Tax Court decision addresses key research credit issues

Overview

The US Tax Court recently held that a taxpayer was not entitled to Section 41 research credits for activities conducted by its shipbuilding subsidiary regarding development of a tanker and dry dock (Little Sandy Coal Co. Inc. v. Commissioner, T.C. Memo. 2021-15). In a 61-page opinion, the court found that the subsidiary did not perform ‘qualified research’ as defined in Section 41(d) and that ‘the includible amount of QREs for each of the Apex tanker and the dry dock pursuant to section 41(a) and (b) [therefore] was zero.’

More specifically, the Tax Court held that:

• The requirement that at least 80% of a taxpayer's research must constitute elements of a process of experimentation (the ‘substantially all’ test) applies to activities and not to physical components of the product being developed or improved. Therefore, said the court, the test is not met simply because at least 80% of the product's elements differ from those of products the taxpayer previously had developed.
• A person who provides services in direct supervision or support of research is not ‘engaged in’ research, so the activities of such a person cannot ‘constitute elements of a process of experimentation’ (POE) for purposes of the substantially all test.
• Because supplies are not activities, when the fraction described in the regulations explaining the substantially all test is computed using costs as a measure of activities, the costs of supplies used in the development of the product are not taken into account.

The takeaway

The research credit regulations highlight specific elements for administration of the credit. They acknowledge with respect to documentation that “the high degree of variability in the objectives and conduct of research activities in the United States compels a conclusion that taxpayers must be provided reasonable flexibility in the manner in which they substantiate their research credits.” 

While no specific examples of documentation are discussed in Section 41 or Section 6001, the final regulations highlight that as long as records are sufficiently detailed and in usable form, they cannot serve as a basis for denying the credit. In this case, it appears the taxpayer may have sought to make sufficient efforts to demonstrate that qualified research was performed, but the court did not accept the taxpayer’s position. 

Taxpayers need to set forth the facts of their development efforts, identify the experimentation process, and gather the documentation to support their projects and POE in accordance with Section 41 and the related regulations.

Taxpayers also should consider shrinking back activities to the component parts that qualify and providing sufficient documentation to support the performance of each required element of a POE with respect to such components. Taxpayers should identify whether they are going ‘all in’ or using a shrinkback method to quantify QREs and accumulate and present the appropriate documentation as support. Taxpayers must build an appropriate strategy, based on their facts, to identify, qualify, and document QREs. 

Finally, taxpayers should evaluate the holdings of cases such as Little Sandy Coal against their own facts.