George v. Commissioner

Which Came First: The Research or the Credit Study?

Forget the age-old question of the chicken or the egg; in this case, the Tax Court grappled with which came first: the qualified research or the research credit study. At stake were millions of dollars in research and development (R&D) tax credits claimed by George's of Missouri, Inc. (GOMI), a major poultry producer, for its broiler chicken production trials between 2012 and 2014. The court, in George's of Missouri, Inc. v. Commissioner, delivered a split decision. It allowed credits for certain trials, specifically those involving Ross 708 chickens, LT Priming, and certain probiotics, finding that these met the requirements for qualified research under Section 41. However, the court disallowed credits for other trials due to lack of substantiation or because the uncertainty the research was meant to resolve was already resolved. Despite this mixed outcome, GOMI avoided accuracy-related penalties because it had relied on its credit study firm, Alliantgroup.

Ruling the Roost: The Business of Birds

Having allowed credits for certain trials, specifically those involving Ross 708 chickens, LT Priming, and certain probiotics, finding that these met the requirements for qualified research under Section 41, the court disallowed credits for other trials due to lack of substantiation or because the uncertainty the research was meant to resolve was already resolved. Despite this mixed outcome, GOMI avoided accuracy-related penalties because it had relied on its credit study firm, Alliantgroup.

Today, George's, Inc. stands as one of the largest fully integrated poultry processing companies in the United States. For four generations, the George family has been involved in the chicken industry, beginning humbly in Bush Creek, Arkansas. As GOMI, George's of Missouri, Inc., the entity responsible for the live production portion of the business, manages the hatcheries, live haul, feed mills, and farms. GOMI's operations are extensive, managing the lifecycle of millions of broilers annually.

The scale of GOMI's operations also presented complex biological challenges. Like other large poultry producers, GOMI constantly battled diseases such as Coccidiosis and Laryngotracheitis (LT), commonly known as LT. Another persistent issue was "Runt and Stunt," a condition where chicks fail to thrive, leading to significant economic losses. Simultaneously, the market demanded "No Antibiotics Ever" (NAE) poultry, pressuring companies like GOMI to find innovative, non-antibiotic solutions to maintain bird health and productivity. This pressure necessitated the exploration of alternative strategies, including modified diets, novel vaccines, and enhanced biosecurity measures.

The Winners: Pilot Models and Priming

Continuing their search for tax savings, GOMI also argued that several other trials qualified for the research and development (R&D) tax credit. The Tax Court agreed in part, accepting the validity of the HatchPak/Tylan 2012 trials, certain probiotic trials (Calsporin/Sporulin), and the LT priming trials.

The key to GOMI's victory lay in demonstrating a "process of experimentation," a requirement under Section 41(d)(1)(C) and Treasury Regulation § 1.41-4(a)(5)(i). This section of the tax code defines qualified research for the R&D tax credit. The court found that for these trials, GOMI had formulated hypotheses, systematically collected data, and conducted contemporaneous analysis. This satisfied the rigorous standards for demonstrating genuine R&D activity. The court emphasized that the poultry industry's data-driven nature and GOMI's meticulous tracking of flock performance provided a solid foundation for comparing experimental results against historical data.

A significant win for GOMI, and potentially for the broader agribusiness sector, was the court's acceptance of the "pilot model" argument. Treasury Regulation § 1.174-2(a)(4) defines a pilot model as a representation of a product used to evaluate and resolve uncertainty during its development. GOMI successfully argued that the millions of chickens used in these trials constituted pilot models. Because GOMI could only resolve uncertainty about the efficacy of new treatments by observing the chickens' development, the court held that the costs of raising these chickens, including feed expenses, were deductible under Section 174, which governs the deduction of research and experimental expenditures.

The Losers: Substantiation and Resolved Uncertainty

While GOMI celebrated victories in some arenas, several of its research trials failed to pass muster with the Tax Court. The court rejected the claimed research credits for Salinomycin, Phytase, Vaxxitek, and HatchPak 2013. Two principal reasons drove these disallowances: a lack of substantiation and the resolution of uncertainty.

Regarding Salinomycin, Phytase, and Vaxxitek, the court found a critical lack of substantiation. The petitioners, GOMI, failed to provide sufficient documentation to verify that the claimed research activities actually occurred as described. Specifically, the court could not confirm that the alleged trials took place, nor could it identify the specific chicken flocks involved in the experiments. GOMI's feed recipe records for the Salinomycin trials, for example, contradicted their claims about altered dosages of Salinomycin and the addition of chemical coccidiostats. The court stated, "These alleged trials are a clear example of the chicken (research credit study) coming before the egg (research)."

The Phytase trials suffered a similar fate. Despite GOMI's claims of varying phytase dosages, the court found no evidence of such variation in the feed recipes. The court stated that GOMI's feed logs showed that as far back as 2010, GOMI was adding Phyzyme TPT 2500 to its broiler feed ingredients in a range between 0.3 and 0.5 pound per ton of feed. "During the alleged trial period, GOMI added Phyzyme TPT 2500 within this range."

Vaxxitek also failed due to lack of substantiation. The court could not corroborate that the Vaxxitek vaccine was administered at varying dosages to the flocks petitioners identified. The court noted conflicting testimony, a lack of documentation regarding the dosages, and lack of special food labels that we can link with flocks that received the vaccine.

In contrast, the HatchPak and Tylan trials failed the "Section 174 Test" in 2013, not because of substantiation issues, but because the uncertainty surrounding the efficacy of the HatchPak and Tylan combination had been resolved by the end of 2012. Section 174 governs the deduction of research and experimental expenditures. The court explained that while uncertainty can extend beyond a single tax year, the taxpayer must demonstrate that the information objectively available in the tax year for which they seek the credit did not establish the capability, method, or appropriate design. Citing Siemer Milling Co., the court emphasized that a taxpayer cannot claim uncertainty for a later identical test if a previous test provided objective information resolving that uncertainty.

The court found that the successful 2012 trials, involving 14 flocks, provided a "definitive answer" that HatchPak and Tylan effectively controlled coccidiosis under GOMI's standard production process. Testimony from GOMI's employees further confirmed that they believed the uncertainty was resolved after the 2012 trials. The court concluded that the subsequent failure of HatchPak and Tylan in 2013 did not retroactively create uncertainty that did not exist at the beginning of the 2013 research activities. This aspect of the ruling underscores the importance of the timeline of R&D activities when claiming research tax credits; previous success can undermine claims of ongoing uncertainty.

The 6% Floor and The Penalty Shield

The Tax Court's decision in this case had both mathematical and procedural consequences. First, because GOMI (George's Organic Meats, Inc.) failed to substantiate its qualified research expenses (QREs) for the base years of 2009, 2010, and 2011, the court invoked Section 41(c)(5)(B), which significantly reduced the research credit.

Section 41 provides a credit for increasing research activities. Section 41(c)(5) offers an "alternative simplified credit" (ASC). The ASC generally equals 14% of the current year’s QREs that exceed a base amount, which is calculated as 50% of the average QREs for the three preceding taxable years. However, Section 41(c)(5)(B) stipulates that if the taxpayer has no QREs in any of the three preceding years, the credit is equal to just 6% of the current year's QREs.

Because GOMI could not provide sufficient documentation for 2009-2011, the Tax Court determined that GOMI had no QREs during those years, triggering the 6% limitation for the credit years of 2012, 2013, and 2014. For 2013, GOMI had QREs of $7,280,578, and for 2014, QREs of $1,919,559. The reduced credit rate significantly lowered the ultimate payout.

On the procedural front, the IRS argued that GOMI should be penalized for accuracy-related penalties under Section 6662(a) for tax years 2014 and 2016, either due to negligence or a substantial understatement of income tax. Section 6662(a) imposes a 20% penalty on underpayments of federal income tax attributable to negligence or disregard of rules or regulations. Negligence, as defined in Section 6662(c), includes failing to make a reasonable attempt to comply with the tax code or to keep adequate records.

However, Section 6664(c)(1) provides a "reasonable cause" exception, stipulating that penalties under Section 6662 shall not apply if the taxpayer demonstrates reasonable cause for its position and acted in good faith. The court found that GOMI met this standard.

The court emphasized that GOMI reasonably relied on the advice of Alliantgroup, a competent professional firm with extensive experience in conducting tax credit studies, especially within the agriculture industry. GOMI provided Alliantgroup with open access to its books and records, and Alliantgroup diligently reviewed documents and interviewed employees. The court contrasted this situation with Betz v. Commissioner, T.C. Memo. 2023-84, where the court found that reliance on Alliantgroup was not reasonable. Ultimately, the Tax Court declined to impose penalties, determining that GOMI acted with reasonable cause and in good faith.

Impact: A Mixed Basket for Agribusiness

The Tax Court's decision in this case offers a mixed bag of takeaways for agribusinesses claiming research and development (R&D) tax credits under Section 41. The court navigated complex issues, reinforcing the importance of contemporaneous documentation and the nuances of applying the Section 41 credit to live animal trials.

One positive outcome for taxpayers is the validation of the "pilot model" argument, particularly in the context of live animal research. Under Treasury Regulation Section 1.174-2(a)(4), a pilot model is any representation or model of a product produced to evaluate and resolve uncertainty concerning the product during its development. The court's acceptance of feed costs as deductible expenses associated with these models provides a pathway for agribusinesses to substantiate their R&D activities.

However, the decision also serves as a stark reminder that contemporaneous records are non-negotiable. Post-hoc credit studies, while helpful, cannot salvage unsubstantiated research trials. As seen in Little Sandy Coal Co. v. Commissioner, arbitrary estimates of time and effort are insufficient. Taxpayers must meticulously document their research activities as they occur. This reinforces the "substantially all" test, derived from the "Process of Experimentation" under IRC § 41(d)(1)(C) and Treas. Reg. § 1.41-4(a)(5)(i), necessitating taxpayers show their methodical plan and test hypotheses to bridge the gap from uncertainty to a final solution.

Furthermore, the court clarified the limits of claiming R&D credits for repeated experiments. Once a trial succeeds, the "uncertainty" required for R&D credits under Section 41 dies. Repeating a successful experiment does not qualify for the credit. The focus must be on resolving uncertainty, not merely replicating known outcomes.

Despite disallowing portions of the claimed credits, the Tax Court's decision to shield GOMI from penalties offers a final lesson. Even if some credits are ultimately disallowed, reliance on reputable credit firms like Alliantgroup can protect against penalties, provided the taxpayer grants open access to records and the firm conducts diligent reviews. This aligns with the principle that taxpayers should act with reasonable cause and in good faith when conducting tax credit studies, especially within the agriculture industry. GOMI provided Alliantgroup with open access to its books and records, and Alliantgroup diligently reviewed documents and interviewed employees. The court contrasted this situation with Betz v. Commissioner, T.C. Memo. 2023-84, where the court found that reliance on Alliantgroup was not reasonable. Ultimately, the Tax Court declined to impose penalties, determining that GOMI acted with reasonable cause and in good faith.