Key takeaways from little sandy coal R&D tax credit appeal

The U.S. Court of Appeals for the Seventh Circuit issued its opinion in Little sandy coal company, Inc. V. Commissioner of internal revenue on March 7, 2023.

The decision reads, in part, “We disagree with some aspects of the tax court's reasoning, but ultimately, Taxpayer claimed more tax credit than it could prove.”

Although the appeals court affirmed the tax court’s decision in favor of the IRS, the case can be generally viewed as more favorable to taxpayers in terms of the appeals court’s evaluation of the substantially all rule contained in Internal Revenue Code (IRC) Section 41(d)(1)(C).

Background

Little Sandy Coal Company, the taxpayer, claimed IRC Section 41 research tax credits for the design and construction of 11 first-in-class vessels during its tax year ended June 2014. Upon review, the IRS disallowed the tax credits and the taxpayer subsequently petitioned for redetermination by the U.S. Tax Court.

For the tax court trial, the parties agreed to review two of the vessels as representatives for the relevant issues: tanker and dry dock.

The tax court held, in part, that providing services in direct supervision or support of research isn’t engaged in research and thus such activities cannot constitute elements of a process of experimentation for purposes of the substantially all rule.

Further, the tax court held that because Little Sandy Coal didn’t meet its burden of proving substantially all its research activities constituted elements of a process of experimentation, none of the expenses incurred were qualified research expenses.

While the appeals court affirmed the ultimate decision noting the taxpayer “failed to provide a principled way to determine the portion of employee activities that constituted elements of a process of experimentation,” it disagreed with the tax court’s holding that direct supervision and support of research couldn’t constitute elements of a process of experimentation.

Key takeaways

The following outlines key takeaways for businesses.

The regulation further provides that if at least 80% of the research activities constitute elements of a process of experimentation for a purpose described in IRC Section 41(d)(3), the substantially all requirement is satisfied even if the remaining 20% or less don’t constitute elements of a process of experimentation for a purpose described in IRC Section 41(d)(3), so long as these remaining research activities satisfy the requirements of IRC Section 41(d)(1)(A) — relating to IRC Section 174 — and aren’t otherwise excluded under IRC Section 41(d)(4).

The substantially all fraction

Importantly, the appeals court emphasized the word elements in the numerator of the substantially all computation and stated “the numerator is broad enough to encompass research activities that are not per se experimentation or testing.”

The appeals court provides that the correct approach in determining substantially all is such that “direct support and supervision activities should be considered in both the numerator and denominator of the fraction,” thereby rejecting the tax court’s categorical exclusion of direct support and supervision from the numerator.

The appeals court points to examples in the regulations to illustrate that the production of prototypes or pilot models, and the associated expenses, can be included in the substantially all numerator.

While demonstrating nexus for the activities performed on a given project is still a critical component that should be documented, as was illustrated throughout the case, taxpayers can include direct supervision and support as elements of a process of experimentation in the numerator when determining if a particular business component meets the substantially all requirement for qualified research.

Use of pilot models in a process of experimentation

The appeals court underscored the requirement that pilot models be used in the process of experimentation. The court explained merely making a pilot model isn’t enough to pass the process of experimentation test; such model must be used to evaluate one or more alternatives using a scientific method.