Appeal of Swat-Fame, Inc.

Appeal of Swat-Fame, Inc., et al., 2020-OTA-046P, decided by Administrative Law Judge Amanda Vassigh, is a precedential Office of Tax Appeals (OTA) opinion addressing whether an apparel company's design and sample-development process for four garments satisfied the process of experimentation test for the California research credit. Swat-Fame, an S corporation that designed women's and girls' clothing sold at major retailers, and its shareholders sought refunds of research credits claimed for tax years 2008 through 2012, which the Franchise Tax Board (FTB) denied.

The Four Sample Projects

By agreement of the parties, the appeal was resolved based on four representative projects: denim Bermuda shorts (Project UB636N), a jacquard-and-charmeuse party slip dress (Project D11072), a ruffled-skirt-and-leggings children's set (Project Z1743D01), and a printed-and-solid-fabric sundress with a smocked shrug (Project M93771). For each project, Swat-Fame's research study, prepared by alliantgroup, described a design and prototyping process in which the company's designers and creative directors evaluated fabrics, trims, and construction techniques and refined garments through fit testing before manufacture.

No Process of Experimentation

OTA found that, while Swat-Fame's product development process was thorough, it did not rise to the level of a structured, scientific-method process of experimentation. For the Bermuda shorts, the company experienced shrinkage and waistband-stability problems during washing but kept no evidence that it recorded wash conditions, formed a hypothesis, and re-tested under controlled conditions -- and much of the denim treatment (lasering, stonewashing) was for aesthetic rather than functional purposes. For the party slip dress, the difficulties with jacquard and charmeuse fabric arose from the customer's own stylistic fabric choice, which the process of experimentation test excludes as a matter conforming to "style, taste, cosmetic, or seasonal design factors" under IRC section 41(d)(3)(B). For the ruffled skirt, the ruffles served no functional purpose, and reinforcing seams for stretch leggings reflected simple trial and error rather than a systematic evaluation of alternatives. For the sundress and shrug, adding fabric lining and a hook-and-eye clasp, and reinforcing pockets after a stonewash tear, were resolved with known, off-the-shelf solutions rather than an iterative testing process.

OTA emphasized that the process of experimentation test requires that at least 80 percent of a company's activities for each business component constitute a systematic trial-and-error methodology involving a hypothesis, testing, data analysis, and refinement -- not merely "taking steps to resolve uncertainty or to improve a product," citing Union Carbide Corp. and Subsidiaries v. Commissioner, T.C. Memo. 2009-50. Because appellants offered no evidence permitting application of the shrinking-back rule to a smaller subset of any project, the credit was denied in its entirety for all four projects.

Significance

Swat-Fame is the leading California precedent applying the process of experimentation test to consumer product and apparel design, and it is frequently cited by subsequent OTA opinions -- including Appeal of Pino, 2020-OTA-375P -- for the proposition that iterative product refinement alone, without a documented scientific-method testing process, does not satisfy IRC section 41(d)(1)(C), and that design choices driven by style, taste, or customer preference fall outside the definition of qualified research.