What is a Pilot Model, and Why Does it Matter for Your R&D Tax Credit Claim?
Most business owners likely don’t think of a prototype as a tax deduction or credit. Under federal tax law, however, the physical object built by your team to test whether something will work carries real tax significance. If your business builds, tests, or iterates on products or equipment during development, you may be producing a pilot model as defined by the IRS, and the costs associated with that work may qualify for the research and development (R&D) tax credit under IRC §41.
The Treasury Department Definition
The term comes from Treas. Reg. §1.174-2(a)(4), which 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."
The regulation specifies that the term includes a fully functional representation or model of the product, or a model of the component of the product.
A few things stand out in the language:
1. A pilot model doesn’t have to be a scaled-down or simplified version. A full-size, operational unit built for the purpose of resolving technical uncertainty is a pilot model.
2. The model can represent the whole product or one component of it. If your team is trying to resolve uncertainty about a specific part of a system, the costs tied to building and testing that component may qualify even if the rest of the product is already established.
3. The finalized product for commercial sale will not qualify. Once technical uncertainty has been resolved and activities transition into routine commercial production, the costs of manufacturing additional units generally are not qualified research expenses.
The pilot model definition in §1.174-2(a)(4) is the same definition the IRS uses in its Large Business & International Directive guidance for taxpayers following ASC 730 accounting. The IRS defines a prototype, or pilot model, as any representation or model produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product.
How Pilot Model Costs Connect to IRC §41
IRC §41 provides a credit for increasing research activities. To calculate the credit, a business identifies its qualified research expenses (QREs) which, under IRC §41(b)(2)(A) include wages paid for qualified services, amounts paid for supplies used in the conduct of qualified research, and certain computer rental amounts.
The supplies category is where pilot models come in. Treas. Reg. §1.41-2(b)(1) provides that supplies are used in the conduct of qualified research if they are used in the performance of qualified services by an employee of the taxpayer. Materials consumed in building or testing a pilot model typically meet this standard, provided the research activity itself passes the four-part test under §41(d).
The linkage between §174 and §41 is direct. Under §41(d)(1)(A), one of the requirements for an activity to constitute qualified research is that expenditures for that activity must be eligible to be treated as expenses under §174. The pilot model regulation under §1.174-2(a)(4) is therefore not a separate concept sitting off to the side. It is part of the eligibility chain that runs from the physical work your team is doing all the way through to your credit calculation.
§41 also confirms that supplies used in research must be used in the performance of qualified services. Indirect expenditures and general and administrative expenses do not qualify.
The Line Between Qualifying and Non-Qualifying Costs
The regulations draw a line between pilot model costs and production costs. Treas. Reg. §1.174-2(a)(2) provides that costs paid or incurred in in the production of a product after the elimination of uncertainty concerning the development or improvement of the product are not eligible under IRC §174, and by extension, will not qualify under §41.
A practical example: a custom machine builder produces a model to evaluate and resolve uncertainty about a new design. The costs of producing and testing that model qualify, but once the proper design is established and the company builds the final machine for sale to the consumer, those production costs do not qualify.
The same regulation notes that the ultimate success, failure, sale, or use of the product will not be relevant to eligibility, but a failed a prototype that was still aimed at resolving uncertainty as part of the research will still qualify. What matters most is the nature of the activity, not whether or not it succeeded.
The regulation also addresses situations in which a defect surfaces after initial production is complete. If a component fails during quality control testing because of a design problem and the company incurs additional costs to retest that component, the redesign costs may qualify as a new pilot model. The reconfigured component is treated as a separate pilot model to the extent it is produced to evaluate and resolve the newly identified uncertainty.
What Qualifies as a Pilot Model
The pilot model concept is not limited a specific industry. The statutory language under Tres. Reg. §1.174-2(a)(3) refers to any pilot model, process, formula, invention, technique, or similar properly, which encompasses a wide range of industries and activities.
In practice, pilot model costs appear in a variety of contexts:
- A manufacturer builds a one-off unit of a new custom machine to test whether the design integrates the required features before committing to full production.
- A food and beverage company produces trial batches of a new formulation to evaluate stability, safety, and performance under different conditions.
- An agriculture operation uses separate animal groups or crop plots to test and compare new protocols, where the test animals or crops themselves serve as the physical substrate of the experiment.
- A medical device company produces functional prototypes of a new device to test performance and safety prior to regulatory submission.
- A boat builder constructs a test hull or component assembly to evaluate new materials or structural designs before moving to a production run.
What links these together is that the physical thing being built or used was built or used to answer a question. The moment that purpose shifts from evaluating alternatives to the moment commercial production begins, which is when the business component is developed to the point where it meets its basic functional and economic requirements, and is ready to be produced or used in the intended format.
The George v. Commissioner case confirmed this principle in an agricultural context. The Tax Court upheld the company’s feed costs as qualified supply expenses, treating the test animals as pilot models, with the logic being the same as the machine builder example in the regulations: the experimental animals were the physical model being used to evaluate and resolve uncertainty about health, growth, and performance outcomes. The concept travels across industries because it is rooted in what the work is trying to accomplish, not the sector in which the work is happening.
The Four-Part Test Still Applies
Having a pilot model doesn’t mean that the associated costs automatically qualify for the credit. The underlying research activity must still pass the four-part test under IRC §41(d)(1):
• Permitted Purpose: The activity must be aimed at developing or improving a product or process.
• Technological in Nature: The work must rely on engineering, physical or biological science, or computer science principles.
• Technical Uncertainty: The activity must involve a genuine technical uncertainty about whether the developers are capable or do not know the best method to achieve a goal.
• Process of Experimentation: Your team must have a process that is capable of testing alternatives evaluating approaches.
The pilot model analysis addresses the supplies piece of the QRE calculation, but the activity producing or using that pilot model still needs to qualify as research. A business building prototypes purely for cosmetic purposes, a customer’s styling preference, or as a part of routine quality control inspection of finished good does not have qualified research simply because it produced a physical model.
Treas. Reg. §1.41-4(c)(10) expressly excludes from qualified research activities related to “style, taste, cosmetic, or seasonal factors.” The exclusion for routine testing or inspection of materials or products for quality control is also codified in Treas. Reg. §1.174-2(a)(3).
Documentation
While documentation doesn’t need to be overly-scientific, claiming the R&D tax credit does require support for your activities.
For pilot model costs specifically, records can include:
- A clear description of what uncertainty the model was built to resolve. What did your team not know, and what were they trying to discover?
- Documentation of the pilot model usage, distinguishing between research phase vs. the transition to production use.
- Invoices, purchase orders, or cost records for materials consumed in building and/or testing the pilot model.
- Records of who worked on the pilot model and in what capacity, distinguishing between typical administrative work vs. work on the research.
- Test results, data, observations, or conclusions drawn from the model testing.
The IRS expects records that will show that your business was actively attempting to solve an uncertainty, and the records submitted for the claim will need to defend those associated costs.
What RK Partners Can Do
Identifying pilot models costs as a part of your R&D tax credit claim requires a keen eye that is trained to find the facts and compile documentation that can hold up to IRS scrutiny.
This might seem daunting, but at RK Partners, we work exclusively with R&D tax credits, nothing else, which means that we are dedicated to conducting interviews, reviewing records, and preparing analysis. We take all the heavy lifting off your employees and make sure that we gather the pertinent information and hand your CPA a defensible claim to file alongside your taxes.
If your team builds, tests, or iterates on products, processes, or equipment and you are not currently claiming the R&D tax credit, or you are, but you’re unsure if you’ve specifically analyzed your pilot model costs, contact us for a consultation. The initial conversation is risk-free and could prove to be a very lucrative step forward in capturing R&D tax credits for your company.
