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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' activities are for the purpose of the style or aesthetics of a garment, as opposed to a qualified purpose related to the function, performance, quality, or reliability of a garment.

2. As a result of the above holding, there are no qualified research expenses.


FTB denied appellants’ $2.4M refund claims for the following tax years and amounts:

Swat-Fame (Entity) Amount Claims for Refund:

2008: $26,143

2009: $51,168

2010: $107,728

2011: $75,008

Proposed Assessment: 2012: $347,427

Stern (Shareholder) Amount Claims for Refund:

2008: $158,754

2009: $143,530

2010: $196,952

2011: $165,883

Proposed Assessment: 2012: $343,045

Quaranta (Shareholder) Claims for Refund:

2008: $107,635

2009: $102,129

2010: $117,759

2011: $169,999

Proposed Assessment: 2012: $330,348


Background:

Swat-Fame previously entered into an agreement with the alliantgroup to perform a research and development (R&D) study. The R&D study stated that Swat-Fame initiated the product development process through a collaboration of Swat-Fame’s Design Team, including designers, design assistants, creative directors, and its Sales and Marketing departments, to determine the new and improved silhouettes and fabrics for utilization in the upcoming season’s line plan for each of Swat-Fame’s brands.


The R&D study documented its benefit through feedback from designer departments creating new apparel concepts by hand sketch or draft designs utilizing computer aided design (CAD) modeling programs. The R&D study also attempted to document how throughout the initial concept phase, the Design Team considered alternative fabrications, trims, and other components for utilization in the new garment designs. Once the initial drawings were complete, the designers reviewed the designs with Creative Directors, along with other Swat-Fame personnel, including its Sales and Merchandising departments, to determine the styles for prototypes. These activities were then applied to determine the company's qualified research expenses and R&D tax credit claim for the respective periods.


In general, the "process of experimentation" test has three elements:

(1) substantially all (i.e., 80% or more) of the research activities for each business component must constitute (2) elements of a process of experimentation (3) for a qualified purpose. (IRC, § 41(d)(1)(C).) This test must be applied to the claimed research activities with respect to each business component, which in this matter are the four sample projects as analyzed by the OTA.


OTA Review of Four Sample Projects ("Business Components"):

(1) Bermuda Shorts Project (UB636N)

Taxpayer's Technical Research Challenges

-Uncertainty to the optimal design specifications, including appropriate dimensions and materials.

-Issues regarding fit for the garment (wash process caused the material to be susceptible to a higher rate of shrinkage).

-Performed fit tests on the shorts before and after the wash processes were applied to determine the amount of additional material required to accommodate for shrinkage.

OTA Findings:

-No evidence that Swat-Fame engaged in a methodical experimentation process in regard to the issues with shrinkage (e.g. did not record the temperature of the wash that resulted in shrinkage, to then refined the design, and retest the effect of the washing process on the product under the same conditions).

-Swat-Fame also experienced difficulty making the waistband stable, and attempted to fix this problem by adding fusing to the waistband. This didn't solve the issue as the fusing also shrank in the wash. Again, there is no evidence that Swat-Fame engaged in a methodical experimentation process regarding this problem, either.

-Although treatment of denim such as lightening or lasering may use scientific principles

& equipment, such treatment is clearly for the purposes of aesthetics (style &

seasonal design), so such activities would not have a qualified purpose.

-Although portions of this process may involve a process of trial and error, a significant portion of the project was for the purpose of aesthetics, and appellants have not shown that at least 80% of its activities with respect to this project constituted a “systematic trial and error methodology.”

-Although it is not required that more than one alternative be tested, the OTA did not see a series of experiments with an alternative that would constitute a process of experimentation.


(2) Dress w/Adjustable Straps Project (D11072);

Taxpayer's Technical Research Challenges:

-Uncertainty as to the optimal design.

-Challenges in implementing certain elements of the design, e.g. spaghetti straps were thin & required evaluation of straps location & ability to support the dress during several fit tests.

OTA Findings:

-Although spaghetti straps may serve a functional purpose (keeping the dress up), the weight of the fabric raised challenges in this project, and Swat-Fame tried several alternative approaches to making it work. However, ultimately the issues were the result of the customer’s decision to use specific fabrics (jacquard and charmeuse) which was driven by style and aesthetic considerations. As a result, appellants have not shown that this project involved a process of experimentation for a qualified purpose.


(3) Two-Piece Set Legging & Skirt Project (Z1743D01); and

Taxpayer's Technical Research Challenges:

-Uncertainty as to fabric measurements to achieve desired fit & ensure the skirt fell on the wearer correctly.

-Uncertainty as to the exact number of ruffles required for each size to develop product within quality specifications.

OTA Findings:

-Although taxpayer encountered difficulties with the amount of fabric required to create ruffles on the skirt causing the seams to split, the uncertainty was driven by how to reinforce the seams while still allowing the ruffled skirt and the leggings to stretch.

-OTA was not persuaded there was much uncertainty involved in reinforcing seams necessary to arrive at the optimal design specifications.

-OTA citing precedent holdings, “[i]t is not sufficient that the taxpayer use a method of simple trial and error to validate that a process or product change meets the taxpayer’s needs.” In regard to the ruffled skirt, the purpose of the ruffles was for style and they did not serve a functional purpose. As a result, appellants have not shown that they engaged in a process of experimentation for a qualified purpose in this case.


(4) Two-Piece Set Sundress & Shrug Project (M93771).

Taxpayer's Technical Research Challenges:

-Uncertainty as to the optimal design, including the smocking dress feature.

-Uncertain as to the number of rows required to create the desired smocked band that laid flat against the wearer. To overcome this uncertainty, Swat-Fame evaluated alternative designs & conducted fit testing which were utilized to determine the right number of rows for smock fit & functionality requirements.

OTA Findings:

-Appellants have not shown adding a lining to give flimsy fabric more “hold” and adding a hook-and-eye clasp to keep a zipper from opening are solutions requiring a process of experimentation, and the evidence does not show that Swat-Fame engaged in a systematic process of experimentation in making these adjustments.

-Similarly, ripped corners in the pockets as a result of stonewashing, appears to have been resolved using a known solution (extra bar tack stitching).

-While the process of stonewashing the shrug and correcting a problemare may be part of product development, OTA was not persuaded there was significant uncertainty to solve these issues or a systematic process of experimentation took place.


KEY TAKEAWAYS:

Documentation is king. Diligent documentation analysis and retention of records during R&D credit claims (especially cash refunds through amending) will often dictate successful audit resolution or tax court litigation results.


Here, the taxpayer failed to (1) accurately document its systematic process of experimentation (e.g. temperature wash testing trial logs), (2) establish bifurcation between functional enhancement (reliability, durability, strength, etc.) qualified research activities versus style & aesthetic activities during development, or clearly support the performance of (3) multiple and iterative scientific testing methodologies establishing a "process of experimentation" representing 80% or more of its qualified activities with nexus to an established "business component" (e.g. development project / specific activity).


When investigating reasonable qualified activities percentages to be applied to associated expenses, either through time-tracking software or oral testimony with key technical contacts, it's important to consider how representative and supportable the actual qualified amounts being claimed. The lack of contemporaneous documentation, or unwillingness to prepare or record such support, including overzealous qualification of expenditures, may often lead to unfavorable tax audit findings, as demonstrated earlier.


Although aesthetic and style modifications do not generally qualify for the R&D tax credit, other ancillary activities related to developing or improving the apparel product and/or technical processes -- integrating prototype machinery or equipment to enhance manufacturing processes, designing improved fabric strain blends for durability / strength, chemical dye reformulations subject to regulatory adherence, or weather-resistant textiles -- among other activities, may still qualify for the R&D credit.


Moreover, apparel companies should recognize its own software development efforts may also qualify for the R&D credit. Apparel companies are increasingly developing software to increase efficiency and improve (1) customer-facing channels, such as e-commerce and point-of-sale solutions, and (2) internal processes, such as supply chain and warehouse management systems.


Lastly, to help determine qualification, evaluating the types of employees and contractors you engage -- such as designers, textile specialists, chemists or lab technicians, packaging engineers, sample makers & testers, process engineers, or lean manufacturing employees -- can help evaluate whether an R&D credit tax opportunity is worth investigating.


Remember, in general the IRS and state taxing authorities have historically acknowledged the rightful eligibility of apparel and textile companies & manufacturers claiming the R&D tax credit, including (1) Textile Mills & Textile Product Mills, (2) Apparel Manufacturing, and (3) Leather & Allied Product Manufacturing [See SOI Tax Stats - Corporation Research Credit, Table 2: Corporations Claiming a Credit, by Manufacturing Subsector].


Today major U.S. apparel companies such as Nike or Levi Strauss & Co. continue to invest millions of dollars in product design & development, software enhancements, and manufacturing & distribution chain improvements. And these same companies, rightfully so, continue to claim reasonably supportable R&D tax credits pursuant to its organized books, records, and technical support in case of potential audit.

As the saying goes, "pigs get fat, hogs get slaughtered."

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