Executive summary:
Taxpayer failed to adequately document research for the federal research and development (R&D) credit.
- Arbitrary estimates of time performing R&D may not be enough to take the R&D credit.
- Substantiate, substantiate, substantiate if you want to claim an R&D credit.
- Taxpayers must adequately document that “substantially all” of the research activities constitute elements of a process of experimentation.
Appellate Court affirms Little Sandy
The US Court of Appeals for the Seventh Circuit affirmed a 2021 US Tax Court ruling, although it diverged from some of the Tax Court’s reasoning. In Little Sandy Coal Company, Inc. v. Commissioner, 7th Cir., No. 21-3145, March 7, 2023, the court ruled that the “[T]axpayer did not offer a principled way to determine what portion of the employee activities for each vessel constituted elements of a process of experimentation, much less research activities.”
Little Sandy Coal Company, Inc. is the parent of a shipbuilding company, Corn Island Shipyard, Inc., in southern Indiana. In 2014, the taxpayer claimed R&D tax credits related to activities performed for the design and construction of 11 first-in-class vessels – i.e., vessels it had never built before. For purposes of the trial, the parties agreed to treat two of the vessels – a tanker barge and a dry dock - as representatives of the eleven vessels.
In developing its decision, the court focused on the fourth part of the section 41 qualified research four-part test, that substantially all of the research activities must constitute elements of a process of experimentation. The court agreed with the tax court with regards to their evaluation of “substantially all” as a fraction, i.e., research activities that constitute elements of a process of experimentation divided by research activities not excluded under section 41(d)(4) and whose expenses are deductible under section 174.
The court also agreed that the tax court correctly rejected the “novelty argument”, i.e., that because the majority of the tanker and the dry dock were new, substantially all of the activities in designing the vessels constituted elements of a process of experimentation. Rather, the tax court recognized that “section 1.41-4(a)(6) … requires that the substantially all test be applied in reference to activities – not physical elements of the business components being developed or improved.”
However, the court diverges somewhat from the tax court in its analysis of pilot model production expenses and determined that the tax court “erroneously imported a distinction” from section 41(b)(2)(B) regarding qualified services into the numerator of the substantially all fraction in section 41(d)(1)(C). In evaluating alternative possibilities that the vessels were, or were not pilot models, the tax court categorically excluded model production wages from the numerator of the “substantially all” fraction, thus finding that the production activities could not be an element of a process of experimentation. The tax court went on to reason that pilot model production directly supported research activities but did “not have a close enough nexus to the testing to be considered qualified research in its own right.” While the court agreed with the conclusions of the tax court, it noted that section 41(b) and section 41(d) address different subjects, i.e., the former addresses qualified research expenses while the latter deals with qualified research activities.
Here the taxpayer went all in on the substantially all argument and failed to provide any documentation that would allow the court to determine R&D activity at less than the ship level. The court agreed that the taxpayer preformed some R&D, but that without adequate substantiation, taxpayers cannot avail themselves of the R&D credit.
The takeaway from the decision is that the IRS and the courts continue to highlight that taxpayers claiming research tax credits must adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation. Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time-performing experimentation are not enough.
