Business Component vs Sub-Business Components
What is a business component?
Under IRC §41(d)(2), a business component is any product, process, computer software, technique, formula, or invention that a company holds for sale, lease, or license, or uses in its own trade or business.
Why is this definition important?
The four-part test for qualified research must be met at the business component level. If your whole product does not qualify, this doesn’t necessarily mean that nothing will qualify. Instead, IRS regulations require that the four-part test be applied to the level at which substantially all the activities constitute elements of a process of experimentation. In other words, taxpayers who don’t meet the test for qualification at the product level, must break the activities down to the sub-project level. This is known as the “shrink-back” rule.
Taxpayers typically will want to document the activities at the sub-project level. Two federal court cases, Trinity Industries, Inc. v United States and Union Carbide Corp v Commissioner, show what happens when a company correctly defines business components vs. sub-business components but the documentation doesn’t support all of the qualifying activities, and what happens when the shrink-back definition is applied too broadly.
The bottom line.
How you define your business components and how you document the activities can make a significant difference between full credit, partial credit, or not receiving a credit.
The Definition of a Business Component Under IRC §41
The research and development tax credit is defined under IRC §41, and it defines a business component as any product, process, computer software, technique, formula, or invention that a taxpayer intends to hold for sale, lease, or license, or that the taxpayer uses in its own trade or business.
This definition is purposefully broad; it can cover a new SaaS platform, a improvement on a manufacturing process, a proprietary formula, or an internal software built to run operations, as well as a brand-new machine design.
IRC §41(d)(2)(c) adds an important limit to this: when a company is developing a product and the process used to manufacture said product in conjunction, the manufacturing process is treated as its own separate business component from the product itself. The production line built to make an existing product does not inherit the product’s qualification automatically, and vice versa. Each business component must be tested separately.
Under Treas. Reg. 1.41-(a), each business component claimed must independently meet every part of the research credit test as stated:
• Permitted Purpose: The activity must be intended to develop or improve the functionality, performance, reliability, or quality of a business component.
• Technological in Nature: The work must rely on engineering, physical or biological science, or computer science principles.
• Technical Uncertainty: The activity must be undertaken to discover information intended to eliminate uncertainty about the capability, method, or appropriate design of the business component.
• Process of Experimentation: Your team must have a process that evaluates alternatives through modeling, simulation, systematic trial and error, or other methods to eliminate uncertainty.
Many companies confuse this as it is easy to treat an entire product line or entire years’ worth of engineering work as one single business component, but the IRS regulations do not require it, and the IRS is not required to accept.
Why the Distinction Matters
Consider a company building a new piece of industrial equipment. The finished machine may include a novel cooling system, a redesigned control board, and conveyor mechanism that is off-the-shelf. If you try to claim the entire machine as a single business component, the IRS may decide that the conveyor portion may not qualify and could impact the “substantially all” analysis, which creates a risk of losing credits.
This is exactly why the regulations have a built-in mechanism to test smaller pieces separately, and that mechanism is called the shrinking-back rule from Treas. Reg. §1.41-4(b)(2). Instead of an “all or nothing” approach, a taxpayer who has documented costs and activities at a more granular level can isolate the parts of the project that meet the four-part test, even when the project as a whole would not qualify.
The Shrinking-Back Rule
The regulation states that the requirements of IRC §41(d) “are to be applied at the level of the discrete business component.” If the whole component does not satisfy the four-part test and specifically does not meet the substantially all standard requiring that 80 percent or more of the research activity constitute elements of a process of experimentation, the analysis does not stop and automatically disqualify the entire thing.
Instead, the rule requires narrowing to the most significant subset of elements of the business components. If that subset also is not qualified, you narrow again, to the next most significant subset, and continue the process until you either find a subset that satisfies the requirements, or you reach the most basic element of the product, and that element still fails.
Important to note on how this works in practice:
- The rule helps you. Treas. Reg. §1.41-4(b)(2) states that shrinking back is not itself a reason to exclude activities.
- It requires data you have to have created in advance. The rule assumes the underlying records already separate the pieces of the project.
- A sub-business component must independently meet all four parts of the test regardless of the narrowing of the scope.
Relevant Cases
Two federal cases illustrate how this plays out when a claim is litigated.
In Trinity Industries, Inc. v United States, No. 12-11012 (5th Cir. 2014), the taxpayer claimed research credits for the design and construction of several first-in-class marine vessels. The case addressed, among other things, how a vessel could be treated as a business component as well as how the shrinking-back rule could be applied when an entire business component did not satisfy the requirements of IRC §41(d).
The district court found that Trinity had an “all or nothing” approach and had not provided evidence of its expenses at the subcomponent level, and some of the records had also been destroyed by Hurricane Katrina. As a result, when certain vessels failed the process of experimentation at the whole-vessel level, the court could not apply the shrinking-back rule of smaller portions of those vessels.
In Union Carbide Corp. v Commissioner, No. 11-2552 (2nd Cir. 2012), Union Carbide had conducted research projects that the Tax Court found to be qualified research, but the company sought to claim the costs of all supplies used in the related manufacturing processes, including the supplies it would have purchased and consumed regardless of the research. The Second Circuit held that those costs were not credible because the supplies were not used in the conduct of research, and that they were, at most, indirect research expenditures.
Read together, the cases point to similar lessons from different directions. Trinity demonstrates the importance of maintaining sufficiently granular records to identify and quantify qualifying research when a larger business component does not qualify in its entirety. Union Carbide demonstrates that even when the research itself qualifies, not every expense associated automatically becomes a qualified research expense. The underlying activity and specific costs must both satisfy the requirements of §41.
What This Means for Your R&D Tax Credit Claim
If your company is performing research and development that may qualify for the credit, the business component question is not a technicality. A few practical takeaways:
- Track costs and activities by component as well as by project. If a project has multiple distinct pieces, wages, supplies, cloud computing, and contract research costs should be identifiable at each level, not only as a project whole.
- Document the “why” as well as the “what.” The uncertainty the taxpayer was trying to resolve, the alternatives evaluated, and how they were tested are all important.
- Separate product development from process development. If you’re creating or improving the process used to manufacture a product, treat that process as its own business component.
- Don’t wait until filing season to start sorting through your documentation. The shrinking-back rule, and the R&D tax credit in general, requires a diligent eye, and it may require more than a few days.
To Sum Up
What is a business component under the R&D tax credit rules?
A business component is defined as any product, process, computer software, technique, formula, or invention that a company holds for sale, lease, or license, or uses in its own trade or business.
Does my entire product have to qualify?
No. The four-part test can be applied to the whole product, or, if the project doesn’t qualify as a whole, to smaller sub-business components under the shrinking-back rule.
What happens if only parts of my product qualify as research?
If you have cost and activity records broken out at a more granular level, you may be able to claim the credit for the qualifying sub-component even if the overall product doesn’t clear the “substantially all” threshold.
Can the IRS us the shrinking-back rule to deny my claim?
In short: no. The regulation states that it is not in itself a basis for excluding research activities but instead is a mechanism that can work in the taxpayers favor, if properly supported.
Are the manufacturing process and the product itself treated as the same business component?
No. Under IRC §41(d)(2)(c), a manufacturing or product process is treated as its own separate business component from the product it produces, and that both process and resulting product must independently meet the four-part test.
What RK Partners Can Do For Your Business
The business component question is one that we encounter often, and it’s important to understand it so that a credit study is properly compiled. If it is misunderstood, there is a risk of the credit to lose value.
RK Partners works with founders, CFOs, and CPAs to identify business components and sub-business components correctly from the start and build the documentation that will hold up to IRS scrutiny should the need arise. Our team of tax attorneys, engineers, CPAs and consultants have deep experience building and defending R&D tax credit claims, and we handle the heavy lifting so that your team’s time and investment stay as minimized as possible.
If you’re doing product development, software development, or process improvement work and want to know whether your business components are structured to capture the full credit you’re entitled to, we’re here to talk it through, risk-free.
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