Research conducted after the beginning of commercial production of a business component is not qualified research for the federal research credit (section 41(d)(4)(A)). Treas. Reg. 1.41-4(c)(2) places that point where the component is ready for commercial sale or use, or meets the taxpayer’s basic functional and economic requirements, and treats trial production runs, tooling-up, troubleshooting and similar work as falling after it. The exclusion applies separately to a product and to its production process, so process research can still qualify after the product is settled if the process work qualifies on its own and is done before the process meets its own requirements.
This exclusion is one of eight; our guide to what does not qualify for the R&D tax credit covers the others, and the four-part test still has to be met for work before the line.
When Commercial Production Begins
The regulation gives two triggers. Activities fall after the beginning of commercial production if they are conducted after the component “is developed to the point where it is ready for commercial sale or use, or meets the basic functional and economic requirements of the taxpayer for the component’s sale or use” (Treas. Reg. 1.41-4(c)(2)(i)).
Six activities are deemed to fall after that point. Paragraph (c)(2)(ii) lists preproduction planning for a finished business component, tooling-up for production, trial production runs, troubleshooting involving detecting faults in production equipment or processes, accumulating data relating to production processes, and debugging flaws in a business component.
The regulation’s tire example shows the split. In Example 1 of Treas. Reg. 1.41-4(c)(10), a tire manufacturer designs a new type of belt for its tread cooling equipment and tests several designs until one meets its requirements. The design research may be qualified research. The costs to manufacture, install and test the belts after they met the company’s functional and economic requirements are excluded as research after commercial production.
A new version is a new start. In Example 2, a company that has sold a widget for several years starts a project to develop a new or improved widget; the regulation treats it as a new business component, not research after commercial production. Whether a change is a new component or debugging of the existing one depends on the facts.
Pilot Models and Pilot Plants
A pilot model sits on the research side. Treas. Reg. 1.174-2(a)(4) defines a pilot model as “any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product,” including a fully-functional representation. Building and testing one to resolve design uncertainty is development work, and it can be qualified research if the four-part test is met.
Section 174 draws its line in a different place. Treas. Reg. 1.174-2(a)(1) states that costs “may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated.” The credit uses the commercial production test instead, so a cost can be a research expenditure for the deduction and still fall outside the credit.
Pilot plants follow similar logic, with one caution. Under Treas. Reg. 1.174-2(a)(3), a “product” includes a process, so a pilot line built to evaluate and resolve uncertainty about a production process can be read as a pilot model of that process. Its equipment is generally depreciable property, which is not a supply for the credit; under Treas. Reg. 1.174-2(b)(1) its cost is not a research expenditure, although depreciation is to the extent of research use. Our article on supplies and prototype costs covers scrapped, sold and retained prototypes.
Product and Process: Two Separate Clocks
The process is its own business component. Section 41(d)(2)(C) treats any plant process, machinery or technique for commercial production as a separate business component, not part of the product being produced. Treas. Reg. 1.41-4(b)(1) tests process activities without taking product activities into account, and the reverse.
The exclusion applies to each separately. Under Treas. Reg. 1.41-4(c)(2)(iii), “even after a product meets the taxpayer’s basic functional and economic requirements,” process development may still be qualified research if the process separately meets the requirements and the work is done before the process meets those requirements or is ready for commercial use. A product can therefore be in commercial production while its manufacturing process is still being researched. Our article on manufacturing process improvement applies the four-part test to that process work.
Trial runs sit where the two rules meet. The six deemed activities are listed in relation to the business component, while paragraph (c)(2)(iii) applies the exclusion separately to product and process. Whether a trial production run for the product can also be an experiment on a process still in development depends on the facts and on how the two paragraphs are read together; review that position with your tax adviser.
Supplies in production runs raise a second question. In Union Carbide Corp. v. Commissioner (2d Cir. 2012), the research ran on production processes making products for sale, and the company claimed the supplies used in production. The court held that supplies that “would have been used in the course of” the manufacturing process “regardless of any research performed” are not creditable, relying on the phrase “used in the conduct of qualified research” in section 41(b)(2)(A)(ii), the process and product division in section 41(d)(2)(C) and deference to the Commissioner’s reading of Treas. Reg. 1.41-2(b). It did not rest on the commercial production exclusion. For a run on a live line, the first question is whether the process work comes before the process’s own commercial production point; the second is which materials the research used beyond what production would have consumed.
Activities and Their Usual Treatment
Each activity turns on its facts; the table shows general tendencies.
| Activity | Usual treatment |
| Building and testing a pilot model | Generally before the line; four-part test applies |
| Preproduction planning, tooling-up, trial runs | Deemed after commercial production |
| Troubleshooting, production data, debugging | Deemed after commercial production |
| Process development before the process is ready | Not excluded just because the product is ready |
| New or improved version of the product | New business component |
| Materials production would have used anyway | Not creditable (Union Carbide) |
Documenting the Transition at Scale-Up
Record a date for each component. Treas. Reg. 1.41-4(d) sets the recordkeeping rules for the credit. For this exclusion, the useful record is a dated note of when the product met its requirements and a separate one for the process, such as a design release, a customer qualification or an internal sign-off, tied to the specification it satisfied. Work after the process date, such as tooling-up and debugging, falls on the excluded side.
Show the uncertainty that remained at scale-up. Where process work continues past the product’s release, the file should state what was still unknown at production volume (for example, whether a target yield, tolerance or cycle time could be held), the alternatives evaluated and the results. Run logs that separate experimental runs from trial production runs, and material records that separate what an experiment consumed from what production would have used, address both the exclusion and Union Carbide.
Our page on R&D tax credits for manufacturers covers prototypes, processes and materials. To see how the exclusion applies to your own projects, request a no-cost analysis from CSSI Services.
Frequently Asked Questions
What is the commercial production exclusion for the R&D credit?
It is the rule in section 41(d)(4)(A) that research conducted after the beginning of commercial production of a business component is not qualified research. Under Treas. Reg. 1.41-4(c)(2), that point comes when the component is ready for commercial sale or use or meets the taxpayer’s basic functional and economic requirements.
Do trial production runs qualify for the R&D credit?
The regulation deems trial production runs, tooling-up, troubleshooting and debugging to occur after commercial production of a business component, so they are generally excluded. Whether a run can also be an experiment on a process still in development depends on the facts, because the exclusion applies separately to product and process.
Can process research qualify after the product is in production?
It can. Treas. Reg. 1.41-4(c)(2)(iii) allows process development after the product meets the taxpayer’s requirements, if the process work separately meets the requirements for qualified research and is done before the process itself meets the taxpayer’s basic functional and economic requirements or is ready for commercial use.
Is building a pilot model research or production?
A pilot model built to evaluate and resolve uncertainty during development is generally on the research side, and its costs can count if the four-part test is met. Units produced after the design meets the company’s requirements are production.
Are materials consumed in a production-line trial qualified supplies?
They count only to the extent they were used in the conduct of qualified research. In Union Carbide, the Second Circuit held that supplies that would have been used in the manufacturing process regardless of the research are not creditable.
This article provides general information about federal tax rules and is not tax advice. Speak with your tax adviser about your specific circumstances.
