R&E: make sure there is a trade or business.

• Author: Starr, Samuel P.
• Position: Research and experimentation

Letter Ruling (TAM) 9604004 recently concluded that a company's expenditures paid to a research corporation for research, development and testing of health-care products did not qualify as research and experimentation (R&E) expenditures for purposes of Sec. 174.

A company (C) was incorporated in year 1 and entered into agreements with a research and development (R&D) corporation (A). Under the agreements, C had the exclusive right and license to certain patent and technology rights for the research, development, manufacture and sale in specific geographical areas of certain health-care products, which were in various stages of development. The agreements required C to expend all of its cash assets to engage A to research, develop and clinically test the products; however, the agreement was terminable in certain situations. C was required to pay royalties on any of its sales to A, sufficient to allow A to make required royalty payments based on A's agreements with third parties. A had an option to acquire all the rights held by C for each product at a set range of prices, payable in cash, A common stock, or a combination. C was required to obtain A's approval prior to entering into any sublicense or transfer of rights in the products with a third party prior to the expiration of the options at the end of year 2. Without A's permission, C could not issue additional stock, borrow, declare dividends, merge, liquidate, sell assets or use funds for any purpose other than to pay A.

C's board of directors included officers of A, and C and A shared officers. C maintained no physical facility or staff, and A provided services on a cost-reimbursement basis.

A exercised the option to acquire certain products in year 3 and the remainder in year 4. C then liquidated, retaining some funds for costs of liquidation. On its tax return, C treated the payments to A as Sec. 174 R&E expenditures. The IRS disallowed the expenditures because the costs were determined not to be in connection with C's trade or business.

Sec. 174(a) allows R&E expenses paid or incurred during the tax year in connection with the taxpayer's trade or business to be currently deducted. Regs. Sec. 1.174-2(a) (1) provides that R&E expenditures are those incurred in connection with the taxpayer's trade or business, and are such costs as those related to the...