Kollsman Instrument Corp. v. Commissioner

The historical trajectory of the United States’ research and development (R&D) tax incentive framework is characterized by a persistent tension between the legislative intent to spur domestic innovation and the administrative necessity of rigorous substantiation. At the heart of this evolution is the landmark case of Kollsman Instrument Corp. v. Commissioner (T.C. Memo. 1986-66, affirmed by the Second Circuit in 1989), which serves as a foundational precedent for distinguishing between routine production activities and deductible research and development costs. As the Internal Revenue Service (IRS) continues to intensify its scrutiny of research credit claims under Internal Revenue Code (IRC) Section 41, the lessons derived from the Kollsman litigation remain strikingly relevant for modern aerospace, defense, and high-technology enterprises.

The Foundational Conflict in Kollsman Instrument Corp. v. Commissioner

The litigation involving Kollsman Instrument Corporation primarily centered on the intersection of long-term contract accounting and the classification of research-related expenditures. During the mid-1960s, Kollsman was a significant defense contractor, providing sophisticated aerospace equipment to the United States Air Force. The specific dispute arose from a contract for the production of unique goods where the Air Force implemented numerous engineering, specification, and design changes throughout the production process. These modifications led to substantial cost increases, prompting Kollsman to seek equitable adjustments to the contract price.

For the tax years 1963 through 1967, Kollsman utilized the "cost percentage of completion" method of accounting. Under this methodology, the company computed the percentage of project completion by comparing actual costs incurred in a given year to the estimated total costs for the entire project. This percentage was then applied to the estimated gross contract price to determine the income reportable for that year. The net taxable income was derived by deducting the actual costs expended from this allocated income.

The dispute in this case arose because until 1966 Kollsman's estimate of the gross contract price it hoped to obtain was substantially higher than the fixed contract price of $6,718,480. Because Kollsman did not know the exact contract price that it would ultimately be entitled to receive, it estimated the gross contract price and applied each year's cost percentage of completion to that estimated gross contract price to arrive at the income from the contract that was allocated to that year.

The Accounting and Deduction Dispute

A critical turning point occurred in 1966 when the Air Force’s contracting officer allowed a price increase of only $128,780, significantly lower than the amount Kollsman had anticipated. Realizing it had vastly overestimated the contract price and consequently overreported income for the years 1963 through 1965, Kollsman claimed a deduction of $4,359,000 on its 1966 tax return. The company described this as a "Reduction of 1963-1965 claim against U.S. Air Force per 1/10/66 determination of Contracting Officer". The Commissioner of Internal Revenue challenged this, asserting that the proper year for the deduction was 1967—the year in which the final contract price was definitively determined.

The Tax Court and the Second Circuit Court of Appeals agreed with the Commissioner, relying on Treasury Regulations section 1.451-1(a). This regulation provides: "Where an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made". Under this section of the regulations, 1967 was the appropriate year for a deduction based on Kollsman's previous overestimates of income, since 1967 was the year in which the exact amount that would be paid on the contract was determined.

Furthermore, Kollsman attempted to recharacterize the 1966 deduction as an inventory write-down, arguing that the market price for the goods was lower than their cost. Because Kollsman was contractually bound to sell the products to the Air Force, and because the goods were unique, the "market price" for the goods was equivalent to the contract price. The court rejected this argument, noting that an inventory write-down is inconsistent with the cost percentage of completion method of accounting used by Kollsman. The costs that Kollsman incurred each year from 1963 through 1966 were not claimed as part of its year-end inventory, but were instead deducted from the percentage of the estimated gross contract income accrued during each year. Thus, from the work completed on this contract in 1966, there was no "inventory" on hand for Kollsman to "write-down".

The Section 174 R&D Controversy

Beyond the timing of contract losses, the Notice of Deficiency also reflected the commissioner's determination that Kollsman had improperly claimed a deduction in 1966 of $868,000 for research and development expenses that should have been amortized over three years. This aspect of the case highlighted a critical distinction that still impacts taxpayers today: the boundary between investigative research intended to develop a new concept and the mere application of existing designs to a manufacturing process.

The court's analysis in Kollsman reinforced the principle that the regulatory definition of research or experimental expenditures is reasonable and consistent with the intent of the statute to limit deductions to those expenditures of an investigative nature expended in developing the concept of a model or product. Because the court found that Kollsman was only required to manufacture products for which it had been supplied the designs and specifications, the Section 174 test was not satisfied for many of the disputed costs. This established a precedent that remains central to the research credit: the "discovery" of information must involve more than just fulfilling a client's specific production requirements.

Evolution of the R&D Tax Credit Framework

The research tax credit, now codified under Section 41, was originally introduced to the Internal Revenue Code by the Economic Recovery Tax Act of 1981 and was codified as section 44F. The credit was subsequently amended by the Tax Reform Act of 1984 and was redesignated as section 30 before the Tax Reform Act of 1986 redesignated the credit as section 41. In the recodification of section 30 as section 41 under the Tax Reform Act of 1986, the definition of “qualified research” was amended to include requirements in addition to the requirement that the expenses qualify under section 174.

Section 174 generally provides that research and experimental expenditures paid or incurred during the taxable year in connection with a taxpayer's trade or business may, at the taxpayer's election, be deducted currently rather than capitalized. These expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.

The Four-Part Test for Qualified Research

To be eligible for the credit under Section 41, an activity must satisfy four cumulative tests.

• The Section 174 Test: The activities involve the elimination of uncertainty concerning the development or improvement of a product, so that the expenses of the activities would be deductible under Sec. 174.
• The Business Component Test: The activities are useful in the development of a new or improved business component.
• The Technological in Nature (Discovery) Test: The activities discover information that is technological in nature, meaning the purpose of the activity is to discover information that is based on the principles of established science.
• The Process of Experimentation Test: Substantially all of the activities are experimental in nature and conducted for a permitted purpose related to a new or improved function, performance, reliability, or quality.

The "Substantially All" Requirement

The process-of-experimentation test expands on the Section 174 test as it applies to the entire research process, not just the elimination of uncertainty. The process of experimentation substantially all requirement is satisfied only if 80 percent or more of a taxpayer's research activities, measured on a cost basis or other consistently applied reasonable basis, constitute elements of a process of experimentation for a qualified purpose. Thus, if 80 percent or more of a taxpayer's research activities for a business component constitute elements of a process of experimentation, the substantially all requirement is satisfied even if the remaining 20 percent or less of the research activities do not constitute elements of a process of experimentation, so long as those remaining activities may be treated as research or experimental expenditures under section 174.

Generally, to meet the requirements of this test, the taxpayer should establish a systematic progression of work that proceeds from hypothesis, observation, and evaluation and leads to logical conclusions. This often involves identifying one or more alternatives intended to eliminate uncertainty and identifying and conducting a process of evaluating those alternatives through modeling, simulation, or a systematic trial-and-error methodology.

Case Law Analysis and Comparative Precedents

The legacy of Kollsman is woven through subsequent R&D credit litigation, which has progressively raised the bar for documentation and the proof of scientific methodology.

Union Carbide and the Production vs. Research Boundary

In Union Carbide Corporation & Subsidiaries v. Commissioner (T.C. Memo. 2009-50), the Tax Court determined that 2 of 5 representative projects, which were conducted at manufacturing plants during production processes, constituted qualified research under Code Sec. 41(d). Distinguishing ordinary production activities, the Court found that projects involving “anticoking” and polyethylene catalyst (“UCAT-J”) research activities were qualified insofar as they satisfied the Code Sec. 174 test, were undertaken to discover information that was technological in nature, and constituted a process of experimentation.

However, the Court struck down as not qualified the remaining 3 projects, finding that ordinary production activities weren't part of the experimental process. The Court also rejected the taxpayer's claims for additional costs of supplies/raw materials, finding that such were incurred in respect to the commercial production and sale of finished products vs. research-experimentation. This mirrors the Kollsman ruling where the court distinguished between nondeductible production activities and deductible research activities.

Suder v. Commissioner and the Recognition of Incremental Innovation

The case of Suder v. Commissioner (T.C. Memo. 2014-201) involved Eric Suder and his company, Estech Systems, Inc. (ESI), who claimed federal research tax credits for developing new telephone systems and related technology. The court decided that most of ESI's projects did qualify for the federal research tax credit because they met the legal requirements for qualified research such as solving technical challenges and following a systematic development process.

The Suder decision indicated that businesses which are often building on the work of others may be eligible for the research tax credit, and emphasized that there is not a requirement under the research tax credit to "reinvent the wheel". The court recognized the reality that much of the work of industry is the application of known engineering principles to components and that those components do not function in isolation. However, the court ruled that the CEO's wages were unreasonably high and had to be reduced when calculating the credit.

Little Sandy Coal and the Burden of Proof for Support Activities

The Federal Court of Appeals for the Seventh Circuit, in Little Sandy Coal Company v. Commissioner, affirmed the United States Tax Court's disallowance of federal income tax credits for a taxpayer's research expenses for two watercrafts. A finding that substantially all of the activities constituted elements of a process of experimentation was necessary for a finding that the taxpayer was entitled to the research credits. The Seventh Circuit ruled that even if a fabricated dry dock were a "pilot model" the cost of which was deductible for tax purposes, it did not enter into the credit calculation because the taxpayer did not prove that the pilot model was used in an experimental test.

The court characterized the submergence-buoyancy test of the floating dry dock as a quality control test because it merely ascertained whether the floating dry dock submerged and rose “as designed and according to a customer's desired parameters”. This reinforces the Kollsman-era distinction between testing the viability of a new concept versus testing whether a production unit meets specifications. The Seventh Circuit wanted evidence of the specific activity of each employee that constituted an element of the experimental process and found none.

Implications for Defense and Aerospace Research

For companies like Kollsman, the intersection of government funding and the research credit creates a unique set of challenges. Research is generally not qualified if it constitutes "funded research" within the meaning of IRC Section 41(d)(4)(H).

The Funded Research Doctrine

To avoid the funded research exclusion, a taxpayer must demonstrate that they retain substantial rights in the results of the research and that the payment for the research is contingent on the success of the research. In Smith et. al. v. Commissioner and System Technologies, Inc. v. Commissioner, the Tax Court denied the IRS summary judgment on the funded research issue. In System Technologies, the IRS argued that research was funded because payments under the contracts were not expressly contingent on the success of the research. However, the Court stated that if the research failed, Indiana state law provided a remedy inclusive of refunds of payments made, thus concluding that the payments for the research were contingent on success and the research was not funded.

Aerospace R&D Complexity

The aerospace industry in the 1960s was dominated by massive R&D programs, with FY 1969 estimates for the Department of Defense and NASA totaling $8.86 billion. Kollsman Instrument Corp. was a central player, building optical subsystems including space sextants, sunfinders, and navigation display equipment for the Apollo Lunar Landing program. Modern cases involving similar high-stakes hardware, such as the manufacture of a wafer and mask set containing a prototype integrated circuit design, have seen the IRS argue that such items are depreciable property rather than supplies, thus making them ineligible for the credit under section 41.

Modern Documentation Standards and IRS Scrutiny

Current IRS enforcement, exemplified by Phoenix Design Group, Inc. v. Commissioner (T.C. Memo 2024-113), emphasizes the importance of clearly identifying technical uncertainty and maintaining contemporaneous documentation that substantiates a process of experimentation. The IRS now expects clear documentation of technological uncertainty at the outset of a project—not just general uncertainty about design challenges.

Identification of Technical Uncertainty

The Section 174 Test requires investigatory activity, which is the attempted acquisition of information. While emails and meetings can be examples of acquiring information, basic calculations on available data are not considered an investigative activity because the taxpayer already has all the information necessary to address that unknown. Taxpayers must identify specific technical challenges that were not readily resolvable using existing knowledge or capabilities.

Substantiating the Process of Experimentation

The Tax Court has denied significant R&D tax credits because companies failed to prove that at least 80% of their research followed a structured process of experimentation. To meet the requirements of this test, the taxpayer should develop a hypothesis as to how a new alternative might be used to develop a business component, test that hypothesis in a scientific manner, analyze the results of the test, and then either refine the hypothesis or discard it and develop a new one. The IRS now takes a stricter stance, requiring:

• A clear breakdown of business components.
• Detailed documentation linking expenses to research activities.
• A strong narrative explaining the process of experimentation.

Companies are more likely to get court support in their estimates (under the Cohan rule) if it is proven that R&D activities are in existence and it is only the estimation of the amount of R&D at issue and the estimation method is credible. However, the Seventh Circuit's approach in Little Sandy Coal may disallow research credits for a number of industries whose approach to research is less formal.

Strategic Implications for Future R&D Tax Credit Applications

The analysis of Kollsman Instrument Corp. v. Commissioner and its successor cases provides a roadmap for modern practitioners. The core implication is that the "nature" of the activity—not the "product" itself—dictates eligibility for the credit.

Contractual Engineering for Credit Eligibility

As seen in the Kollsman and Betz cases, the terms of contracts with customers are decisive. Taxpayers must ensure that they:

• Retain substantial rights in the results of the research.
• Bear the financial risk of failure, with payments contingent on successful design milestones rather than just the passage of time or the incurrence of costs.
• Can distinguish their investigative research from the mere manufacture of products based on designs supplied by the customer.

Managing Supply and Wage Expenditures

The dispute over supply costs remains active. The IRS has argued that only supplies purchased specifically for research, rather than all supplies used in research, qualify for the credit—a position that could largely eliminate the credit for supplies used in plant-scale testing. Furthermore, when claiming the wages of senior executives like CEOs, companies must ensure the compensation is "reasonable" for the research work performed and backed by records showing the CEO's actual hours worked on projects.

For a business component to meet the substantially all requirement, the following relationship must be documented:

$$\text{Experimental Activities (Cost)} \geq 0.80 \times \text{Total Research Activities (Cost)}$$

If this 80% threshold is met, the total qualified research expenses ($QRE$) for that component can be calculated as:

$$QRE = \text{Wages} + \text{Supplies} + (0.65 \times \text{Contract Research Expenses})$$

Conclusion: The Enduring Impact of the Kollsman Precedent

The decision in Kollsman Instrument Corp. v. Commissioner continues to resonate as a primary guardrail for the R&D tax credit. It reinforces the necessity of distinguishing between the "investigative nature" of research and the "routine nature" of production. In the decades since the ruling, the US tax system has transitioned from a relatively flexible deduction-based incentive under Section 174 to a highly scrutinized, credit-based system under Section 41 that demands scientific rigor and contemporaneous proof.

The core implication for future applications is that "technological" work is not inherently "qualified research." A company may be building advanced hardware, but if that work is performed under a funded contract with designs provided by the customer, or if it lacks a documented, systematic trial-and-error process to resolve a predefined uncertainty, it will fail to meet the modern standards of the Tax Court. The evolution of the "Process of Experimentation" and "Funded Research" doctrines suggests that the burden of proof has shifted entirely to the taxpayer to maintain an audit-ready trail of documentation that captures not just the costs, but the scientific method itself.