R&D tax credit: Little Sandy Coal opinion clarifies “substantially all” test

A March 2023 opinion from the U.S. Court of Appeals for the Seventh Circuit provides important taxpayer-friendly elements, while affirming the lower court’s denial of a research and development (R&D) tax credit. The appellate court’s opinion in Little Sandy Coal v. Commissioner upholds the tax court’s ruling that the taxpayer failed to prove which employee activities constituted research activities. However, it also opined as to how to properly calculate and apply the “substantially all” test, a particularly contentious issue between the IRS and taxpayers during recent examinations of R&D credits.

How Little Sandy Coal failed to properly claim the R&D tax credit

The taxpayer, a shipbuilding company, claimed the R&D tax credit for qualified research expenses attributable to the design and construction of 11 new vessel types that it had never built before. After reviewing documentation for two of the 11 vessels, the IRS asserted, and the tax court upheld, that the taxpayer failed to meet the “substantially all” test, it failed to properly apply the “shrink back” provisions, and it failed to provide contemporaneous documentation to sufficiently substantiate its R&D credits.

Ultimately, the appellate court upheld the rejection of Little Sandy’s claim for the R&D tax credit just as the IRS and lower court did, but primarily due to a failure to properly document the activities that it claimed qualified for the credit.

“Substantially all” and the process of experimentation for R&D tax credit

While the appellate court upheld the denial of the credit, it went on to reject the tax court’s conclusion that direct support and direct supervision of qualified research are categorically excluded from the process of experimentation, a position widely asserted by the IRS during recent examinations of R&D credits. Instead, the opinion indicates that these activities must be analyzed and — if they constitute elements of a process of experimentation — then direct support and direct supervision of qualified research should be included in both the numerator and denominator of the fraction used to apply the “substantially all” test.

One component of qualifying for the credit, according to IRC Section 41(d)(1)(C), is that “substantially all of the research activities must constitute elements of a process of experimentation,” and Section 1.41-4(a)(6) further explains that taxpayers must show that “research activities that constitute elements of a process of experimentation” (the numerator) constitute at least 80% of “research activities” (the denominator).

In the Little Sandy Coal case, the taxpayer claimed that wages and costs associated with activities performed in direct support and direct supervision of qualified research activities should be counted in both the numerator and denominator of the fraction when calculating if the 80% test was met. The tax court ruled that these amounts should be considered “research activities” and included in the denominator, but that direct support and direct supervision lacked sufficient connection to a process of experimentation to be included in the numerator.

The Court of Appeals noted that this would make a taxpayer’s ability to pass the “substantially all” test dependent on how expensive a pilot model would be. The higher court ruled that costs associated with direct support and direct supervision of research activities qualify for inclusion in both the numerator and denominator of the 80% calculation, as long as the costs in question qualify as “research expenses” deductible under Section 174 of the Internal Revenue Code.

The higher court ruled that costs associated with direct support and direct supervision of research activities qualify for inclusion in both the numerator and denominator.

Documentation and the R&D tax credit

An important lesson to be learned from the Little Sandy Coal case is the significance of documentation when presenting an R&D tax credit claim to the IRS. The taxpayer in this case made numerous claims about test procedures, pilot models, subcomponents, and time allocations but failed to retain sufficient records to show how it met the criteria of IRC Section 41.

For instance, Little Sandy claimed that certain components of the pilot models would improve the function, performance, reliability, and quality of the boats, such as a stern notch and towing bridle on a tanker and an outboard side plate on the dry dock. But the company’s documentation failed to break out the specific costs of the research expenses directly allocable to these improvements, as is required by the shrink back provision in Sec. 1.41-4(b)(2). They took what observers have termed an “all-or-nothing” approach in saying that the overall improvements to the vessels met the requirements of the credit claim. Had Little Sandy documented costs more carefully and tracked them to different subcomponents of the vessels developed, it seems they might have been able to salvage at least some of the R&D tax credit claim.

Getting the most for R&D spending

As the Little Sandy Coal case demonstrates, taxpayers that claim the R&D tax credit need to meet both the requirements of the law and the exacting standards of documentation expected by the IRS. A system of contemporaneous recordkeeping, including notes, test results, time-tracking data, cost data, and evidence of technological uncertainty or scientific experimentation, is a critical component to substantiating a claim for the credit.

To learn more about how your business might qualify for the R&D tax credit and to effectively support a claim, please contact your Plante Moran advisor.