nevco’s other engineers by

chairing weekly senior management meetings and by working daily on

new product development with Mr. Paslay. We agree that Mr. Robert

presided over those meetings and met with Mr. Paslay. However, those

activities do not constitute “engaging in the direct supervision . . . of

12

[*12] research activities” under Treasury Regulation § 1.41-2(c)(2),

which provides:

The term “direct supervision” as used in section 41(b)(2)(B)

means the immediate supervision (first-line management)

of qualified research (as in the case of a research scientist

who directly supervises laboratory experiments, but who

may not actually perform experiments).

“Direct

supervision” does not include supervision by a higher-level

manager to whom first-line managers report, even if that

manager is a qualified research scientist.

Mr. Paslay, not Mr. Robert, was the first-line manager of

personnel in the engineering department. Under that regulation, Mr.

Robert does not qualify as the direct supervisor of staff subordinate to

Mr. Paslay in the engineering department. Mr. Robert directly

supervised Mr. Paslay during the relevant period; that is, he was the

“higher-level manager” to whom Mr. Paslay reported. As quoted above,

Treasury Regulation § 1.41-2(c)(2) specifically excludes from the

definition of direct supervision “supervision by a higher-level manager

to whom first-line managers report.” Thus, Mr. Robert did not perform

qualified services through his direct supervision of Mr. Paslay.

2.

Direct Support

Petitioners argue that Mr. Robert performed qualified services by

providing “direct support” of persons performing qualified research. The

regulations under section 41(b)(2)(B)(ii) provide that the term “direct

support” includes services in the direct support of either “[p]ersons

engaging in actual conduct of qualified research” or “[p]ersons who are

directly supervising persons engaging in the actual conduct of qualified

research.” Treas. Reg. § 1.41-2(c)(3). Treasury Regulation § 1.412(c)(3)(ii) provides as examples of direct support a secretary “typing

reports describing laboratory results derived from qualified research,” a

laboratory worker “cleaning equipment used in qualified research,” and

a machinist “machining a part of an experimental model used in

qualified research.” Mr. Robert did not provide direct support as that

term is used in the regulations. 8 Thus, wages paid to Mr. Robert may

8 The examples in the regulations are very similar to those in legislative history

accompanying the enactment of a predecessor of section 41(b)(2)(B)(ii) in the Economic

Recovery Tax Act of 1981. S. Rep. No. 97-144, at 80 (1981), as reprinted in 1981

U.S.C.C.A.N. 105, 185; H.R. Rep. No. 97-201, at 117 (1981), as reprinted in 1981-2 C.B.

352, 361.

13

[*13] not be taken into account in computing the credit under section

41(b)(2)(B)(ii).

D.

Conclusion

Upon due consideration of the foregoing, petitioners may not

consider any wages paid to Mr. Robert in computing Nevco’s section 41

research credit for 2014 or 2015.

To reflect the foregoing,

Decision will be entered under Rule 155.