Opinion
4759-22
08-29-2023
PHOENIX DESIGN GROUP, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Travis A. Greaves, Judge.
Currently before the Court is petitioner's Motion for Protective Order Pursuant to Rule 103 filed July 20, 2023. Therein, petitioner requests that we limit discovery and trial to a subset of 3 to 6 projects selected from the 20 projects petitioner deemed qualified for the Credit for Increasing Research Activities under § 41 (research credits) and used for statistical sampling. For the reasons set forth below, we will deny petitioner's motion.
Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all statutory references are to the Internal Revenue Code (I.R.C. or Code), Title 26 U.S.C., in effect at all relevant times.
Background
The following facts are derived from the pleadings, the parties' motion papers, and the exhibits and declarations attached thereto. They are stated solely for purposes of deciding petitioner's motion and not as findings of fact in this case. See Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994).
Between 2015 and 2019 (years at issue), petitioner was treated as a C corporation for Federal income tax purposes. Petitioner was engaged in the business of engineering and consulting and focused primarily on designing mechanical, electrical, plumbing, and fire protection systems. Between 2013 and 2016, petitioner engaged in 409 research projects related to its business. Petitioner engaged a third party, alliantgroup, LP, to determine its eligibility for the research credits. After eliminating de minimis projects, alliantgroup determined that 238 research projects may qualify for the research credits. Alliantgroup selected 24 projects and determined that 20 of those projects qualified for research credits (qualifying sample).
The result of this study was then extrapolated to the 238 research projects to determine the amount of qualified research credits. Petitioner used this study in the preparation of its returns.
Following an audit of petitioner's tax returns for the years at issue, respondent determined $553,547 in collective deficiencies and penalties under § 6662, resulting from the disallowance of the research credits. Petitioner timely filed with this Court seeking redetermination of the notice for the years at issue.
All dollar amounts are rounded to the nearest dollar.
On January 18, 2023, the parties met to begin the informal discovery process. Shortly after, petitioner produced documents relating to one of the qualifying sample research projects. On March 13, 2023, respondent sent petitioner his first request for informal discovery. On May 22, 2023, respondent sent petitioner his second request for informal discovery, specifically requesting production related to all 238 research projects underlying the research credits. Between April 10, 2023, and June 16, 2023, petitioner responded to the first informal request for discovery by providing information relating to the qualifying sample. Petitioner also provided an explanation of the sampling method used by alliantgroup to determine eligibility for credits.
On July 20, 2023, petitioner filed a Motion for Protective Order Pursuant to Rule 103, asking this Court to limit discovery and trial to a subset of 3 to 6 projects selected from the qualifying sample. On August 21, 2023, respondent filed a Response to Motion for Protective Order Pursuant to Rule 103.
Discussion
Pursuant to § 41, qualified research expenditures, must be related to "qualified research," involving activities that meet the following four-part threshold test: (1) the § 174 test, (2) the technological information test, (3) the business component test, and (4) the process of experimentation test. § 41(d); Max v. Commissioner, T.C. Memo. 2021-37, at *28 n.10. This discovery dispute centers around whether petitioner must show satisfaction of the four-part threshold test for each project to which the claimed credit relates or whether petitioner may show satisfaction for all projects based on a selected sample.
Given the breadth of factual issues involved in determining a taxpayer's eligibility for the research credits, it is common for the taxpayer and the IRS to agree to a representative sample of the research projects that will be tried in front of the Court and binding on all research projects. See, e.g., Suder v. Commissioner, T.C. Memo. 2014-201, at *1. Taxpayers and the IRS have also agreed to try a sample of the research projects, which is not binding on the remaining research projects, with the expectation that the Court's decision will enable the parties to resolve their differences regarding the remaining projects. See Little Sandy Coal Corp., Inc. v. Commissioner, T.C. Memo. 2021-15, at *20, aff'd, 62 F.4th 287 (7th Cir. 2023); Union Carbide Corp. v. Commissioner, T.C. Memo. 2009-50, slip op. at 8, aff'd, 697 F.3d 104 (2nd Cir. 2012). When taxpayers and the IRS agree to try a sample of the research projects but fail to agree as to the method, we have previously selected the methodology for choosing a sample. See Tangel v. Commissioner, No. 27268-13 (filed Feb. 22, 2018) (order requiring the parties to file an objection, if any, to the Court's sampling procedure). These prior uses of sampling to determine eligibility for research credits all rely on the parties' stipulation to the use of a sample. Without the agreement of both parties, we have previously held that limiting the scope to a sample of research projects is improper because doing so would relieve a taxpayer of his burden of proving entitlement to the research credits. See Betz v. Commissioner, T.C. Memo. 2023-84, at *77 n.30; see also Bayer Corp. v. United States, 850 F.Supp.2d 522, 538, 545-46 (W.D. Pa. 2012).
Limiting the scope of discovery in accordance with petitioner's motion is improper. Credits are a matter of legislative grace, and taxpayers bear the burden of demonstrating their entitlement to the credits claimed. See Feigh v. Commissioner, 152 T.C. 267, 270 (2019). In this case, petitioner bears the burden of showing that the amount of research credits claimed for each tax year was proper. Petitioner has not shown that the 3 to 6 projects selected from the return projects are representative of the 238 projects underlying the research credits and would produce statistically valid results. With four years at issue, allowing petitioner to narrow the scope of the case to 3 to 6 projects could result in a nonreflective decrease in its tax liability and prejudice respondent.
Petitioner also argues that we should limit discovery because production related to all 238 research projects is not proportional to the amount at issue in this case. Petitioner claims that allowing the scope of discovery to encompass all research projects would require the production of "millions of pages of discovery" while the amount at issue is relatively low. Rule 70(b)(1) discusses the proportionality requirement for discovery:
Discovery must be proportional to the needs of the case, considering the importance of the issues at stake in the action, the amount in controversy, the parties' relative access to relevant information, the parties' resources, the importance of the discovery in resolving the issues, and whether the burden or expense of the proposed discovery outweighs its likely benefit.
While we appreciate the burden on petitioner to provide information on all 238 research projects, the need for this discovery is great. The only issue in this case is whether petitioner properly reported its research credits for the years at issue. This issue involves consideration of the underlying research projects to determine compliance with § 41. Respondent's request for details relating to the research projects is reasonably calculated to produce relevant information to petitioner's eligibility for the research credits. Respondent's limited access to the information also favors not limiting discovery. Respondent attempted, through informal channels, to acquire information regarding the research projects but petitioner rejected these attempts, limiting discovery to the qualifying samples. Respondent has no alternative method of securing information on the research projects. The significance and necessity of discovery in the resolution of this case outweighs the expense to petitioner in complying.
Accordingly, we deny petitioner's Motion for Protective Order. Although the Court is not inclined to grant petitioner's motion, the Court advises respondent that his continued cooperation and willingness to better streamline this case for trial is expected since it will preserve both judicial resources and resources of the parties.
Upon due consideration, it is
ORDERED that petitioner's Motion for Protective Order Pursuant to Rule 103, filed July 20, 2023, is denied.