Zmation, Inc. v. Department of Revenue

Zmation, Inc. designs, fabricates, and tests custom industrial machines, integrating computers, machine vision, robotics, and closed-loop control systems to meet individual customer specifications. Zmation's president and shareholder, Craig Howard, claimed an Oregon research tax credit — which incorporates the same definitions as the federal credit under IRC section 41 — for engineering work performed on eleven projects across the 2016 and 2017 tax years, submitting client emails referencing 'testing' and 231 pages of handwritten engineering notes as supporting evidence.

Uncertainty Was Conceded, But Not the Right Kind Throughout

The court accepted that Zmation faced genuine uncertainty on many of its projects, since the Department offered no expert testimony to rebut that showing. But it found that some of the work Zmation described as its research — such as 'rewriting' or 'upgrading' existing software to run on Windows 10 — amounted to debugging or modifying commercially available software rather than the kind of uncertainty contemplated by IRC section 174. The court also rejected Zmation's claim that its 'pilot models' resolved design uncertainty separate from production, finding the machines built under contract were the very products sold to customers, not models built to later be sold as in the regulatory examples.

No Way to Separate Experimentation From Production Costs

Applying Little Sandy Coal Co., Inc. v. Commissioner, the court held that even where some of Zmation's work may have involved a genuine process of experimentation, Zmation provided only total hours worked per engineer per project, with no way to distinguish testing or redesign work from ordinary fabrication and production labor. Because the court could not determine whether qualifying activity made up substantially all of any project, and could not separate any research costs from the costs of simply building the machines under contract, Zmation failed to meet its burden of proving the amount of any qualified research expenses.

Any Qualifying Research Appeared to Be Funded

The court further found that, to the extent any of Zmation's software development involved qualified research, it was excluded as funded research under IRC section 41(d)(4)(H). Zmation's contracts required customers to pay for machines regardless of research outcome, and its own contracts expressly assigned ownership of the 'custom code' developed for each project to the customer — one contract barred Zmation from even disclosing the code to third parties. Because Zmation did not retain substantial rights in the research it performed, any qualifying work was treated as funded by its clients and excluded from the credit.

The court denied Zmation's appeal in full, finding Plaintiffs had not established by a preponderance of the evidence that they were entitled to the research tax credit for either tax year.

Significance: This is an unusually detailed Oregon Tax Court opinion applying all four qualified-research tests and the funded-research exclusion to a small custom-manufacturing business, and it illustrates how even sympathetic, well-documented uncertainty can fail to support a credit where a taxpayer cannot separate experimentation costs from production costs, and where its own customer contracts assign away the underlying research and its associated risk.