In the case of Little Sandy Coal Co. Inc. v. Commissioner, the court held a taxpayer was not entitled to the R&D tax credit for activities related to the development of a tanker and a dry dock. The court determined the taxpayer’s activities failed to meet the “substantially all” test related to the process of experimentation. The “substantially all” test states that at least 80% of a taxpayer’s research must constitute elements of a process of experimentation for a project to qualify for the credit. This case highlights the court’s approach in calculating the percentage of activities that constitute elements of a process of experimentation and encourages taxpayers to consider the “shrink-back” rule when the overall project fails to meet the “substantially all” test under Section 41(d)(1)(C).
Corn Island Shipyard, Inc. (CIS) is a subsidiary of Little Sandy Coal Co., Inc. CIS claimed approximately $1.1 million in R&D tax credits related to the development of 11 vessels. The IRS and CIS agreed to treat two of these vessels, a tanker and dry dock, as representative of all vessels in regard to relevant issues. CIS argued that substantially all of the activities in developing the vessels constituted elements of a process of experimentation because more than 80% of the elements of each vessel differed from those vessels CIS had previously developed. One vessel was entirely new and the other was a significantly redesigned version of a predecessor. CIS also argued that the work of its production employees constructing novel elements of the redesigned vessel directly supported research and constituted elements of a process of experimentation.
The court held the following:
The US Court of Appeals for the Seventh Circuit issued its opinion regarding the case on March 7, 2023. The US Court of Appeals ultimately affirmed the tax court’s decision in favor of the IRS, but noted some aspects it did not agree with.
First and foremost, the US Court of Appeals asserted that direct supervision and direct support can be elements of a process of experimentation, thereby rejecting the tax court’s categorical exclusion of direct support and direct supervision from the numerator. This is a taxpayer friendly development as it makes it easier to meet the 80% process of experimentation threshold. The US Court of Appeals largely agreed with other aspects of the case. Notably, it emphasized the need for taxpayers to clearly illustrate how pilot models are used in the process of experimentation and the fine line between routine quality control testing and experimentation. The US Court of Appeals also reinforced the shrink-back rule by stating “by choosing an ‘all or nothing’ strategy, Taxpayer swung for the fences and missed” and that “other taxpayers seeking to avail themselves of the research tax credit would be well advised to document research activities for subcomponents if they cannot demonstrate a process of experimentation at the business component level.”
This case highlights the importance of demonstrating that 80% or more of the R&D activities constitute elements of a process of experimentation. The regulations provide an extensive definition of the process of experimentation criteria. The preamble to the regulations describes the process of experimentation as an evaluative process that should be capable of evaluating more than one alternative. The regulations exclude non-qualified activities, such as research relating to style, taste, cosmetic, or seasonal design factors, when explaining the “substantially all” criteria. The court determined that wages paid for direct supervision or direct support activities are not considered elements of a process of experimentation. While these wages could be qualified research expenses (QREs), they were detrimental in meeting the “substantially all” rule for experimentation. Notably, the code and regulations are silent as to whether direct supervision or direct support activities can constitute elements of a process of experimentation.
A thorough analysis of R&D projects should be undertaken to determine the applicability of the “shrink-back” rule. This is extremely important when examining R&D projects that have multiple large systems as subcomponents of the overall project. The “shrink-back” rule also highlights the value in defining what constitutes a qualified project when claiming R&D tax credits. While aggregating smaller R&D projects into one or a few large projects has the advantage of being more efficient and less documentation intensive, this strategy can be detrimental in substantiating a R&D tax credit.
Companies claiming R&D tax credits should be prepared to describe their development efforts, identify the process of experimentation, and illustrate that 80% or more of each qualified project constitute elements of a process of experimentation. Companies should consider the application of the shrink-back rule for projects where the overall business component does not as strongly satisfy the “substantially all” test for the process of experimentation.
Earnd can help you qualify projects and quantify how they meet the “substantially all” test as your company pursues R&D tax credits.