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Apparel Designer Unable to Establish "Process of Experimentation" Denied $2.4M CA R&D Tax Credits

OFFICE OF TAX APPEALS - STATE OF CALIFORNIA, In the Matter of the Appeals of: SWAT-FAME, INC.; BRUCE STERN AND JUDITH STERN; AND MITCHELL QUARANTA AND NINA QUARANTA, OTA Case Nos. 18010702, 18012114, & 18012115, Date Issued: March 22, 2019


Swat-Fame Inc. (Swat-Frame), an S corporation, is an apparel designer for women and girls clothing available at major retailers. The company's design staff also develops and refines thousands of new and improved garment designs every year.


Accordingly, Swat-Fame and its shareholders (appellants) filed amended California returns seeking tax refunds for increasing research activities under Internal Revenue Code (IRC) section 41 as adopted and modified by R&TC section 23609, for the tax years 2008 through 2011.


When the Franchise Tax Board (FTB) denied the claims, appellants filed timely appeals, which the Office of Tax Appeals (OTA) subsequently upheld the prior ruling. The OTA confirmed that the appellants failed to demonstrate that Swat-Fame engaged in qualified research as required by R&TC Sec. 23609 and IRC Sec. 41.


ISSUES

1. Whether appellants have demonstrated that the activities of Swat-Fame, Inc. (“SwatFame” or “company”) constituted “qualified research” under R&TC section 23609.

2. Whether appellants have substantiated Swat-Fame’s “qualified research expenses.”


HOLDINGS

1. Appellants have not demonstrated that the activities of Swat-Fame constituted “qualified research” under R&TC section 23609.

-Appellants failed to demonstrate that substantially all of the activities related to each of the sample project reviewed by the OTA constituted a "process of experimentation" for a "qualified purpose".

-Appellants have not demonstrated that 80% or more of Swat-Fame’s activities for any of the four projects reviewed constituted elements of a process of experimentation for a qualified purpose.

-Appellants' activities appear to be simple trial & error as opposed to engaging in the scientific method.

-Appellants'