                       T.C. Memo. 2001-66



                     UNITED STATES TAX COURT



          NICHOLAS E. EUSTACE, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 21088-96, 21149-96,        Filed March 20, 2001.
                 21150-96, 21167-96,
                 21168-96, 21177-96,
                 21400-96.



     Gary J. Fernandez and Mark A. Camasta, for petitioners.

     William T. Derick and Catherine M. Thayer, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION

     1
      Cases of the following petitioners are consolidated
herewith: Estate of Thomas A. Eustace, Deceased, Vicky Eustace,
Executor, docket Nos. 21149-96 and 21177-96; Estate of Thomas A.
Eustace, Deceased, Vicky Eustace, Independent Administrator and
Vicky Eustace, docket No. 21150-96; Michael T. Eustace, docket
No. 21167-96; Steven A. and Michelle L. Dye, docket No. 21168-96;
and Robert R. and Elsa M. Eustace, docket No. 21400-96.
                                  - 2 -


     FOLEY, Judge:     By notices dated July 2, 1996, respondent

determined deficiencies and additions to petitioners’ Federal

income taxes as follows:
                Nicholas Eustace, docket No. 21088-96
                          Year      Deficiency

                          1992       $3,239

 Estate of Thomas A. Eustace, Deceased, Vicky Eustace, Executor,
                docket Nos. 21149-96 and 21177-96

         Year        Deficiency      Sec. 6662(a) Addition

          1990         $71,505                $14,301
          1991             588                   --

     Estate of Thomas A. Eustace, Deceased, Vicky Eustace,
Independent Administrator and Vicky Eustace, docket No. 21150-96

                          Year      Deficiency

                          1991        $721

                Michael T. Eustace, docket No. 21167-96

                          Year      Deficiency

                          1992        $3,346

       Steven A. and Michelle L. Dye, docket No. 21168-96

         Year       Deficiency      Sec. 6651(a)(1) Addition

         1992        $3,388                      $147

       Robert R. and Elsa M. Eustace, docket No. 21400-96

           Year      Deficiency      Sec. 6662(a) Addition
          1990       $219,475               $43,895
          1991         44,685                 7,850
          1992        207,428                41,486
                                - 3 -

Unless otherwise indicated, all section references are to the

Internal Revenue Code for the years in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

After concessions, the issue is whether petitioners are entitled

to the section 41 research credit.

                          FINDINGS OF FACT

     When the petitions were filed, each petitioner or

petitioner’s representative resided in Illinois or Indiana.

Petitioners were the shareholders of Applied Systems, Inc.

(Applied Systems), an S corporation founded, in 1980, to produce

computer software for independent insurance agencies.

     Applied Systems had five departments:    Programming (i.e.,

product development), customer services, sales, marketing, and

operations.    The programming department had four groups, each

headed by a vice president:    The Agency Manager (TAM),

Forms/Interface Module (FIM), rating module, and advanced

engineering.    Of Applied Systems’ 450 employees, 26 worked on the

TAM module, 25 on FIM, and 131 on the rating module.    Petitioners

claim that Applied Systems paid its employees $2,139,888,

$2,363,089, and $3,694,097 of wages relating to the research

credit during 1990, 1991, and 1992, respectively.

     Applied Systems produced software for processing client and

insurance policy information, invoices, insurance claims,

standard insurance forms, word processing, marketing, and
                                - 4 -

accounting.    Some of the software calculated premiums (i.e.,

rated policies) and transmitted data between independent agencies

and insurance companies (i.e., carriers).

I.   TAM

      In 1983, Applied Systems released the first version of TAM,

a program designed to automate the day-to-day functions of

independent agencies.    Applied Systems sold TAM directly to such

agencies.    TAM consisted of three modules:   The TAM module, FIM,

and First Rate (i.e., rating module).    During the years in issue,

Applied Systems sold the TAM and FIM modules together as one

product and sold First Rate separately.    The software ran on IBM-

compatible personal computers (PC’s) and local area networks

(LAN’s).

      A.   TAM Module

      Applied Systems released the first version (i.e., series) of

the TAM module in 1983 and the second and third series by 1989.

The TAM module enabled an agency to search for prospective

clients whose data matched certain criteria, draft personalized

sales letters, generate followup reports, dial telephone numbers,

track appointments, access First Rate (i.e., to calculate

premiums), access FIM (i.e., to fill out forms), process

insurance applications, track policy issuance, enter changes and

claims, run marketing analysis reports, and process renewals.
                                  - 5 -

     In January 1990, Applied Systems released TAM 4.0 for a

beta-test (i.e., during which agencies used the software in a

working environment to identify problems not discovered during

in-house testing).   In September 1990, Applied Systems began to

develop TAM 4.1, a series for large agencies.     In 1991, Applied

Systems beta-tested TAM 4.1.    Throughout 1992, Applied Systems

debugged TAM 4.1 and worked on TAM 5.0.     In October 1992, Applied

Systems decided to make TAM 4.1 its main product and adjust it

for small agencies by deactivating certain features.

     Applied Systems made 190 modifications to the TAM module in

converting Series 4.0 to 5.0.     During the years in issue, the

modifications to the TAM module included the following.

          1.   Rounding Numbers

     Applied Systems’ clients identified rounding errors in the

calculation of money amounts.     Programmers traced the errors to

extra decimal places in the compiler program.

          2.   Locking Transactions

     Applied Systems programmed the TAM module for “locking”

(i.e., allowing more than one user at a time to conduct

transactions with a particular file).

          3.   Expanding Representation

     Programmers expanded the representation on each byte of

memory from 9 to 32 objects (e.g., agencies, branches, or
                                  - 6 -

departments), increasing the software’s ability to satisfy the

needs of larger client agencies.

           4.   Managing Memory

     Programmers, using software purchased from a third-party

vendor, increased the memory available to run the TAM module by

transferring some memory contents to disk.

           5.   Multitasking

     Programmers, using software purchased from a third-party

vendor, implemented a function, called “Big Interrupt”, that

allowed users to perform multiple tasks at one time.

           6.   Indexing

     Programmers, using software purchased from a third-party

vendor, developed indexes to locate data in data bases.

     B.   FIM Module

     In 1986, Applied Systems released the first series of FIM.

FIM used Agency/Company Organization for Research and Development

(ACORD), (i.e., an insurance industry association) standards to

print forms and transmit data to carriers.    FIM automatically

inserted into a form any relevant data from existing client and

policy data bases.     FIM enabled an agency to send (i.e., upload)

forms, and the data thereon, to carriers through an electronic

interface.   FIM supported single-entry multicompany interface

(SEMCI), which allowed an agency to enter data only once and send

it to multiple carriers.    By 1989, FIM could also receive (i.e.,
                                 - 7 -

download) data, such as insurance policies.    During the years in

issue, Applied Systems integrated FIM with the TAM module by

structuring data bases, configuring data, and formatting data and

characters for printing.    Applied Systems made 55 modifications

to FIM in converting Series 4.0 to 5.0.

     C.   First Rate Module

     Prior to the years in issue, the rating module enabled

agents to rate personal insurance policies in a dozen States.      In

late 1988, Applied Systems purchased Alpha Touch, a rating vendor

based in Bloomington, Minnesota.    Alpha Touch had software that

could calculate premiums relating to personal insurance written

in the Midwestern States.     Applied Systems used the Alpha Touch

software to expand First Rate, enabling the module to calculate

premiums relating to more carriers, all 50 States, and

commercial, as well as personal, insurance.

     During the years in issue, Applied Systems’ employees

created programs applicable to carriers not already included in

First Rate.   The employees referred to State regulations and

carrier manuals to determine the required data elements and the

rating formulas.   At the end of 1990, Applied Systems began work

on rating programs applicable to commercial insurance.

Commercial insurance rating involved more types of insurance

coverage than personal insurance.    From 1990 through 1992,

Applied Systems created approximately 3,000 programs.    Applied
                                  - 8 -

Systems regularly updated each program to reflect rating formula

modifications each carrier made at least once a year.

     D.   Other Projects

     During the years in issue, Applied Systems also worked on

data conversion, Independence, WinTAM, Diamond, and

evaluations/R&D.

           1.   Data Conversion

     From 1990 through 1992, Applied Systems offered an

electronic data conversion service to agencies switching from

another automation system to the TAM module.       This service

allowed agencies to use the data from their old systems without

manually reentering the data into the TAM module.       In a typical

data conversion, Applied Systems would take the data off the old

system, put it on a PC, create a program to transfer the data to

data base files needed for the TAM module, and run the program to

transfer the data.    In an average week, Applied Systems was

converting, in 1990, four systems; in 1991, seven systems; and in

1992, nine systems.

           2.   Independence

     In 1991, Applied Systems purchased Liberty and Leader

Systems (i.e., automation vendors that were subsidiaries of

carriers) and began the Independence project to integrate the

software of these systems with FIM.       As a result of the

acquisition, Applied Systems added to its user base the customers
                                 - 9 -

of Liberty and Leader, based in Georgia and Indiana,

respectively.   These new customers could convert to the TAM

module or retain their existing software, which required

integration with FIM.     The computer language of Liberty and

Leader (i.e., COBOL) was different from that of FIM (i.e., C).

Independence involved figuring out how to run FIM with, and pass

data to and from, the acquired systems.

          3.    WinTAM

     In 1992, one of Applied Systems’ competitors announced that

it would release a Microsoft Windows version of its software by

the year’s end.   In response, Applied Systems formed a group of

employees to develop a version of the TAM module for use in the

Windows environment (i.e., WinTAM).      Applied Systems decided to

keep the TAM module in the old Disk Operating System (DOS)

environment, but put it in a Windows format.     This decision

allowed Applied Systems to bring a Windows version to market

before completing the product development.     In September 1992,

Applied Systems demonstrated an early version of WinTAM at an

annual insurance industry convention.

          4.    Diamond

     In the latter part of 1992, Applied Systems started to

design an automation system, called Diamond, to serve large

carriers (i.e., while the TAM module served independent
                                   - 10 -

agencies).    Diamond would manage and update policies to reflect

customer transactions.

            5.   Evaluations/R&D

      Applied Systems’ evaluations/R&D work consisted of

evaluating and developing, by the creation of short routines,

compatibility between TAM and third–party hardware and software

products.

II.   Credit Claimed

      On its 1990, 1991, and 1992 tax returns (i.e., Forms 1120S,

U.S. Income Tax Returns for an S Corporation), Applied Systems

did not claim any research credit.          On December 30, 1993, Applied

Systems hired a new tax manager, who determined that Applied

Systems should claim research credits relating to the years in

issue.   The tax manager interviewed employees and delineated the

employees and activities that he believed qualified for the

research credit.    On June 24, 1994, and August 30, 1995, Applied

Systems submitted amended returns, relating to the 3 years in

issue, to claim the respective research credit “that was

erroneously omitted from the original filing of the Form 1120S.”

On the amended returns, Applied Systems claimed research credits

of $235,536, $127,426, and $289,449, relating to the wages of 227

employees in 1990, 1991, and 1992, respectively.         Petitioners,

pursuant to amended pleadings filed in April 1997, added the

wages of 21 employees (i.e., $635,371) to their claim.
                                - 11 -

                                OPINION

I.   Definition of Qualified Research

      Pursuant to section 41(d)(1), “qualified research” must

meet, in pertinent part, the discovery and process of

experimentation tests.

      A.   The Discovery Test

      Qualified research must be undertaken for the purpose of

discovering information which is technological in nature.    Sec.

41(d)(1)(B)(i).    In this case, “qualified research” is research

that is undertaken to discover information that goes beyond the

current state of knowledge in the computer science field.    Sec.

41(d)(1)(B); United Stationers, Inc. v. United States, 163 F.3d

440, 444 (7th Cir. 1998); Norwest Corp. v. Commissioner, 110 T.C.

454, 493 (1998).    In the context of section 41(d)(1)(B)(i),

“discovery demands something more than mere superficial newness;

it connotes innovation in underlying principle.”    United

Stationers, Inc. v. United States, supra at 444.

      B.   The Process of Experimentation Test

      Substantially all of the activities of qualified research

must constitute elements of a process of experimentation for a

purpose that relates to a new or improved function, performance,

reliability or quality.    Sec. 41(d)(1)(C), (d)(3)(A).   In section

41(d)(1)(C), “substantially all” means at least 80 percent of the

activities that constitute a process of experimentation.     Norwest
                              - 12 -

Corp. v. Commissioner, supra at 497; sec. 1.41-2(d)(2), Income

Tax Regs.   A “process of experimentation involves something more

than simply debugging a computer program.”     United Stationers,

Inc. v. United States, supra at 445.     In this case, “qualified

research” consists of activities at least 80 percent of which

constitute a process of experimentation aimed at eliminating

uncertainty about the technical ability to develop software.      See

sec. 41(d)(1)(C); Norwest Corp. v. Commissioner, supra at 496-

497; sec. 1.41-2(d)(2), Income Tax Regs.

II.   Parties’ Contentions

      Respondent contends that Applied Systems did not conduct

“qualified research” because its employees did not undertake

research to discover information that is technological in nature,

and substantially all of the employees’ research activities did

not constitute elements of a process of experimentation.

Petitioners contend that the section 41(d) definition of

“qualified research” requires “only that there be significant

programming changes to software”.   Petitioners further contend

that Applied Systems’ work meets the requirements of the

discovery test, because “All computer programming relies on

computer science principals [sic]”, and the process of

experimentation test, because employees did “consider

alternatives when adding additional functionality to the

Petitioner’s [sic] computer programs.”
                                - 13 -

III.   Analysis

       We note at the outset that petitioners’ reconstruction of

qualifying expenses was unreliable, inaccurate, incomplete, and

wholly insufficient to establish what various workers did and

whether such expenses qualify for the research credit.      In

addition, petitioners failed to have their computer expert

address technical issues relevant to the case, and, as noted

below, the testimony of petitioners’ witnesses further supports

our conclusion that work performed by Applied Systems’ employees,

during the years in issue, does not qualify for the research

credit.

       A.   TAM

       Most of the product development of the TAM module occurred

during 1980 through 1989.     In describing a “sophisticated

approach” that Applied Systems had “invented” and used in the TAM

module, petitioners’ programmer testified:      “This would have been

in the ‘80s.”     During the years in issue, employees merely

updated the TAM module.     Solutions to problems of rounding

numbers, locking transactions, and expanding representation were

commonly known in the computer science field and did not present

significant programming challenges.      Applied Systems’ purchase

and use of third-party software to facilitate managing memory,

multitasking, and indexing tasks indicates that these techniques

were also known in the computer science field.      Petitioners’
                               - 14 -

programmer testified that he “could immediately know whether

something could be made to work or whether it just wouldn’t

work.”

     Applied Systems’ employees performed the following tasks

relating to FIM:    Establishing the capability to display business

forms, enter data into their blank fields, integrate the data

with a data base, and print standard forms.   All these tasks were

feasible before 1990.   Similarly, employees working on First Rate

converted State regulations and carrier formulas into programs.

This task is part of the normal skilled practice of software

development and does not advance or refine any principles of

computer science.   Petitioners’ computer expert testified,

relating to the expansion of the rating module:   “It’s hard for

me to think about writing each of those programs as constituting

research.”   Applied Systems’ vice president in charge of First

Rate testified:    “Really from 1990 to ‘92 there were minor

enhancements, modifications to make things easier.    There weren’t

a lot of major changes.”

     In essence, these tasks did not go beyond the current state

of knowledge in the computer science field and did not involve a

process of experimentation.

     B.   Other Projects

     Petitioners contend that work on data conversion,

Independence, WinTAM, and Diamond qualifies for the research
                                - 15 -

credit.   We disagree.   Data conversion is commonly provided by

software vendors.    There was no technical uncertainty, for

example, that a COBOL program could be rewritten in C, and, by

1990, the principles for converting software from DOS to Windows

had been published.    Petitioners’ programmer testified that,

during the years in issue, Applied Systems did not fundamentally

convert the TAM module from DOS, but, as “a simple plan we could

do fast”, merely put the TAM module in a Windows format, so “we

could start demonstrating something under Windows more quickly”.

Applied Systems’ vice president testified, relating to Diamond,

that employees were “trying to figure out what the product was

supposed to do”, but “weren’t doing any coding” (i.e.,

programming), during the years in issue.     Petitioners presented

insufficient evidence relating to evaluations/R&D and failed to

address this issue on brief.

IV.   Conclusion

      Petitioners fell woefully short of presenting sufficient

evidence to establish, as required by section 41, that Applied

Systems’ activities met the requirements for the research credit.

Applied Systems did not undertake research to discover

information beyond the current state of knowledge in the computer

science field.     Nor did Applied Systems conduct a process of

experimentation aimed at eliminating uncertainty about the

technical ability to develop the software.
                                - 16 -

     Although the TAM module, FIM, First Rate, Diamond, etc. do

not meet the requirements of section 41(d)(1), the research

credit may, nevertheless, be applicable to the most significant

set of elements of these products in relation to which all the

requirements are met.   See H. Conf. Rept. 99-841 (Vol. II), at

II-72 to II-73 (1986), 1986-3    C.B. (Vol. 4) 1, 72-73.

Petitioners acknowledge that they do not have

     the substantiation necessary to tie salaries to
     activities at the subcomponent level, * * * . However,
     the Cohen [sic] rule would apply in this circumstance,
     and the Court would be required to make a reasonable
     allocation of salaries to functionality.

The rule of Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir.

1930), does not require the Court, in this case, to make such an

allocation, and we decline to do so.     Accordingly, respondent’s

determinations are sustained.

     Contentions we have not addressed are moot, irrelevant, or

meritless.

     To reflect the foregoing,



                                           Decisions will be entered

                                     under Rule 155.
